4025 / When is a split dollar plan that was entered into or materially modified after September 17, 2003 treated as a loan and what are the tax consequences?

A split dollar arrangement will be treated as a loan if:

(1)  payment is made by the non-owner to the owner;

(2)  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)  repayment is made from, or secured by, either the policy’s death benefit, cash value, or both.¹

If a split dollar arrangement is treated as a loan, the owner is considered the borrower and the non-owner is considered the lender.² If a 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.³

In a split dollar arrangement between an employer and employee, the lender is the employer and the borrower is the employee. Each payment under a 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 by the employer, although no deduction will be allowed in a corporation-shareholder arrangement. The employee then is 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 generally will be considered personal interest and therefore not deductible.

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Planning Point: If the policy is owned by a third party, such as an irrevocable trust in a collateral assignment structure, the economic benefit is treated as a gift by the employee to the trust.

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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 on the demand of the lender.⁴ All other below market loans are term loans.⁵ A split dollar term loan generally 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, imputed interest will be smaller in the early years of the arrangement but will increase each year the arrangement is in place.