by George G. Jones and Mark A. Luscombe
The Internal Revenue Service has finally released the long anticipated proposed regulations on split-dollar life insurance arrangements.
Taxpayers will be required to adopt one of two possible tax treatments for their split-dollar arrangement based on which taxpayer under the guidelines will be treated as the owner of the insurance policy. Until the regulations become final, however, taxpayers will be able to set up split-dollar arrangements based on current guidance.
Background
For many years, taxpayers could rely on the guidance promulgated in Rev. Rul. 64-328 and Rev. Rul. 66-110 for the tax treatment of split-dollar insurance arrangements. Under those rulings, an employee was required to treat as compensation all economic benefits provided by the employer under the arrangement without regard to whether the employer or employee was the owner of the policy.
Over time, however, the IRS became concerned that the principles of Rev. Rul. 64-328 and Rev. Rul. 66-110 were no longer adequately addressing the new twists on split-dollar arrangements. This was particularly true of so-called equity split-dollar arrangements, where the employee had an interest in the cash surrender value of the policy.
In follow-up to a TAM on the same issue, the IRS, in Notice 2001-10, departed from the economic benefit approach to split-dollar insurance to apply loan concepts to split-dollar arrangements under certain conditions involving equity split-dollar arrangements. Under the loan concept, the non-owner of the policy is treated as loaning premium payments to the owner of the policy.
Notice 2001-10 raised a lot of objections in the practitioner community and the IRS revoked it with Notice 2002-8, which permits taxpayers to continue to utilize the economic benefit principles in the taxation of split-dollar arrangements until final regulations are promulgated on the subject. Notice 2002-8 also permits taxpayers, if they so chose, to treat the premium payments under the policy as a loan.
The proposed regulations
The proposed regulations provide a much more complete definition of what constitutes a split-dollar insurance arrangement. It is defined as an arrangement (that is not part of a Code Sec. 79 group term life insurance plan) between an owner of a life insurance contract and a non-owner of the contract under which either party to the arrangement pays all or part of the premiums, and one of the parties paying the premiums is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the contract.
In the context of the performance of services, a split-dollar arrangement is any arrangement (whether or not described in the general rule above) between an owner and a non-owner of a life insurance contract under which the employer or service recipient pays, directly or indirectly, all or any portion of the premiums, and the beneficiary of all or any portion of the death benefit is designated by the employee or service provider, or is any person whom the employee or service provider would reasonably be expected to name as a beneficiary.
The proposed regulations would make the loan treatment mandatory under certain circumstances. Generally, where the employer is the owner of the policy and pays the premiums, the traditional economic benefit rules will govern the arrangement. Where the employee is the owner of the policy and pays the premiums, the loan principles will govern.
Ownership in either case is based on the person named as the policy owner. If two or more persons are named, the first-named person generally is treated as the owner, except that, if two or more persons are named and have identical rights and benefits under the policy in every respect, those persons are treated as owners of separate contracts.
Some special exceptions are provided to this rule involving situations in which the only benefits available under the split-dollar arrangement would be the value of the current life insurance protection. A non-owner is any person (other than the life insurance company itself, acting in that capacity) other than the owner having any direct or indirect interest in the policy.
Similar rules apply where the context is donor/donee or corporation/shareholder rather than employer/employee.
Under the proposed regulations the economic benefit principles can apply in both non-equity and equity split-dollar arrangements. The proposed regulations specify the tax treatment in the non-equity context but defer rules on equity treatment until comments are received in response to the proposed regulations.
In the non-equity case, the non-owner includes as compensation the amount of current life insurance protection received for the year, calculated based on the average death benefit of the policy less the amount of the benefit payable to the owner, applying the life insurance premium factor specified by the IRS.
The economic benefit principles also apply if the arrangement is entered into in connection with the performance of services and the employee or service provider is not the owner of the policy or if the arrangement is entered into between a donor and a donee and the donee is not the owner of the policy.
The loan principles will apply where the non-owner makes payments directly or indirectly to the owner; the payment can be characterized as a loan under general principles of federal tax law; and the loan is to be repaid either from the proceeds of the policy or from its cash surrender value.
Planning
The final regulations will not apply retroactively. Until the final regulations are promulgated, taxpayers may rely on the guidance in Notice 2002-8 or the proposed regulations. Given the somewhat greater flexibility afforded by Notice 2002-8, as opposed to the proposed regulations, tax practitioners may wish to discuss with their clients the merits of putting a split-dollar insurance arrangement in place prior to the finalization of these regulations.
The regulations are not likely to be finalized any earlier than the end of October of this year as a date of Oct. 23, 2002 has been set for hearings on the proposed regulations. Clients that already have split-dollar arrangements in place that were entered into before Jan. 28, 2002, also are able to use under Notice 2002-8 the more favorable P.S. 58 life insurance premium factors in Rev. Rul. 55-747 if permitted by the insurance contract.
