Taxation of equity split-dollar arrangements.

• Author: Elinsky, Peter I.

Gross Income

The IRS recently ruled in Letter Ruling (TAM) 9604001 that a taxpayer who enters into a split-dollar life insurance arrangement "must include in income each year that the arrangement is in force...any cash surrender buildup in the policies that exceeds the amount that is returnable to [the corporation that paid the insurance premiums] when the arrangement is discontinued." The Service's position for taxing this excess cash surrender value appears to be based on Sec. 83.

Because many split-dollar arrangements are structured such that the insured-employee is entitled to any cash surrender value in the underlying policy that exceeds the amount of the employer's cumulative premium payments on such policy (hereinafter referred to as "equity split-dollar arrangements"), the IRS's conclusion in TAM 9604001 has significant ramifications for many taxpayers. Although a TAM applies only to the taxpayer for whom it was issued, it nevertheless constitutes authority in determining whether there is substantial authority for not reporting the excess cash surrender value of a life insurance policy owned under an equity split-dollar arrangement as income.

Fortunately, however, there appear to be at least two return filing positions under current law for not taxing the excess cash surrender value under a typical collateral assignment equity split-dollar arrangement.

TAM 9604001

In TAM 9604001, an employer, two insurance companies and a trust entered into the following transaction: The employer paid the insurance companies for two paid-up $500,000 life insurance policies on an employee's life; the insurance companies issued the life insurance policies to the trust as owner of the policies; the trust entered into a split-dollar: agreement with the employer; and the trust assigned the policies to the employer as collateral for the trust's obligation under the split-dollar agreements to repay the premiums paid to each insurance company.

Under the terms of the split-dollar agreements, the trust continues as the policies' owner and designated beneficiary of the policy proceeds. In addition, the trustees possess all incidents of ownership in the policies. The agreements further provide that the employer has an unqualified right to receive a portion of the death benefits equal to the total amount of the premiums paid, and that no amount will be paid from the death benefit proceeds to the policies' beneficiary until the full amount due the employer has been paid.

The agreements may be terminated for various reasons, including: []Bankruptcy or cessation of the employer's operations. []Termination of the employee's employment agreement. []Written notice by the trust or the employee.

If the agreements are terminated before the employee's death, the trust must reimburse the employer before the collateral will be returned to the trust. If the policies are canceled or surrendered, the employer is to be reimbursed from the cash surrender proceeds.

The insurance documents indicate that the policies' cash surrender value will exceed the premiums paid in the fourth year of the policies' existence. The split-dollar and collateral assignment agreements also provide that (1) any dividends on the policies are applied to purchase paid-up additional insurance on the employee's life, and (2) the trust may borrow from the policies or pledge or assign them, but only to the extent that a policy's cash surrender value exceeds the premiums paid by the employer.

IRS Position

The Service's conclusion in TAM 9604001, that the excess cash surrender value in an equity split-dollar arrangement between an employer and employee is taxable income to the employee, appears to be based on a theory...