4029 / What are the income tax consequences of the transfer or rollout of a policy subject to a split dollar arrangement entered into before September 18, 2003?

The IRS considered this issue in two private letter rulings. In the first private letter ruling, the split dollar plan provided that the insured employee would be entitled to a portion of the life insurance policy’s cash surrender value annual increase equal to the employee’s share of the annual premium. The employee’s portion of the annual premium was determined by a payment schedule which entitled the employee to a portion of the cash surrender value of the policy. The plan’s rollout provision stated that if the employee remained employed for a specified time, the policy then would be transferred to the employee without cost. The net cash value of the policy transferred to the employee at that time would equal the employee’s cumulative premium, or if greater, the cash surrender value less the employer’s cumulative premiums.

The IRS concluded that when the policy is transferred to the employee, the employee would have taxable income to the extent the cash value in the policy exceeded the amounts the employee contributed. The IRS reasoned that the cash surrender value would be property transferred in connection with the performance of services and therefore the amount exceeding the employee’s basis, that is, the employee’s contributions, immediately would be taxable under IRC Section 83. Under IRC Section 83(h), the employer would be entitled to a deduction equal to the amount included in the employee’s income. This deduction would be offset by the employer’s recognition of a gain equal to the amount received in excess of its basis. Further, the insured employee must include in income each year the annual P.S. 58 cost of life insurance protection the employee received, to the extent paid for by the employer.¹

The employee was not entitled to use the employee’s contributions to offset the employer-provided insurance protection. The ruling does not indicate how the amount of protection provided by the employer is calculated, but it has been suggested that the calculation should be made in a manner consistent with Revenue Ruling 64-328.²

The second private letter ruling involved an endorsement arrangement in which the employer owned all the cash values but was to receive death benefits limited to its premium contributions. At the eighth policy year, the employer borrowed an amount equal to its premium contribution from the policy, leaving some amount of cash value in the policy, which then was rolled out to the employee. The IRS, once again, applied IRC Section 83 and found that in the year of the rollout the employer recognized gain in the policy to the extent the cash value exceeded its cumulative premium basis.³ The employer was entitled to an IRC Section 162 business deduction equal to the total cash value less the employee’s premium contributions. The employee likewise must include under IRC Section 83 the full amount of the policy cash value less the premiums the employee paid over the first seven years.⁴

The IRS has provided little or no guidance on the more customary split dollar plan in which an employer’s interest is limited to its aggregate premium outlay both during lifetime and at death. Under these circumstances an employer’s contractual rights to cash values are limited to the premiums it has paid, which the amount is borrowed from or withdrawn out of the policy in the year of rollout. Typically, the employee pays premiums to offset the economic benefit and contractually owns cash values in excess of the employer’s aggregate premium outlay. The 1979 ruling suggested an employee’s premium outlay could not be used to offset both the economic benefits and serve as the employee’s basis in mitigating the tax on the cash values. The 1983 ruling does not clearly respond to this issue. Neither ruling considered the policy loan in measuring the value transferred to the employee.

In Neff v Commissioner,⁵ the Tax Court looked at a case involving the termination of a pre-final regulation equity collateral assignment split dollar arrangement. Unfortunately, the case provided little guidance on most issues. The opinion did confirm that at least the amount of corporate premiums was taxable income to the employee when the employment arrangement was terminated and the collateral assignment was released. The court rejected the taxpayer argument that the compensation to the employer was limited to the present value of the premiums discounted to the insured’s life expectancy.

Although there are no IRS rulings on point, whether a policy has failed the seven pay test of IRC Section 7702A(b) and therefore is classified as a modified endowment contract should be considered in determining the income tax consequences of a split dollar rollout. Any policy distributions, including policy loans, generally may be taxed less favorably if a policy is a modified endowment contract than if it is not ( Q 13).

Where a split dollar arrangement provides a permanent benefit ( Q 255) to a member of a group covered by group term life insurance issued by the same insurer or an affiliate, the arrangement may be considered part of a policy providing group term life insurance and its taxation subject to rules discussed in Q 254.