Policyholders Beware of New Tax Treatment
November 19, 2003
Joshua Husbands - Portland
R. Scott "Scott" Johnston- New York
Split dollar life insurance refers
to a tax-advantageous method for paying the premiums on life
insurance policies. Historically, where an employer has paid life insurance
premiums for the benefit of an employee, the employee has included in her income
only the annual cost of term life insurance coverage for the amount of life
insurance protection provided under the policy.
Recently, the Treasury Department has finalized regulations that alter the
long-standing method
of taxation of these arrangements making action necessary in some cases prior to
December 31, 2003.
Split dollar arrangements entered into after September 17, 2003, will be
governed by the final
regulations, which will treat the taxation of these arrangements
in two ways.
First, under the “economic
benefit” approach, the payment
of premiums will be treated as providing an economic benefit to the employee
equal to the annual term cost. Additionally, in some cases, the IRS will tax the
incremental build-up of policy cash value over the amounts that are
to be repaid to the employer
on an annual basis.
The second approach, the “split
dollar” loan, will tax the arrangement as a loan between the parties. If the
arrangement is to be taxed under the economic benefit analysis, the mechanics of
how the donee will be taxed is largely unchanged, other than the imposition of
new, annual-term cost measurements. If the arrangement
is to be taxed as a split dollar loan
and that loan does not bear sufficient interest, then the taxation of the
arrangement will be governed by
“below market” loan principals
under the final regulations.
Split dollar arrangements existing prior to September 18, 2003, will,
in most instances, continue to be eligible for taxation under the economic benefit approach, but in
certain cases there will be adverse
tax consequences upon the termination of the arrangement.
Of most concern to parties to existing split dollar arrangements will be the
method of taxation for arrangements historically known as the collateral equity
split dollar arrangement. Though there has been no published guidance as to how
the IRS will treat the equity build-up in a pre-September 18, 2003,
collateral-equity, split dollar arrangement, Treasury representatives have
indicated that they will seek to tax any excess in the cash value that inures to
the employee’s benefit over what they are obligated to repay to the employer
upon termination of the
arrangement.
There are a number of planning alternatives for minimizing the tax that may
be imposed under the new rules governing split dollar agreements. The scope of
those
alternatives is well beyond the
parameters of this alert, but if
you have an existing split dollar life insurance agreement in place, you should
seek the advice of competent tax counsel immediately. Many of the most important
options for existing split dollar plans will expire at midnight on December 31,
2003, so time is of the essence.
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