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Split-Dollar Insurance: December 31, 2003 Deadline Looms

Taxpayers with “split-dollar” life insurance arrangements face a December 31, 2003 deadline for deciding whether to continue the arrangement. The deadline is part of a new set of rules the IRS has enacted to control the tax results of split-dollar arrangements.

What is a “Split-Dollar” arrangement?

“Split-dollar” is not a kind of life insurance. “Split-dollar” policies are conventional life insurance policies in which the ownership is divided between two parties. While intra-family split-dollar arrangements exist, most split-dollar arrangements are part of an executive benefit package. In a typical split-dollar policy, an employer pays some or all of the premiums on an employee, retaining the right to recover the premiums, or some other amount, out of policy proceeds. The employee is entitled to the remaining policy proceeds.

Policy ownership is divided using either a “collateral assignment” of the policy or an “endorsement” of policy rights.

In a “collateral assignment,” the employee owns the policy, but assigns it to the employer as collateral for the employer’s rights to a portion of the policy proceeds. An “endorsement” policy is owned by the employer, who assigns the proceeds beyond its interest in the policy to the employee, or to a beneficiary of the employee.

What is “Equity” Split-Dollar, and why was it popular?

In “equity” split-dollar arrangements, the employer recovers only the amount of premiums paid. The employee gets the remaining death benefit and the buildup of cash surrender value when it exceeds the premiums paid. When the cash value exceeds the premiums paid, the employee is said to have “equity” in the policy. In most cases, the employee only reported the value of term life insurance coverage in income; no tax was paid as the employee “equity” in policy values increased.

What is the December 31 deadline all about?

There is a one-time grace period that ends December 31 that applies to split dollar arrangements that were in place on January 28, 2002. Taxpayers with equity split-dollar plans – these will normally be “collateral assignment” arrangements – can either terminate the arrangement or convert it into a loan by December 31. The employee will permanently avoid tax on the existing equity in the policy as long as the policy remains in place.

If the arrangement is treated as a loan, its treatment depends on whether the loan bears interest under the tax law. If the loan is interest-free, the tax law imputed interest rules will cause the taxpayer to have imputed compensation based on the loan interest. This imputed interest will be treated as salary to the employee (and salary expense to the employer), and interest income to the employer and (non-deductible) interest expense to the employee.

If an interest-free loan is used, it can run until the death of the insured, or it can be a demand loan (or annually-renewed one-year loan). If it is a term loan, a quirk in the tax law will require all compensation for the remaining loan term – deemed to be the insured’s life expectancy – to be income in the year the loan is made; this will generally be 2004 for split-dollar arrangements. Income on interest free demand loans, by contrast, is imputed in smaller amounts, determined each year.

If a conventional interest-bearing loan is used, no special tax treatment comes into play.

The options need to be examined for each policy. What follows is a summary of the most common options.

Terminate the arrangement. For equity split-dollar arrangements that were in effect before January 28, 2002, taxpayers have until December 31, 2003 to terminate the arrangement and distribute the policy to the employee without the employee being taxed on their existing policy equity.

Pros:

· No tax is ever paid on employee equity to date while the policy remains in place.

· Existing equity can be borrowed out tax-free.

Cons:

· Employees will be taxed on any premium reimbursement rights that are forgiven (usually this means premiums paid to date). This can sometimes be avoided by assigning the entire policy to the employer.

· If the policy remains in place and remaining equity is not sufficient to pay future premiums, the employee will have to pay them, unless the employer is willing to increase salary to cover their cost.

This option may be attractive: for old policies with sufficient equity to pay remaining premiums and /or the accumulated premium liability.

Convert the arrangement into an interest-bearing loan. Taxpayers with equity arrangements that were in place before January 28, 2002 can agree to treat the arrangements as an interest-bearing loan in the amount that the employer is entitled to recover. This treatment must apply consistently for all periods after 2003. Once the arrangement becomes a loan, the employee is no longer be taxed on the value of the term coverage. Additional premiums paid become additional loans.

Pros:

· No current income tax results.

· Equity is never taxed.

· The employee is free to withdraw cash value from the policy.

Cons:

· The loan increases over time, potentially burdening the estate.

This option may be attractive: For existing policies with insufficient equity to cover future premiums, or for policies that may soon develop equity.

Convert the arrangement into an interest-free loan.

Pros:

· Equity is never taxed .

· The employee is free to withdraw cash value from the policy.

Cons:

· The loan increases over time, potentially burdening the estate.

· If the loan term is the life of the insured, there is a potentially large income item in the year the loan is taken out.

· If the loan is a demand loan, the taxpayer assumes interest rate risk in future years.

· If the loan is a demand loan, the taxpayer is at the mercy of the employer’s willingness to maintain the loan.

This option may be attractive: For existing policies with insufficient equity to cover future premiums, or for policies that may soon develop equity.

Do nothing. Taxpayers with equity arrangements that were in place before January 28, 2002 may take no action and continue to be taxed on the term values of their policies.

Pros:

· The employee can continue to use the insurance company term rates to value the insurance benefit included in income.

· No other taxable income results if the employee does not tap policy equity before death.

· If there is no equity in the policy, taxpayers may be able to convert the arrangements to loans before the policy becomes taxable.

Cons:

· Any future equity withdrawals will probably be taxable.

· As the insured ages, the annual term amount included in income can get uncomfortably large.

· The IRS refuses to provide assurance that future conversions to loans can be accomplished tax-free.

This option may be attractive: for polices which are not likely to have employee equity anytime soon.

For Newer Arrangements:

New rules apply to arrangements put in place after January 28, 2002. Taxpayers should consult their tax advisors regarding these arrangements.

Fight or Switch?

Some taxpayers feel the new rules are invalid and intend to fight them. We think it prudent to assume the rules will remain in place and to proceed accordingly.

Summary

Taxpayers with split-dollar arrangements need to review them before year-end. The rules are complex – much more complex than covered in this letter – and their application depends largely on the details of each arrangement. Working with their tax and insurance advisors, taxpayers should evaluate their arrangements and the need to act before December 31.

Please call Joe Kristan, Jay Anderson, or your Roth & Company tax advisor for further information.