Split Dollar Life Insurance: The Equity Regime Versus the Loan Regime

Abstract

This article provides a comprehensive summary and analysis of the Treasury Department's final regulations regarding the taxation of split-dollar life insurance arrangements that were issued last year. Over the past 40 years, such arrangements have been quite popular for purposes of employment, gift and estate planning. For example, such arrangements have been used in compensatory arrangements (i.e., to fund a form of deferred compensation for certain key employees; to provide life insurance protection on such employees; in stockholder arrangements; and in private arrangements between donors and donees). The complex and tedious final regulations apply broadly to any split-dollar life insurance arrangement entered into on or after September 18, 2003, and any such prior arrangements that are "materially modified" (the final regulations provide a nonexclusive list of what constitutes a material modification). The final regulations are intended to "...curb a backdoor form of executive compensation and promote greater transparency."

Despite numerous comments to the proposed regulations, the Treasury Department explicitly rejected the adoption of more flexible rules and retained and modified its previously used objective approach. Instead, the so-called two "mutually exclusive regimes" of the previous proposed regulations are retained and are applied depending on who owns the underlying life insurance policy. Specifically, if the employee owns the policy, the employer's premium payments are treated as "loans" to such employee. Thus, unless the employee is required to pay market-rate interest to the employer, the employee will be taxed on the difference between the market-rate of interest and the actual interest. The rules applicable to such an arrangement are referred to as the Loan Regime. With respect to the Loan Regime, the final regulations provide a new anti-abuse rule and several changes in the treatment of accrued but unpaid interest that is waived, cancelled or forgiven, including imposing a deferral charge.

Alternatively, if the employer owns the policy, the employer's premium payments are treated as providing taxable economic benefits (i.e., assigned an interest in the policy cash value, the cost of current life insurance protection or any other benefit) to the employee. The rules applicable to such an arrangement are referred to as the "Equity Regime."

The final regulations, however, do not address the potential application of Section 402 of the Sarbanes-Oxley Act of 2002 to split-dollar life insurance arrangements. The Sarbanes Act generally prohibits a public company from making personal loans to its executives and directors. Public companies have let existing split-dollar life insurance arrangements owned by such individuals to either lapse or require the payment of premiums out of the accrued cash value until further guidance is provided. In the preamble to the final regulations, the Treasury Department specifically states that the final regulations do not address this issue because it is within the jurisdiction of the SEC to interpret and administer the Sarbanes Act.

The Treasure Department notes that other tax rules, such as those contained in Section 457 of the Internal Revenue Code (relating to deferred compensation plans of state and local governments and tax-exempt organizations), may require a non-owner under an "equity" split-dollar life insurance arrangement to recognize income earlier than required by the final regulations.

Finally, in conjunction with the release of the final regulations, Rev. Rul. 2003-105 was released. Such ruling states that prior revenue rulings are generally obsolete with two important exceptions. First, the prior revenue rulings, to the extent provided by Notice 2002-8, still apply to any split-dollar life insurance arrangement that is entered into prior to September 18, 2003 as long as it has not be materially modified. Second, with respect to any split-dollar life insurance arrangement that is entered into prior to January 28, 2002 under which the employer has made premium or other payments, Notice 2002-8 still provides that the IRS will not assert that a taxable transfer of property has occurred on the termination of such arrangement if such arrangement is terminated before January 1, 2004 or is converted to the Loan Regime, as described in such notice.