4027 / What are the income tax results of a split dollar plan entered into before September 18, 2003?

Split dollar arrangements that were entered into before September 18, 2003, are governed by various rulings and other guidance that were issued by the IRS between 1964 and the issuance of final regulations on split dollar arrangements in 2003. This guidance includes Notice 2002-8,¹ which provides transition rules for arrangements not subject to split dollar regulations. No inference is to be drawn, however, from Notice 2002-8 or the proposed or final regulations regarding the appropriate tax treatment of split dollar arrangements entered into before
September 18, 2003.

For the treatment of split dollar arrangements entered into after September 17, 2003, see Q 4023 and Q 4024.

Notice 2002-8

For split dollar arrangements entered into before September 18, 2003:

(1)  The IRS will not treat an employer as having made a transfer of a portion of the cash value of a life policy to an employee for purposes of Section 83 solely because the interest or other earnings credited to the cash value of the policy cause the cash value to exceed the portion payable to an employer;

(2)  Where the value of current life insurance protection is treated as an economic benefit provided by an employer to an employee, the IRS will not treat the arrangement as having been terminated, and thus will not assert that there has been a transfer of property to the employee by reason of termination of the arrangement, as long as the parties to the arrangement continue to treat and report the value of the life insurance protection as an economic benefit provided to the employee. This treatment will be accepted without regard to the level of the remaining economic interest that the employer has in the life insurance contract; and

(3)  The parties to the arrangement may treat premium or other payments by an employer as loans. The IRS will not challenge reasonable efforts to comply with the rules regarding original issue discount and below-market loans. All payments by an employer from the beginning of the arrangement, reduced by any repayments to the employer, before the first taxable year in which payments are treated as loans for tax purposes must be treated as loans entered into at the beginning of the first year in which payments are treated as loans.

For split dollar arrangements entered into before January 28, 2002, under which an employer has made premium or other payments under the arrangement and has received or is entitled to receive full repayment, the IRS will not assert that there has been a taxable transfer of property to an employee on termination of the arrangement if (1) the arrangement is terminated before January 1, 2004, or (2) for all periods beginning on or after January 1, 2004, all payments by an employer from the beginning of the arrangement, reduced by any repayments to the employer, are treated as loans for tax purposes and the parties to the arrangement report the tax treatment in a manner consistent with this loan treatment, including the rules for original issue discount and below-market loans. Any payments by an employer before the first taxable year in which payments are treated as loans for tax purposes must be treated as loans entered into at the beginning of the first year in which payments are treated as loans.

Notice 2001-10

Notice 2001-10 was revoked by Notice 2002-8. For split dollar arrangements entered into before September 18, 2003, taxpayers may rely on the guidance contained in Notice 2001-10. Under Notice 2001-10, the IRS generally will accept the parties’ characterization of an employer’s payments under a split dollar plan, provided that:

(1)  the characterization is not clearly inconsistent with the substance of the arrangement;

(2)  the characterization has been consistently followed by the parties from the inception of the agreement; and

(3)  the parties fully account for all economic benefits conferred on the employee in a manner consistent with that characterization.²

Under Notice 2001-10, there are three different ways that a split dollar plan may be characterized.

First, a plan can be characterized as a loan subject to the below market loan rules.

Second, a plan can be characterized so as to be governed under the traditional split dollar rules of Revenue Ruling 64-328.³

Finally, a plan can be characterized in such a way so that the employer’s payments are treated as compensation.

Value of Economic Benefit

The employee is taxed on the value of the economic benefit he or she receives from his or her employer’s participation in the split dollar arrangement.⁴ One of the benefits an employee receives is current life insurance protection under the basic policy. The value of this benefit to an employee may be calculated by using government premium rates. For many years, P.S. 58 rates were used to calculate the value of the protection,⁵ but the IRS revoked Revenue Ruling 55-747 and provided new Table 2001 rates. P.S. 58 rates generally may be used prior to 2002; Table 2001 rates generally may be used starting in 2001.⁶ Notice 2002-8 provides for some grandfathering of P.S. 58 rates. For split dollar arrangements entered into before January 28, 2002, in which a contractual agreement between an employer and employee provides that P.S. 58 rates will be used to determine the value of current life insurance protection provided to an employee or to an employee and one or more additional persons, the employer and employee may continue to use P.S. 58 rates.⁷

If an insurer publishes rates for individual, initial issue, one year term policies (available to all standard risks) and these rates are lower than the P.S. 58 or Table 2001 rates, as applicable, these insurer rates may be substituted.⁸ Only standard rates may be substituted, not preferred rates (such as those offered to non-smoking individuals).⁹ The substituted rate must be a rate charged for initial issue insurance and must be available to all standard risks.¹⁰

For arrangements entered into before September 18, 2003, taxpayers may use an insurer’s lower published premium rates available to all standard risks for initial issue one year term insurance. For arrangements entered into after January 28, 2002, and before September 18, 2003, for periods after December 31, 2003, however, an insurer’s rates may not be used unless (1) the insurer generally makes the availability of the rates known to those who apply for term insurance coverage from the insurer, and (2) the insurer regularly sells term insurance at those rates to individuals who apply for term insurance coverage through the insurer’s normal distribution channels.¹¹

The IRS has said that taxpayers should make appropriate adjustments to premium rates if life insurance protection covers more than one life.¹² Where a policy death benefit is payable at the second death, rates for single lives should be used to measure the survivor’s economic benefit.

Employer’s Premiums Nondeductible

An employer cannot take a business expense deduction for its share of the annual premium because the employer is a beneficiary under the policy, within the meaning of IRC
Section 264(a)(1).¹³ Moreover, it appears that an employer cannot deduct the value of the economic benefit, that is, the Table 2001 or P.S. 58 cost that is taxable to an employee because the employer has not paid or incurred any expense other than nondeductible premium expense.¹⁴

Death Proceeds

On the death of an employee, both the portion of the proceeds received by the employer and the portion of the proceeds received by the employee’s beneficiary are ordinarily exempt from federal income tax under IRC Section 101(a) as life insurance proceeds received by reason of the insured’s death.¹⁵ Death proceeds of split dollar life insurance payable to a corporation may affect the calculation of the alternative minimum tax ( Q 316).

Stockholder-Employees

Although the issue was not litigated, the IRS treated the P.S. 58 benefit of a substantial stockholder-employee as a dividend in Johnson v. Commissioner.¹⁶ The IRS already had ruled that in the case of a split dollar arrangement between a nonemployee stockholder and the corporation, the economic benefit flowing from the corporation to the insured stockholder is taxed as a corporate distribution or dividend.¹⁷