Is split-dollar life insurance still a fringe benefit?

• Author: Swanson, Robert D.

Split-dollar life insurance (SDLI) is a method of dividing the economic benefits and burdens of life insurance between a company and an employee, allowing the company to subsidize the employee's coverage. As this article explains, SDLI raises income, estate and gift tax and imputed interest issues; further, a recent IRS ruling may serve to curtail its popularity.

A fringe benefit still available to business owners and key personnel is split-dollar life insurance (SDLI), an arrangement in which an employee and employer share the costs and benefits of a cash value life insurance policy, Often, the employer pays the total premium (or pays an amount equal to the annual increase in the cash surrender value (CSV) of the policy), and the employee pays the balance of the premium (if any). The employee is treated as receiving income of the excess of the value of the insurance protection received over the premiums he paid. If the employee dies or the policy is terminated, the employer receives some (or all) of die policy's CSV and the employee's estate, trust or heirs receive the balance of the payout. SDLI arrangements may be used with any type of permanent life insurance.

In Rev. Rul. 55-713,(1) the IRS held that an SDLI arrangement provided an interest-free loan to the employee (and, hence, taxable income) equal to the annual increases in the policy's CSV Subsequently, in Dean,(2) the Tax Court held that the interest-free loan did not result in taxable income to a controlling shareholder-employee. In response, Rev. Rul 64-328(3) held that an employee had a taxable economic benefit of the value of the insurance protection received in excess of the premiums paid by him; this ruling continues to be the basis for tax law in this area.

This article will explain SDLI and consider various related issues. Recent letter rulings involving SDLI for S corporation shareholders and employees will be reviewed. While these rulings pertain to S corporations, they provide insight as to how to keep policy proceeds out of the insured's estate.

SDLI Mechanics

The effect of the Tax Reform Act of 1986, the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconciliation Act of 1993 and the Small Business job Protection Act of 1996 on qualified retirement plans, welfare benefit plans and nonqualified deferred compensation plans has enhanced the benefit of SDLI arrangements. Because SDLI arrangements are nonqualified, a corporation can discriminate as to the person(s) covered. From the insured's standpoint, an SDLI arrangement is advantageous; it is less expensive than personally owned life insurance.

In Rev. Rul. 64-328, the IRS ruled that an SDLI agreement between an employee and employer resulted in income to the employee based on the "economic benefit" conferred by the plan. The IRS valued the benefit using the P.S. 58 costs, but later ruled that the insurer's lowest yearly renewable standard term rates could be used.(4) The IRS later ruled that when an SDLI plan involves a second-to-die life insurance policy the cost of one-year term insurance may be based on the rates in joint-life Table 38, U.S. Life Tables and Actuarial Tables rates.(5) Either of these costs is much less than the cost of whole life insurance,

Example 1: A controlling shareholder J, age 45, wants to provide sufficient insurance to pay his estate taxes. He enters into an agreement with Y corporation to provide him with $1,000,000 of life insurance. The premium on this policy is $21,525, which is paid by Y The cost to age 65 based on the insurer's rates is lower than the P.S. 58 rates; thus, the former is used and results in $28,595 of taxable income to J. If J's marginal tax rate is approximately 40%, the cost of this insurance would be $11,438 over 20 years, which is very low given the amount of protection provided.(6)

From an employer's standpoint, SDLI can offer a valuable fringe benefit at annual cost. On the insured's death or on earlier termination of the policy, the employer will have its premiums returned. Because the premiums will be returned, they are not deductible, according to Rev. Rul. 64-328; thus, the cost to the company is the loss of the use of the funds used to pay the premiums.

Premium Splitting

There are numerous ways to split premiums in an SDLI arrangement. In most cases, the employer pays all the premiums and the insured is treated as receiving taxable income. In a "classical split," the employer pays a premium equal to the annual increase in the policy's CSV; the employee pays the balance. In another arrangement, the "P.S. 58 offset" or "contribution" split, the employee contributes the cost to buy a one-year term policy of equivalent coverage; the employer pays the balance of the premium. There are many variations on these approaches.

The split of CSV and death benefits when an insured employee dies is usually determined by the employer's interest in the arrangement. The share of the employer's split can be a return of premiums paid, the policy's CSV at the date of death, or the greater of the two. The employee's estate, trust or heirs receive the balance of the payout.

Policy Ownership

The two traditional SDLI structures are the "endorsement" and the "collateral assignment" methods. Two other techniques are the "undocumented" and the "contractual" methods.

Under the collateral assignment method, the policy is owned by the insured or a third party (e.g., an irrevocable trust).The employer's interest in the policy (e.g., its right to recover premium payments) is contained in a collateral assignment of the policy by the owner. The rights assigned to the employer vary considerably, from virtually all rights in the policy to a "bare bones" collateral assignment.

With the endorsement method, the employer owns the policy, and the employee's rights are contained in an endorsement filed with the insurer. In a traditional endorsement policy, the employee's sole right would be to Dame the beneficiary of the death proceeds in excess of the employer's interest in such proceeds. This method is most often used when the employer wants to maintain control of the policy.

Under the undocumented method, the policy is not used to protect the employer's advances; rather, that is accomplished through a contractual arrangement with the employee. This approach may provide greater certainty in the estate tax area for majority shareholders; because the employer does not have an ownership interest in the policy, there should be no incidents of ownership attributable from the corporation to the controlling shareholder. Care must be taken to ensure the shareholder does not have other incidents of policy ownership.

With the "co-ownership" method (sometimes termed "split ownership") the employee or other owner directly owns a share of the policy's CSV; therefore, there is no transfer of those values from the employer. Such arrangements must be structured to prevent the employer from canceling or surrendering the policy; otherwise, the employee's position may be illusory.

A New Threat?

In Letter Ruling (TAM) 9604001,(7) the Service took a position on the income and gift tax treatment of SDLI that appears inconsistent with the regulations and prior rulings. The taxpayer in the TAM was chairman, chief executive officer and 51% owner of a holding company that owned 98% of a subsidiary. In 1991, the subsidiary, two insurance companies and a life insurance trust entered into the following transactions: (1) the subsidiary paid each of the insurance companies for two paid-up life insurance policies on the taxpayers life; (2) the companies issued the policies to the trust as owner of the policies; (3) the trust entered into SDLI agreements with the subsidiary; and (4) the trust assigned the policies to the subsidiary as collateral for the trust's obligation under the arrangements to repay the premiums the subsidiary had paid to each insurance company.

The SDLI agreements provided that if the subsidiary became bankrupt or if the taxpayer's employment terminated prior to his death, the trust would be required to reimburse the subsidiary for the premiums it had paid. If the policies were canceled or surrendered, the subsidiary would be reimbursed from the cash surrender proceeds. The trust, as owner of the policies, could borrow from them or pledge or assign them to the extent a policy's CSV exceeded the premiums paid by the subsidiary. Dividends on the policies were to be used to purchase additional paid-up insurance on the taxpayer's life.

The Service ruled that, even though...