4024 / When is a split dollar plan that was entered into or materially modified after September 17, 2003 governed by the economic benefit theory and what are the tax consequences?

If a split dollar arrangement is not treated as a loan, the contract’s owner is treated as providing economic benefits to the nonowner. For gift and employment tax purposes, the nonowner and the owner must take into account the full value of the economic benefits provided to the nonowner by the owner, reduced by any consideration paid by the nonowner. Depending on the relationship between the owner and the nonowner, the economic benefits may consist of compensation income, a dividend, a gift, or some other transfer under the IRC.¹

The value of the economic benefits is equal to:

(1)  the cost of life insurance protection provided to the nonowner;

(2)  the amount of any cash value the nonowner has current access to, to the extent that these amounts were not taken into account in previous years; and

(3)  the value of other benefits provided to the nonowner.

The cost of life insurance protection may be determined by a life insurance premium factor issued by the IRS.² Presumably, Table 2001 will be used until the IRS issues another table.³ In addition, in Notice 2002-8, the IRS found that an insurer’s renewable term rate could be used to measure the annual cost of life insurance protection if the insurer generally makes the availability of the product known to those who apply for term insurance, the insurer’s product is regularly sold through normal distribution channels, and the product otherwise meets the IRS’ previously stated requirements for such use.⁴

Under the economic benefit regime, a nonowner has no 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. Any amount the nonowner pays toward a policy will be included in the income of the owner and increase the owner’s investment in the contract.⁵

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 nonowner, the cost of which was paid by the nonowner or the benefit of which the nonowner took into account for income tax purposes.⁶

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Planning Point: In other words, failure to pay or recognize as taxable income the cost of the life insurance economic benefit can make the insurance death benefit taxable to the recipient.

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On the transfer of a policy to a nonowner, the nonowner generally is considered to receive 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 previously were included in the nonowner’s income. Amounts that were previously included in income due to the value of current life insurance protection that was provided to the nonowner may not be used to reduce the amount the nonowner is considered to receive on roll-out. Thus, the taxation on the value of current life insurance protection will not provide the nonowner with any basis in the policy, although taxation for a previous increase in cash value will add basis for the nonowner.⁷