Split Dollar After Jan. 28, 2002Make The Most Of The Opportunity

By Randy L. Zipse

April 14, 2002 at 08:00 PM

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Those readers looking for final answers and black and white rules regarding IRS Notice 2002-8, the IRS most recent chapter on the yet unfinished topic of split dollar life insurance, can save their time and skip this article. However, those readers who want to take advantage of the moment and benefit from what I think can best be described as a short-term opportunity should read on.

On Jan. 3, 2002 the Internal Revenue Service issued Notice 2002-8, its long awaited guidance on split dollar life insurance arrangements. This guidance came as a response to the multitude of questions and complaints raised by the insurance industry after the IRS prior guidance, Notice 2001-10.

During January, I had the privilege of listening to many of the industrys leading experts express their views on Notice 2002-8 and the future of split dollar. Not surprisingly, these experts expressed a range of opinions that made it appear as if each had read a separate version of the notice.

But, despite the uncertainty caused by IRS Notice 2002-8, I could not help but think to myself that the notice wasnt really bad news. In fact, I think that there is no time like the present to talk to clients about split dollar.

I think the impact of the notice is best understood if you focus on the three distinct time periods established by the guidance. First, the notice provides a degree of grandfathering for "split dollar arrangements entered into before January 28, 2002." Second, the notice establishes a regime for split dollar arrangements entered into after Jan. 28, 2002 and "before the date of publication of final regulations." Dont even ask about arrangements dated January 28!

Third, the IRS hints at the regime that will eventually be adopted for arrangements after the date of final regulations. The notice describes what is expected to be in the "expected proposed regulations" that will be issued by Treasury. These "expected proposed regulations" promise to represent the "permanent" solution to split dollar taxation.

Although this article will touch on the first and third time periods established in the notice, the focus of the article will be on the second time period–today. What can we do now to best serve our clients?

During January, many insurance producers and tax advisors rushed to talk to their clients about split dollar. Time was of the essence as arrangements entered into before Jan. 28, 2002 were promised certain advantages that will not be available for arrangements after that date.

Perhaps the biggest touted benefit for arrangements prior to Jan. 28 is that such arrangements can continue to use the insurance companys cost of annual renewable term insurance for the duration of the arrangement.

Moreover, equity split dollar arrangements entered into before Jan. 28, 2002 can be terminated before Jan. 1, 2004 without any taxation on that portion of the cash value owned by the employer or the employers trust.

As someone who always assumed that the cash value in an equity split dollar arrangement that passed to the employee was taxable–this part of the guidance appears to be a major gift by the IRS and a major victory on the part of the Association for Advanced Life Underwriting, which lobbied hard for "grandfathering" of existing arrangements.

In summary, any agent who has clients with existing "equity" split dollar arrangements should sit down and discuss the notice with those clients well in advance of Jan. 1, 2004. Does it make the most sense to terminate the arrangement before Jan. 1, 2004 and take the cash that has accrued to the employees benefit?

Remember, in an equity split dollar arrangement we are only talking about that portion of the cash value in excess of what has been paid by the employer. Does it make more sense to reclassify the transaction as a loan and continue it past 2003?

Or, because the "low" insurance company alternative term rates have been "grandfathered" for these pre-Jan. 28, 2002 arrangements–maybe it makes the most sense to continue the arrangement past 2004 and not take advantage of the opportunity to remove this "excess" cash value. Obviously, key to this decision is the amount of policy cash value and the age of the insured.

Although some people did get their split dollar arrangements in place by the Jan. 28, 2002 deadline, many did not. That shouldnt come as a surprise to anyone. After all, the IRS chose a cut-off date that was less than a month after the release of Notice 2002-8. And, given the complexity of the notice, that time period that was hardly sufficient to open and close a split dollar case that was not already well under way before the date of the notice.

So, now what do we do for those clients who did not get their arrangements completed by Jan. 28?

In many instances, the best solution for many of your clients remains split dollar. Since we cannot turn back the clock, the best time for split dollar is now. Yes, some flexibility is gone for arrangements entered into after Jan. 28, 2002. But, the interim period after Jan. 28 and before final guidance provides many benefits that probably will not be available after final guidance is issued.

When will final guidance be issued? Since we dont know when final guidance will come, now seems to be the optimal time to act. If your client missed the Jan. 28 deadline, dont let them miss this next one.

For arrangements entered into after the Jan. 28, 2002 deadline and before final guidance (the "interim period"), the cost of term insurance can be measured by the current insurance company annual renewable term rates for the years 2002 and 2003. After 2003, the insurance company annual renewable term rates can only be used to measure the cost of term insurance provided under the split dollar arrangement if the "insurer generally makes the availability of such rates known to persons who apply for term insurance coverageand the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurers normal distribution channels."

What does that mean? I dont know and nobody else does either. Like many things with split dollar–the meaning of this new requirement will be learned in a future chapter. However, I will note that Blacks Law Dictionary (4th Edition) defines "regularly" as occurring at "fixed and certain intervals." Being concerned with my health, I get "regular" physical examinations from my doctor–every two years regardless of how I feel.

Why do I focus on this issue? Its because much has been written about this new standard. Many have hypothesized that the cost of term insurance under split dollar arrangements created during this "interim period" will be much higher than for arrangements created before Jan. 28, 2002.

However, even if the alternative term cost does increase, the cost cannot be any higher than the safe-haven rates set forth in IRS Notice 2001-10. And, based upon many of the scenarios that I have looked at, split dollar using the 2001-10 rates still has a place in many estate plans.

So, whats wrong with illustrating split dollar now with the 2001-10 rates? If the transaction makes sense with the 2001-10 rates, it will only be better if the insurance company maintains a lower alternative term rate that meets the new IRS standard. And, although I may ultimately be proven wrong, I get the feeling that many insurers intend to maintain their "low" alternative term product for use in split dollar during this "interim period."

Split dollar arrangements created during todays "interim period" can be structured as either split dollar or as a loan. After final guidance, the IRS has said that split dollar treatment can only be accorded transactions in which the employer owns the life insurance contract. In effect, the IRS is saying that endorsement split dollar will continue to exist after final guidance.

However, new arrangements cannot be structured as collateral assignment arrangements. Why is that important? For years, split dollar arrangements for controlling shareholders have been structured as collateral assignment. Some commentators dont believe that endorsement split dollar can be used without causing estate tax inclusion for insureds that own more than 50% of the stock of the corporation that owns the policy.

Its also been argued that endorsement split dollar cannot be used in private (or family) split dollar arrangements when the insured owns the policy and endorses the death benefit to an irrevocable trust or other independent entity (such as a partnership). Although Im not sure that this is the case, I am one of those who ordinarily uses collateral assignment split dollar for estate planning motivated transactions–such as controlling shareholder and private split dollar.

During this period of interim guidance I intend on continuing to use collateral assignment arrangements in such situations. What will I do after final guidance? Ill cross that bridge when I get to it. But, to me, the freedom to use collateral assignment split dollar without loan treatment is a major reason to look at split dollar during this interim period. For situations where split dollar may make sense because of gift tax concerns, now is the time to take a look at split dollar.

For arrangements entered into during this interim period, the notice seems to tell us that the "equity" (i.e., cash value in excess of employer premiums owned by the employee or the employees trust) will not be taxed to the employee as long as the value of the economic benefit is reported as taxable income by the benefited person.

Seemingly, the notice provides that no income needs to be recognized except the annual benefit of the term insurance provided. For insureds who die at or near life expectancy, split dollar will continue to provide us with the major benefit that we have always sought from such arrangements–affordable permanent insurance at term insurance rates.

Sure, for those insureds fortunate enough to live into old age, the term cost may get cost prohibitive under a split dollar arrangement. For these insureds, a conversion from split dollar to a loan may be appropriate at some point in the future.

When is conversion appropriate? Well, thats easy–when interest on the loan is less expensive than the term insurance under split dollar. To determine the exact date, the split dollar arrangement will need to be monitored each year.

Or, maybe it makes more sense and is easier for the parties to simply plan to terminate the split dollar arrangement by bonus at some point in the future. For instance, when the key employee attains age 70, the parties terminate the split dollar arrangement and the amount owed to the corporation is forgiven by the employer. In most situations, the amount forgiven will be ordinary income to the employee as reasonable compensation (and a gift if the policy is trust-owned). Ordinarily, the employer will get a deduction for the amount as compensation expense.

In summary, what doesnt exist for split dollar today that existed before Notice 2002-8? First, the potential for "free" cash value accruing to the employee in an equity arrangement. I never believed in that anyway, so I dont think that is a big deal.

Second, certainty regarding the "alternative" term rates that can be used to measure the economic benefit of the death benefit provided in the arrangement. The IRS has heightened the standard that insurance companies must use to offer "alternative" rates for split dollar. This heightened standard might raise the cost of the economic benefit.

On the other hand, insurance companies may feel that they can meet the new heightened standard without raising rates. In fact, I believe that this will be the approach taken by many companies once they consider the new standard in some detail. However, after final guidance, all evidence suggests that only IRS mandated table rates (i.e., 2001-10 rates) will be available. So, in effect, this aspect of split dollar is only likely to get worse (not better) as we get more guidance. I think those are the only things that are significantly different today than before Notice 2002-8.

In the future, things are likely to get much worse for split dollar. As already noted, it appears likely that the IRS will mandate the rate for measuring the economic benefit. Most people feel that the final guidance will not allow new transactions to use an alternative rate in any circumstance. According to Notice 2002-8, the final guidance is likely to mandate the use of loan treatment when the policy is owned by the insured or (presumably) the insureds trust. For controlling shareholders and family split dollar situations, that will not be a positive development.

In summary, I dont see the reason to wait for future guidance on split dollar. It seems pretty clear that todays environment is as good as its going to get for split dollar planning. Sure, its important to keep the arrangement flexible. Sure, its important that the insured fully understands what risks are involved in the transaction.

Yes, there are many unanswered questions. However, I think that people who wait until final guidance may be very disappointed that they didnt act earlier. If your clients missed the Jan. 28, 2002 deadline, dont let them miss the next one.

Randy L. Zipse, JD, CPA,

is senior vice president, advanced markets

Manulife Financial, in Boston.

He can be reached via e-mail at [email protected]

Reproduced from National Underwriter Life & Health/Financial Services Edition, April 15, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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