November 19, 2003

Policyholders Beware of New Tax Treatment

Holland & Knight Newsletter
Joshua E. Husbands | Scott Johnston

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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