Review By: R. Marshall Jones

• Notice 2001-10 significantly changes the Service's treatment of equity split-dollar plans.
• Planners should review all existing and planned split-dollar agreements and develop a strategy in light of this "interim guidance."

Historically, business entities have used split-dollar plans to provide life insurance to employees, independent contractors, directors, and shareholders, without taxing the insured on the full annual premium. Split-dollar plans frequently fund life insurance policies with a third party owner, such as an irrevocable trust. The split-dollar agreement defines each party's share of the premiums, the provisions for repayment of some or all of the premiums, and the ownership of the cash values and death benefits by each party.

When the employee owns a portion of the cash value, the plan is an "equity" split-dollar plan. In the absence of formal guidance from the Service, planners have debated for years the issue of whether and how to tax this equity, if at all.

For all split-dollar plans, Notice 2001-10 offers two options: (1) continue to use a non-loan split-dollar approach and tax any additional economic benefits under Sections 83 or 61; or (2) treat any split-dollar advances as loans governed by the below-market rate rules of Section 7872. Under the loan approach, the Service will calculate foregone interest under Section 1274 and treat it as annual compensation to the employee. However, the employee will not incur additional compensation unless he or she does not repay the loan pursuant to the agreement.

TABLE 2001 AND ALTERNATIVE RATES

Notice 2001-10 replaces the P.S. 58 rate schedule with Table 2001, which extends and interpolates the Section 79 group term rate schedule to provide individual rates from ages zero to 99. For tax years ending on or before December 31, 2001, the taxpayer may use either Table 2001 or the P.S. 58 rate. Thereafter, the taxpayer cannot use the higher P.S. 58 rates.

Until December 31, 2003, taxpayers may continue to use the Table 2001 rates or the insurer's current alternative rates, if lower. Beginning January 1, 2004, the taxpayer may use the insurance company's rates only if they satisfy three conditions:

• the company makes the rates known to everyone who applies for term insurance;
• the company uses the rates in policies regularly sold through the company's normal distribution channels; and
• the insurance company does not more commonly sell a higher premium term policy to insureds "under the definition of standard risk most commonly used by that insurer."

The Service apparently wants to tax any cash value left with the employee or the employee's trust whenever the split-dollar agreement terminates; i.e., a forgiven loan under the loan approach or any cash value not paid back under the non-loan approach. When the agreement terminates by the insured's death, this could include income tax on the portion of any death benefit associated with unreturned cash value.

The fact that Notice 2001-10 insists that plans consistently follow either the loan or non-loan approach from inception creates a significant dilemma for clients with existing plans. Since 1964, planners have operated under the Service's guidance that split-dollar advances are not loans. If existing plans change to a loan approach now, they risk losing any grandfathering. If existing plans stay with the non-loan approach, they risk income tax on the employee's net equity in the policy.

Therefore, planners must balance the desire for grandfathering with the tax risk of using or continuing with a non-loan approach after the plan's equity-crossover point-the point in time when total cash values generated by employer contributions exceed the amount the employee will repay. With all plans, it is now more important than ever to develop an appropriate exit strategy, perhaps with multiple options, if the final guidelines do not support continuing the plan as is.

A number of advisors suggest that Notice 2001-10 is wrong or hopelessly complex to administer. Commentators also argue that:

• Section 83 does not apply to split-dollar agreements when the employee owned the policy from the outset;
• there is no other basis to tax the equity in split-dollar plans; and
• Section 7872 should not apply to split-dollar plans.

The Service reasons that under Section 83, regardless of actual ownership, there is a beneficial ownership established by the employer's contributions with the non-loan approach that is "transferred" and taxable to the employee whenever there is no longer a substantial risk of forfeiture. The Service also contends that Congress never intended to exempt split-dollar plans from the application of Section 7872 in a loan context. In any event, the Service asserts that the equity in split-dollar is taxable under general tax principles that require a full accounting for all economic benefits provided.

ALL SPLIT-DOLLAR PLANS

For existing split-dollar plans and other non-loan plans, planners must recognize the equity-crossover point. Notice 2001-10 is not clear as to whether the Service will tax future vested equity increases annually as they occur or when the plan terminates. Changing from a non-loan approach to a loan approach after the equity-crossover point would probably trigger tax as a plan termination. If the client continues the non-loan plan, the eventual tax upon plan termination could be dramatically higher than the costs associated with the loan approach.

When the employee is a controlling shareholder, the loan approach may be the only way to avoid tax on the equity as it accumulates. In general, the employee can defer taxation under Section 83 as long as there is a substantial risk of forfeiture. Since the employer imposes any risk of forfeiture, there is no real risk if the controlling shareholder-employee can change it at any time.

LOANED SPLIT-DOLLAR ADVANCES

With the loan approach, the practitioner has the challenge of casting the agreement as a demand loan or a term loan. The imputed interest will then be the only income taxable each year. The key to avoiding current income tax on the loan balance is to have a consistent loan characterization and a reasonable expectation of repayment.

A loan with an indefinite maturity or a loan that the lender may call at any time is a demand loan. All other loans are term loans. With a demand loan, the rate will change each month as the Applicable Federal Rate (AFR) changes. With a term loan, the length of the note will determine the applicable rate, but the Service will normally treat each premium payment as a separate loan. With both types of loans, the administration of multiple rates or multiple loans could be complex.

PRIVATE SPLIT-DOLLAR PLANS

Private split-dollar is a general term describing split-dollar plans that do not involve a relationship like that of employer-employee. Notice 2001-10 apparently covers all types of split-dollar arrangements, even though Section 83 only applies to taxable transfers of property for services rendered. For example, Footnote 2 of the Notice says,

"For income or gift tax purposes outside of the compensation context, transfers of beneficial interests in the cash surrender value of life insurance contracts may similarly be treated as transfers of property interests in accordance with general tax principles."

When a family member advances premiums, the Service may tax the premium advances as gifts if the payor does not retain a "beneficial interest" and does not have a "reasonable expectation" of repayment. When a trust owns the policy, the economic benefit of any transferred cash value may be an imputed gift subject to gift tax with no offsetting annual exclusions.

REVERSE SPLIT-DOLLAR

In "reverse split-dollar plans," the employee owns the policy, including 100% of the cash value, and the employer pays a designated portion of the death benefit using the P.S. 58 rate to determine the term insurance cost. Notice 2001-10 expressed concern that the P.S. 58 rates allowed the employee to accumulate cash values at little or no cost by overcharging the employer for its term insurance costs. Table 2001 will dramatically reduce the benefit of using a reverse split-dollar approach.

The Service has never ruled on the income tax treatment of split-dollar arrangements that reverse the employer-employee roles described in Revenue Ruling 64-328. Future guidance may address this area in more detail.

SURVIVORSHIP SPLIT-DOLLAR

For now, the P.S. 38 rates and alternative insurance company rates for second-to-die policies will remain unchanged. The P.S. 38 rates use the U.S. Life Table 38 to do an actuarial calculation of the reduced probability that both spouses will die in the same policy year. Notice 2001-10 invites comments as to the assumptions that the Service should use in developing a second-to-die rate table.

Planners should be wary of any rush to implement new split-dollar plans with the hope of grandfathering. Planners should analyze each policy for its appropriateness assuming the unavailability of grandfathering.

Practitioners should also be wary of creative computer illustrations that purport to be a solution to avoid tax on the employee's cash value. For example, the Service has never sanctioned pre-paid P.S. 58 rate accounts. Similarly, opinion letters that claim you can avoid income tax on future cash value increases by making an early Section 83(b) election may be relying on a "transfer" that may not have occurred and may be unreasonably assuming there is no supportable basis for the Service to tax future transfers.

Assuming Notice 2001-10 provisions remain relatively unchanged in the final guidelines, the best way to leverage the employer's dollars with equity split-dollar plans may be the loan approach. Then, depending on the AFR at the time, there may be a significant spread between the income tax paid on the imputed interest income and the actual earnings on the tax-deferred cash values. In a low-interest rate environment, a contract that locks in the interest rate for future premium advances is desirable.

The non-loan approach may be preferred under certain circumstances if the final regulations do not tax the equity cash value accumulations each year; then, it would still allow the employee to accumulate cash values on a tax-deferred basis and pay income tax many years in the future.

Sample of Practice Ready ™Tools

I.R.C. §§ 61, 72, 83, 1274, 7872
Prop. Treas. Reg. §§ 1.7872-10(a)(1) and (a)(2)
Rev.Rul. 66-110, 1966-1 C.B. 12
Rev. Rul. 64-328, 1964-2 C.B. 11
Tech. Adv. Memo. 9604001
Notice 2001-10, 2001-5 I.R.B. 459

Brisendine and Scudere, IRS, Reversing Course, Issues New Interim Guidance for Split-Dollar Life Insurance, JOURNAL OF TAXATION, May 2001, at 294.

Dubitsky, Split-Dollar Split Decision, FINANCIAL PLANNING, Mar. 2001, at 67.

Esperti and Peterson, IRREVOCABLE TRUSTS: ANALYSIS WITH FORMS (Warren, Gorham & Lamont, 1998).

Jones, MAKING DECISIONS ABOUT LIFE INSURANCE (Lee Simmons Assocs. Inc. 1998).

Peckman and Lee, Notice 2001-10 Knocks Out P.S. 58: Taxation of Equity Split Dollar Still in Doubt, Trusts & Estates, Mar. 2001, at 50.

Zaritsky and Leimberg, TAX PLANNING WITH LIFE INSURANCE: ANALYSIS WITH FORMS, 2d. Ed. (Warren, Gorham & Lamont 1997).