It has now been over 3 years since the U.S. Treasury finalized its regulations related to split-dollar arrangements. There remains a significant misunderstanding as to the advisability of the initiation or continuation of split-dollar plans. That is perhaps because different rules apply depending upon when a plan was established, and perhaps because these plans come in so many variations.
Scope of the discussion
Historically, split-dollar plans were arrangements wherein an employer would agree to pay most or all of the premium cost of a cash-value life insurance policy on an employee's life, retaining an interest in the policy's cash value and death proceeds, with the employee or a designated beneficiary holding the remaining policy benefits, primarily the death benefit.
Over time, planners have devised many variations, and split-dollar structures have migrated beyond the employment context. Split-dollar, for example, has become a valuable tool for the estate planner who is endeavoring to remove large amounts of death benefit from the taxable estate, using premium dollars that originate from within the insured's estate in a gift-tax-sensitive manner.
The following discussion relates to split-dollar plans subject to the latest rules, contained primarily in final regulations effective for plans entered into or materially modified after Sept. 17, 2003. Two sets of grandfathering rules may apply to older arrangements, depending upon whether they were entered into before Jan. 28, 2002, ("great-grandfathered') or after that date, and whether those plans have since materially changed. Additionally, the discussion relates primarily to plans taxed under the "economic benefit" regime, as described below.
Economic benefit regime vs. loan regime
Under the new rules, split-dollar plans fall into 1 of 2 tax regimes: economic benefit regime or loan regime. In general, the applicable tax rules depend upon the identity of the policy owner in the records of the insurer.
If the employer or donor is the owner of the policy, the plan will be taxed under the economic benefit regime. In addition, if the employee or donee is the owner but holds no interest in the cash value of the contract, the economic benefit will apply.
Other split-dollar plans are subject to the loan regime, wherein the objective is to provide a tax-favored life insurance benefit while retaining an interest in premium outlays.
Taxation under the economic benefit regime
Taxation under this regime is similar to the historic tax treatment of split-dollar plans. Essentially the employer/donor (hereinafter "sponsor") is deemed to be providing to the employee/donee (hereinafter "recipient") a benefit in the form of the value of the death benefit protection enjoyed by the recipient. In an employment context, the value provided is taxable income, and in the donor-donee context, that value is deemed a gift, with the relevant amount reduced to the extent that the recipient is required to contribute toward its cost.
In contrast to the older tax regime, it is clear that the amounts taxed to or paid by the recipient under the plan create no investment in the policy (i.e., they create no income tax basis). Also, any amounts contributed by the recipient to the cost may constitute income to the sponsor.
If the recipient has access to the cash value, the amount to which the recipient has access will be income, but no current deduction is permitted the sponsor. Also, the recipient receives no tax-free allocation of future cash value growth based upon amounts of cash value previously taxed to him or her. As a result, economic benefit split-dollar plans involving the shifting of cash values to the recipient are generally economically unattractive.
Valuation of the death protection
Historically, one substantial benefit of split-dollar plans involved the evaluation of the death protection provided to the recipient. In general, death protection evaluation relates to what term insurance might cost on the life of the insured. Obviously this is ordinarily based on the age and medical condition of the insured.
Under Revenue Ruling 66-110, the IRS had previously permitted the use of the insurer's published one-year term rates for standard insureds. Many insurers created term products with rates that were substantially less costly than the underlying mortality costs inherent in their cash value policies. As a result, the taxable amounts received by the employee in many cases were far smaller than the real costs within the actual policy. This was particularly true for insureds of impaired health, since the imputed costs were dependent only upon the age, not the actual health, of the insured.
For new plans, unless the insurer maintains a term rate under more stringent rules than applied under Revenue Ruling 66-110, the applicable rates are found in Table 2001 (subject to update by future guidance). Table 2001 rates generally lie somewhere between standard (i.e., smoker) and non-smoker mortality rates, for male insureds, of actual cash value policies. As a result, the mortality rate "arbitrage" of split-dollar plans is largely nonexistent for those who may qualify for non-smoker or better underwriting. One exception may lie in the area of survivorship split-dollar planning.
Survivorship split-dollar-the last best place?
The discussion above might lead one to conclude that economic benefit split-dollar plans may be of limited use as a strategy for employers or donors to provide life insurance to favored recipients. While this may be true generally, there remains, in the area of survivorship split-dollar, a viable use for such arrangements.
For survivorship split-dollar plans, the value of the death protection while both insureds are alive is extrapolated from Table 2001. Previously this calculation conventionally used government Table 38, based upon mortality dating from the 1940s. Thus, for survivorship plans, the costs have been significantly reduced.
Perhaps more importantly, the calculation of the economic benefit differs fundamentally from the derivation of mortality costs underlying modern survivorship life insurance contracts. This is because the split-dollar calculation is undertaken on an annual basis, when it is known that both insureds are living. Thus the cost is based on the probability that both insureds die during the year. After the first death, the rules require that the economic benefit calculation be based on the single life rate for the surviving insured.
In contrast, most survivorship policies do not change mortality rates based upon the death of one of the insureds. Rather, in a given year the insurer's rates look to the probability that the second insured will die, based only upon the insurer's knowledge that both were alive as of the policy issue date.
After the first year, these rates, as a matter of mathematical probability, should be higher than the joint Table 2001 rate. The upshot is that economic benefit split-dollar will generally provide mortality arbitrage so long as both insureds are alive. Thereafter, the single life Table 2001 cost will exceed the actual policy costs.
The question thus arises as to what action to take at the first death. If the sponsor is to retain its then-current interest in the cash value, the plan might be converted into a loan split-dollar plan with a note owed by the recipient to the sponsor. This will terminate economic benefit tax treatment, substituting taxation based upon the interest implications of the note and potential application of the below-market interest rules.
Not to be overlooked is that if the sponsor's investment in the contract is less than its cash value at the time of conversion, a taxable gain may be recognized. (This may be avoided if at the time of conversion the recipient is a so-called "defective" grantor trust as to the grantor-sponsor.)
Economic benefit split-dollar plans are not dead. Irrespective of the economics, they provide a structure for one party to hold the cash value of a life insurance policy while conveying death protection to another. In many situations, however, the alternative of some form of loan arrangement may prove superior from the economic standpoint. Prudent planning will often entail examination of both alternatives.