As of September 17, 2003, the Internal Revenue Service (IRS) and the Department of the Treasury jointly issued new regulations governing the taxation of split dollar life insurance arrangements. These new regulations radically revise the taxation of these arrangements.
The regulations define a split dollar arrangement (SDA) as any arrangement between an owner and a non-owner of a life insurance contract under which:
This definition and the new regulations apply for purposes of federal income, employment, self-employment, and gift taxation of SDAs entered into or materially modified after September 17, 2003.
While there may be as many varieties of SDAs as there are financial professionals designing them, they are generally classifiable as either endorsement SDAs or collateral assignment SDAs.
Generally, under an endorsement SDA, the owner of the life insurance contract endorses to the insured non-owner the right to name the beneficiary of the death benefits of the policy. The owner of the policy also makes some or all of the premium payments. As stipulated by the agreement governing the SDA, the owner will be reimbursed for these payments either from the cash value of the policy (upon termination of the agreement) or from a portion of the death benefits (upon the death of the non-owner).
The agreement governing the SDA also stipulates whether the non-owner will be entitled to any policy equity, which is any portion of the cash value in excess of the amount reserved under the agreement to repay the premium payments made by the owner. If the non-owner is entitled to the policy’s equity, the arrangement is known as an equity SDA.
Under a collateral assignment SDA, the insured party is the owner of the life insurance contract, while the non-owner pays all or part of the premium. These premium payments made by the non-owner are considered to be loans to the owner. As stipulated by the agreement governing the SDA, the owner agrees to assign an interest in the life insurance contract to the non-owner as collateral securing these loans. The loans may be repaid either from the cash value of the insurance policy (upon termination of the agreement) or from a portion of the policy’s death benefits (upon the death of the owner).
Depending on how the SDA is structured, the owner may or may not retain control of the insurance contract’s equity, or the amount of cash value in excess of that reserved to repay the collateral assignment. If the owner relinquishes control of all the policy’s equity, the arrangement is known as a non-equity SDA.
The following is not a comprehensive discussion of the regulations governing the taxation of split dollar life insurance arrangements. You should consult additional resources.
For several decades, the IRS guidance governing SDA taxation generally did not address the distinctions between endorsement and collateral assignment SDAs, nor did it address the taxation of equity accumulation. For the most part, the party to the SDA who benefited from the policy’s insurance coverage was required to include in his or her taxable income the value of each year’s death benefit protection that was in excess of any premium he or she paid that year.
Generally, as long as the party to the SDA who benefited from the policy’s coverage included the value of that coverage in his or her taxable income each year, he or she was not taxed on the accruing equity accumulation to which he or she had rights.
The regulations that became effective in September 2003 define two mutually exclusive regimes for determining the tax treatment of an SDA. Ownership of the life insurance policy underlying the SDA will largely determine the regime that applies for taxation purposes.
If the owner of the policy provides economic benefits (death benefits, rights to policy equity, and/or other benefits) to the non-owner, then the SDA will be governed by the economic benefit regime, and the non-owner must include in his or her taxable income the economic value of those benefits. Thus, the economic benefit regime will govern most endorsement SDAs.
The SDA will be governed by the loan regime if the relationship between the non-owner and the owner of the insurance policy is such that:
Thus, the loan regime will generally govern most collateral assignment SDAs. A special rule, however, indicates that non-equity SDAs entered into in either a compensatory or a gift context will be governed by the economic benefit regime, whether they are collateral assignment or endorsement SDAs.
Under the economic benefit regime, the owner of the life insurance policy underlying the SDA is considered to be providing economic benefits to the insured non-owner of the policy. For tax purposes, both the owner and the non-owner must account for these benefits fully and consistently.
Under the economic benefit regime, the value of the benefits provided by the owner of the insurance contract to the non-owner, reduced by any consideration paid by the non-owner to the owner, is taxable income to the non-owner. These benefits include:
The valuation of these benefits is determined as of the last day of the non-owner’s taxable year, unless both the owner and the non-owner of the policy agree to use the policy’s anniversary date for this purpose. The amount of the policy’s cash value is determined without regard to surrender charges or other similar charges.
The concept of access by the non-owner to the cash value of the life insurance contract underlying the SDA is broadly construed. The non-owner is considered to have access to any portion of the policy’s cash value to which he or she (currently or in the future) has a right, and that is currently (indirectly or directly) accessible to the non-owner, inaccessible to the owner, or inaccessible to the owner’s creditors. A non-owner would be deemed to have access to cash value if he or she can directly or indirectly withdraw or borrow from the policy, totally or partially surrender the policy, or encumber the policy’s cash value. The non-owner would also be considered to have access to the cash value if that cash value is available to the non-owner’s creditors by attachment, garnishment, or levy and execution.
For an SDA entered into prior to September 18, 2003 (and not modified materially since), the economic value to the non-owner of the life insurance coverage may be determined in one of two ways. One way is to base the valuation on IRS Table 2001. The other is to use the insurer’s lower published premium rates that are available to all standard risks applying for initial issue one-year term insurance.
However, if the SDA was entered into after January 28, 2002, any such alternative rates used to calculate the economic value of the insurance coverage after December 31, 2003, must meet two criteria:
Under the loan regime, the non-owner is considered to be lending to the insured owner of the policy the funds to make the premium payments on the life insurance contract underlying the SDA. Each premium payment must be treated as a separate loan. Generally, these loans are expected to be repaid from either the cash value of the life insurance policy (upon termination of the SDA) or the death benefit (upon the death of the owner). The owner of the policy assigns an interest in the policy to the non-owner as collateral to secure the loans.
Generally, the (owner) borrower is expected to pay market-rate interest (based on the applicable federal rate, or AFR, set by the IRS) to the (non-owner) lender on the outstanding loan balances. If the (owner) borrower were doing so, he or she would incur no annual tax liability. The (non-owner) lender would include the interest payments received in his or her taxable income for the year. The borrower would not be able to deduct the interest he or she paid.
However, if the (owner) borrower is paying little or no interest to the (non-owner) lender (as is most often the case), then the below market loan rules apply, and the borrower must pay tax annually on the imputed interest on the loans.
Under the loan regime, the owner of the policy is not taxed directly on his or her share of the cash value equity, either during the arrangement or upon rollout (the termination of the SDA). When the SDA is terminated, the owner of the policy is expected to repay the loans made by the non-owner. The IRS has taken the position that tax-deferred inside buildup of the cash value in the policy applies only to the taxpayer who owns the policy. As a result, once the SDA is terminated, the owner could surrender the policy and be subject to income tax only on the gain on the policy. The gain is the difference between the net cash value received at surrender and the basis in the policy (the total premium paid, less any policy dividends and tax-free withdrawals).
The new regulations are a significant departure from previous IRS guidance governing the taxation of equity SDAs. In the past, the accessible cash value of the insurance policy underlying an SDA was not subject to annual taxation. Since the new regulations stipulate that all SDAs will be taxed under one of the two mutually exclusive regimes, non-owner parties to existing endorsement equity SDAs may now be subject to taxation on their accessible cash value.
In accordance with IRS Notice 2002-8, a party participating in an equity SDA entered into prior to September 18, 2003, may avoid taxation of any currently accessible equity by choosing one of the following alternatives:
This change must be made before January 1, 2004. Failure to do so could result in income taxation of the equity buildup if cash is later withdrawn from the policy or the policy is surrendered.
An individual may be participating in an equity SDA that will not have yet reached the crossover point–the point where the cash value of the policy exceeds the aggregate premium paid–as of January 1, 2004. As a result, the individual need not choose one of the above alternatives by that date. However, to avoid future taxation of any developing equity, the SDA must be unwound (terminated) prior to reaching the crossover point.
The Sarbanes-Oxley Act of 2002 makes it a criminal offense for a public company to lend money to its executives or directors. While converting an equity SDA entered into before January 28, 2002, to a loan arrangement may satisfy the IRS, an employee of a public company with access to accumulated policy equity may still wish to terminate such an SDA before January 1, 2004. Doing so will not only avoid taxation of the accessible cash value but would also circumvent any suspicion of participation in criminal activity.
Policy premiums are not deductible to either the owner or the non-owner.
If the SDA is between an employer and an employee, and the employer pays the employee a bonus to help fund his or her portion of the premium, the amount of the bonus is tax deductible for the employer but is taxed as income to the employee.
Generally, death benefit proceeds attributable to life insurance protection offered under an SDA are excludable from the income of the insured individual’s beneficiary to the extent that the insured individual has either paid for the coverage or taken its economic value into account.
A collateral assignment SDA may involve a third party, such as the covered individual’s spouse, child, or irrevocable life insurance trust. In this instance, the third party owns the insurance policy, makes the collateral assignment to the non-owner in exchange for the non-owner’s premium payments, and may (if it’s an equity SDA) have rights to cash value equity.
When a third party is the owner of the policy, that party should be the covered individual’s named beneficiary. If the third-party policyowner names another beneficiary (a three-party contract), the third-party owner would be deemed to have made a gift of the full proceeds received upon the death of the insured.
Depending on how the SDA is structured, the third-party owner may be subject to income tax on the economic benefit of the insurance coverage or on imputed interest under the below-market loan rules. Further, the covered individual may be treated as having made a gift to the third party, which is subject to gift tax.