What are the New Tax results of Split-Dollar after September 2003
What are the income tax results of a split dollar plan entered into, or materially modified, after September 17, 2003?
The tax treatment of a split dollar arrangement depends on when the arrangement is first entered into. Generally, for split dollar arrangements entered into after September 17, 2003, the taxation of the arrangement is governed by regulations that were issued in 2003. Split dollar arrangements entered into before September 18, 2003, are generally governed by revenue rulings and other guidance issued by the IRS between 1964 and the issuance of the final regulations. For a discussion of the tax treatment of split dollar arrangements not subject to the split dollar regulations, see Q 449.
For split dollar arrangements entered into after September 17, 2003, the tax treatment will be under one of two mutually exclusive regimes; the arrangement will be treated either as the life insurance policy owner providing economic benefits to the non-owner, or as the non-owner making loans to the owner. Treas. Reg. §1.61-22(b)(3). The person named on the policy as the owner is generally considered the owner of the policy. A non-owner is any person (other than the owner) having an interest in the policy (except for a life insurance company acting only as the issuer of the policy). Treas. Reg. §1.61-22(c). A split dollar arrangement will be treated as a loan if: (1) payment is made by the non-owner to the owner; (2) the payment is a loan under general principles of federal tax law or a reasonable person would expect the payment to be repaid to the non-owner; and (3) the repayment is made from, or secured by, either the policy's death benefit, cash value, or both. Treas. Reg. §1.7872-15(a)(2). Loan treatment will generally occur in a collateral assignment arrangement.
Economic Benefit Treatment
If the split dollar arrangement is not treated as a loan, the contract's owner is treated as providing economic benefits to the non-owner. Economic benefit treatment will generally occur in an endorsement arrangement. The non-owner (and the owner for gift and employment tax purposes) must take into account the full value of the economic benefits provided to the non-owner by the owner, reduced by any consideration paid by the non-owner. Depending on the relationship between the owner and the non-owner, the economic benefits may consist of compensation income, a dividend, a gift, or some other transfer under the tax code. Treas. Reg. §1.61-22(d)(1). The value of the economic benefits is equal to: (1) the cost of life insurance protection provided to the non-owner; (2) the amount of cash value the non-owner has current access to (to the extent that amounts were not taken into account in previous years); and (3) the value of other benefits provided to the non-owner. The cost of life insurance protection will be determined by a life insurance premium factor put out by the IRS. Treas. Reg. §1.61-22(d)(2)-(3). Presumably, Table 2001 will be used until the IRS issues another table. See Notice 2002-8, 2002-1 CB 398.
Under the economic benefit regime, the non-owner will not receive any investment in the contract with respect to a life insurance policy subject to a split dollar arrangement. Premiums paid by the owner will be included in the owner's investment in the contract. Also, any amount the non-owner pays toward a policy will be included in the income of the owner and increase the owner's investment in the contract. Treas. Reg. §1.61-22(f).
Death benefits paid to a beneficiary (other than the owner of the policy) by reason of the death of an insured will be excluded from income to the extent that the amount of the death benefit is allocable to current life insurance protection provided to the non-owner, the cost of which was paid by the non-owner or the benefit of which the non-owner took into account for income tax purposes. Treas. Reg. §1.61-22(f)(3).
Upon the transfer of the policy to a non-owner, the non-owner is considered to receive generally the cash value of the policy and the value of all other rights in the policy, minus any amounts paid for the policy and any benefits that were previously included in the non-owner's income. However, amounts that were previously included in income due to the value of current life insurance protection that was provided to the non-owner may not be used to reduce the amount the non-owner is considered to receive upon roll-out. Thus, the taxation on the value of current life insurance protection will not provide the non-owner with any basis in the policy, while taxation for a previous increase in cash value will add basis for the non-owner. Treas. Reg. §1.61-22(g).
Loan Treatment
If the split dollar arrangement is treated as a loan, the owner is considered the borrower, and the non-owner is considered the lender. Treas. Reg. §1.7872-15(a)(2). If the split dollar loan is a below market loan, then interest will be imputed at the applicable federal rate (AFR), with the owner and the non-owner of the policy considered to transfer imputed amounts to each other. See IRC §7872. In a split dollar arrangement between an employer and employee, the lender would be employer and the borrower the employee. Each payment under the split dollar arrangement will be treated as a separate loan. The employer is considered to transfer the imputed interest to the employee. This amount is considered taxable compensation, and generally will be deductible to the employer (however, no deduction will be allowed in a corporation-shareholder arrangement). The employee is then treated as paying the imputed interest back to the employer, which will be taxable income to the employer. This imputed interest payment by the employee will generally be considered personal interest and therefore not deductible.
The calculation of the amount of imputed interest differs depending on the type of below market loan involved. A below market loan is either a "demand loan" or a "term loan." A demand loan is a loan that is payable in full upon the demand of the lender. IRC §7872(f)(5). All other below market loans are term loans. IRC §7872(f)(6). Generally, a split dollar term loan will cause more interest to be imputed in the early years of the arrangement, with the amount of imputed interest decreasing each year. In a split dollar demand loan, the imputed interest will be smaller in the early years of the arrangement, but will increase each year the arrangement is in place.
For more information on below market loans, see Q 705.
Effective Date of Regulations
These regulations apply to split dollar arrangements entered into after September 17, 2003, and arrangements entered into on or before September 17, 2003, that are materially modified after September 17, 2003. Treas. Reg. §§1.61-22(j), 1.7872-15(n). The final regulations provide a "non-exclusive list" of changes that will not be considered material modifications. This list includes: (1) a change solely in premium payment method (for example, from monthly to quarterly); (2) a change solely of beneficiary, unless the beneficiary is a party to the arrangement; (3) a change solely in the interest rate payable on a policy loan; (4) a change solely necessary to preserve the status of the life insurance contract under Code §7702; (5) a change solely to the ministerial provisions of the life insurance contract (such as a change in the address to send premiums); and (6) a change made solely under the terms of the split dollar agreement (other than the life insurance contract) if the change is dictated by the arrangement, is non-discretionary to the parties, and was made under a binding commitment in effect on or before September 17, 2003. Treas. Reg. §1.61-22(j)(2). An exchange of policies under Code §1035 is not on the list of non-material modifications.
The final regulations also contain rules on when a split dollar arrangement is considered to be entered into. A split dollar arrangement is entered into on the latest of the following dates: (1) the date the life insurance contract is issued; (2) the effective date of the life insurance contract under the arrangement; (3) the date the first premium on the life insurance contract is paid; (4) the date the parties to the arrangement enter into an agreement with regard to the policy; or (5) the date on which the arrangement satisfies the definition of a split-dollar life insurance arrangement. Treas. Reg. §1.61-22(j) (1)(ii). ASRS, §65, ¶140.