Split Dollar Rules Compliance 7

This section of the memorandum assumes that the present scenario is subject to the final split-dollar regulations (contrary to the conclusions discussed in the part of this memorandum entitled "Split-Dollar Rules Application"). Under the final regulations, there are two mutually exclusive approaches—an economic benefit approach and a loan approach—for determining the tax treatment of split-dollar life insurance arrangements. Ownership of the life insurance contract determines which regime applies. The owner for these purposes is the party designated as such on the insurance contract. Since the LLC is the designated owner of the life insurance contract in the present scenario, but the LLC's relationship with the preferred member and the common member does not clearly fit into the categories of the regulations, it is difficult to determine how the split-dollar regulations would be applied on these facts.

Under the economic benefit regime, the owner of the life insurance contract is treated as providing economic benefits to the non-owner of the contract. The value of the economic benefits, reduced by any consideration paid by the non-owner, is treated as provided from the owner to the non-owner. If the relationship between the owner and the non-owner is that of employer and employee, the value of the economic benefits received will be taxed as a form of compensation. The employer would also account for the economic benefits as a compensation payment, and report them on the appropriate employment tax and information returns.

For these purposes, the value of the economic benefits provided by the owner to the non-owner for a taxable year is the sum of the cost of any current life insurance protection provided to the non-owner, the amount of policy cash value to which the non-owner has current access (to the extent that such amount was not taken into account for a prior taxable year), and the value of any other economic benefits provided to the non-owner.

The non-owner is considered to have current access to any portion of the policy cash value to which he has a current or future right of access, directly or indirectly, or which is inaccessible to the owner, or is inaccessible to the owner's general creditors.

Under the loan regime, a payment made pursuant to a split-dollar life insurance arrangement is a "split-dollar loan," and the owner and non-owner are treated, respectively, as borrower and lender. Three conditions (stated more fully below) must be met for loan treatment to apply: (i) The payment is made either directly or indirectly by the non-owner to the owner; (ii) the payment is a loan or a reasonable person would expect the payment to repaid in full; and (iii) the repayment is to be made from, or is secured by, the policy's death benefit proceeds or cash surrender value.

If a split-dollar loan does not provide for adequate stated interest, the loan is a below-market split-dollar loan subject to Code §7872, and Reg. §1.7872-15 in particular. As a below-market loan, the transaction will be recharacterized as a loan with interest at the applicable federal rate ("AFR"), coupled with an imputed transfer by the lender to the borrower. The timing, amount, and characterization of the imputed transfer between the lender and borrower will depend on the relationship of the parties (e.g., employer-employee), and whether the loan is a demand loan or a term loan. For example, if a split-dollar employee loan carries interest at 3% at a time when the AFR is 5%, 2% in interest is deemed to have been paid by the borrower to the lender and retransferred from the lender to the borrower as compensation.

Only certain types of loans can be considered below-market split-dollar loans. Reg. §1.7872-15(e) provides that the scope of the regulations is limited to the types of below-market loans enumerated in Code §7872(c)(1). That section refers to gift loans, compensation-related loans (directly or indirectly between an employer and a employee, or an independent contractor and a person for whom such independent contractor provides services), corporation-shareholder loans, tax avoidance loans, loans to qualified continuing care facilities, and other loans if the interest arrangements have a significant effect on a federal tax liability of the lender or the borrower.

In the present scenario, the most likely category of below-market split-dollar loan would be an indirect below-market loan between an employer and an employee, or an independent contractor and the person hiring same. As an indirect arrangement, the specific provisions of the final regulations relating to indirect split-dollar loans would be relevant. Reg. §1.7872-15(e)(2) provides that

If, based on all the facts and circumstances, including the relationship between the borrower or lender and some third person (the indirect participant), the effect of a below-market split-dollar loan is to transfer value from the lender to the indirect participant and from the indirect participant to the borrower, then the below-market split-dollar loan is restructured as two or more successive below-market loans (the deemed loans) as provided in this paragraph (e)(2)....The deemed loans are: (A) A deemed below-market split-dollar loan made by the lender to the indirect participant; and (B) A deemed below-market split-dollar loan made by the indirect participant to the borrower.

If these restructuring provisions were applied to the present facts, the probable result would be a deemed loan from EBG to the business which is the employer in the license transaction (the indirect participant), and a second loan by the business to its executive employee, deemed to be the borrower. The provisions of §7872 and the final regulations would be applied separately to each deemed loan.

If a split-dollar loan provides for sufficient interest, then, except as otherwise provided in Reg. §1.7872-15, the loan is subject to the general rules for debt instruments (including the rules for original issue discount). In general, interest on a split-dollar loan is not deductible by the borrower. Code Secs. 264 and 163(h).

In the event the present scenario were determined to be a split-dollar arrangement under the final regulations, the two possible ways the regulations could apply are: (a) EBG as the preferred member of the LLC, acting on its own behalf, or perhaps as agent of the employer in the license transaction, is the owner providing economic benefits to the non-preferred member (employee) as the non-owner of the contracts; or (b) The employer in the license transaction is treated as the borrower of a loan from EBG, and the lender of a successive loan to the non-preferred member (employee) under the indirect loan rules. In the second case, the non-preferred member would apparently be considered to be the "owner" of the life insurance and the ultimate borrower of the two-step loan. The amount of the loan would presumably be the amount of the capital contributions made by the preferred member to the LLC.

Of the two possible applications of the split-dollar regulations to the present transaction, the parties' tax treatment under the loan scenario is significantly more advantageous than the treatment that would follow from a characterization of the arrangement as a transfer of economic benefits. This is primarily because, if the non-preferred member is treated as the non-owner, he will be deemed to have received the value of the sum of the following: The cost of any current life insurance protection provided to him, the amount of policy cash value to which he has current access, and the value of any other economic benefits provided. Since a non-owner is considered to have access to policy cash value if he can, directly or indirectly, make a withdrawal from the policy, borrow from the policy, or effect a total or partial surrender of the policy, in the present scenario the non-preferred member would be deemed to have received most of the cash value of the policies owned by the LLC, in addition to the cost of life insurance protection provided to him.

Moreover, the split-dollar regulations limit the exclusion from tax of the death benefit proceeds, under Code §101(a), to the amount of death benefit proceeds attributable to life insurance protection for which the non-owner has paid (or which he has taken into account as a benefit received). To the extent a non-preferred member of the LLC has neither paid for nor taken into account the value of his current life insurance protection, death benefit proceeds paid to his estate is considered under the regulations to be a separate transfer of cash not shielded from tax by the §101(a) exclusion.

The totality of the tax consequences of characterizing its transaction as an economic benefit transaction under the split-dollar regulations makes this an extremely unattractive option.

The second possibility, a split-dollar loan, affords tax consequences much closer to the parties' expectations. To qualify for loan treatment, payments made by the non-owner (lender) to the owner (borrower) must meet the following tests:

1. The payment is made either directly or indirectly by the non-owner to the owner (including a premium payment made by the non-owner directly or indirectly to the insurance company with respect to the policy held by the owner);
2. The payment is a loan under general principles of federal tax law or, if it is not a loan under general principles of federal tax law (for example, because of the nonrecourse nature of the obligation or otherwise), a reasonable person nevertheless would expect the payment to repaid in full to the non-owner (with or without interest); and
3. The repayment is to be made from, or is secured by, the policy's death benefit proceeds, the policy's cash surrender value, or both.

Reg. §1.7872-15(a)(2)(i).

If the preferred member is deemed to be the "non-owner," then these tests are quite clearly met by the structure of the present transaction. First, the capital contributions made by the preferred member to the LLC can be considered as premium payments made by the preferred member indirectly to the insurance company, through the LLC. Second, the preferred member can certainly be considered to have a reasonable expectation of full repayment of the amount of its capital contributions. Third, under the LLC Agreement, the preferred member's right to repayment is closely tied to the death benefit under the preferred policy, as well as a portion of the death benefit under the investment policy. Thus, all three tests are met for loan treatment.

It is interesting that the regulation provisions quoted above do not require that there be an interest component stated for the loan. In fact, it is represented that the preferred return of the preferred member under the LLC Agreement includes the amount of the original contributions plus either a simple or compounded interest component at or above the AFR.

Therefore, the payments by the preferred member to the LLC can be easily characterized as split-dollar loans. Following the analysis of the regulations, the next question would be whether or not the loan made by the preferred member provides for sufficient interest. If the preferred return of the preferred member has been defined to include a compounded rate of interest at the AFR, then the loan provides for sufficient interest under the split-dollar regulations. On the other hand, if the preferred return does not include the compounded AFR rate, then, as discussed above, the loan will be recharacterized as a loan with the AFR rate of interest, coupled with an imputed re-transfer by the preferred member to the non-preferred member. It is difficult to determine how this imputed re-transfer would be characterized for tax purposes, since there is no pre-existing relationship between the preferred member and the non-preferred member. If the preferred member were deemed to be acting on behalf of the non-preferred member's employer, then the imputed re-transfer would presumably be treated as compensation to the non-preferred member.

In order to ensure that, in the event the split-dollar regulations were to be applied to the present transaction, the preferred member's payments to the LLC will be characterized as a split-dollar loan and the economic benefits regime will not apply, the intention of the parties with respect to this issue should be clearly stated in the LLC Agreement, and, if possible, on the insurance policy applications. It has been represented that these steps are being implemented.