Notice 2002-8: IRS overhauls split dollar.

• Author: Parrott, W. Michael
• Position: Life insurance plans

On January 3, 2002, the Internal Revenue Service issued Notice 2002 8, 2002-4 I.R.B. 398, ("the notice"), which represents the most significant development in the taxation of split dollar life insurance plans since 1964.

In the notice the IRS addresses two key issues that have been the subject of several controversial IRS pronouncements on split dollar plans in recent years: 1) the tax treatment of the employee's interest in the policy cash value in so-called "equity" split dollar plans; and 2) the standards used to determine the insurance company term rates that may be used to measure the value of current life insurance protection. The IRS also announces a fundamental change in the taxation of split dollar plans by prescribing two alternative theoretical approaches. The new rules are presented in the context of employment-related split dollar plans. However, the notice states that the same principles are expected to govern split dollar plans in other contexts, including gift and corporation-shareholder contexts.

Background

Beginning in 1964 with Rev. Rul. 64-328, 1964-2 C.B. 11, the IRS has treated split dollar life insurance as an employee benefit plan in which the employer's premium investment in the policy provides current life insurance protection for the employee. The annual economic benefit of the life insurance protection, measured by one-year term insurance rates, is includible in the employee's gross income to the extent that it exceeds the employee's contribution to the plan. To measure the benefit, the parties may choose between so-called "P.S.58" one-year term rates supplied by the government, or the insurer's term rates, if lower. However, the insurer's rates must be its current published gross premium rates for initial issue individual one-year term insurance made available to all standard risks. Rev. Rul. 66-110, 1966-1 C.B. 12; Rev. Rul. 67-154, 1967-1 C.B. 11. Also includible in the employee's gross income are policyholder dividends or other amounts paid in cash to the employee or used to provide the employee additional term insurance or paid-up insurance. Rev. Rul. 66-110. These principles apply to all split dollar plans for income tax purposes regardless of whether the endorsement method, the collateral assignment method, or some other form of split dollar is used. Rev. Rul. 64-328. The IRS has also held that in a split dollar arrangement where the employer provides a benefit to a third party on behalf of the employee, the economic benefit is includible in the employee's gross income, and then treated as a gift from the employee to the third party. Rev. Rul. 78-420, 1978-2 C.B. 67.

None of these rulings specifically addressed the situation that arises in "equity" split dollar plans, where the employee accrues an increasing interest in the policy's cash value. Under such plans, the employer is entitled only to reimbursement for its cumulative premium contributions, with the remainder of the policy benefits belonging to the employee or the employee's designated beneficiary. Consequently, the policy cash value, due to interest credited and other policy earnings, eventually exceeds the employer's interest. This excess is generally referred to as the employee's "equity."

Later, the IRS held in private rulings that the employee's "equity" would be includible in gross income under [section] 83 in the first taxable year in which the employee's interest became substantially vested. Priv. Ltr. Ruls. 7916029 and 8310027. See Treas. Reg. [section] 1.83-3(e). Technical Advice Memorandum 9604001 involved a split dollar plan between the employee's irrevocable life insurance trust and the employer. The IRS again applied [section] 83 and ruled that the employee was taxable annually on increases in the employee's "equity," in addition to the value of life insurance protection. Further, the IRS ruled that each year the employee made deemed gifts to his trust, for gift tax purposes, equal to the total amount includible in the employee's gross income.

Notice 2001-10

In January 2001, the IRS issued Notice 2001-10, in which the IRS provided interim guidance on "equity" split dollar, as well as on the valuation of current life insurance protection. The IRS also announced a new dual approach to the taxation of split dollar plans. The IRS retained the "traditional" approach to split dollar taxation in which it followed its line of reasoning from the private rulings and applied principles of [section] 83 to include in gross income the employee's acquisition of a substantially vested interest in the cash value (reduced by consideration paid by the employee for the cash value interest), in addition to the value of current life insurance protection. However, the IRS provided a moratorium on the taxation of the employee's cash value interest pending further study and the publication of future guidance. The IRS introduced a new alternative approach in which the split dollar plan is characterized as a series of loans by the employer to the employee, taxable under the "below market loan" rules of [section] 7872. The IRS also replaced its antiquated "P.S.58" rates with new, significantly lower term rates in "Table 2001."

Notice 2002-8

Notice 2002-8 revokes Notice 2001-10. However, the general thrust of the IRS analysis...