Split-dollar life insurance has become a common executive benefit. Beginning in 2001, in a series of notices and regs, IRS significantly changed its position on how split-dollar life insurance should be taxed. The tax advantages of so-called “equity” arrangements have been significantly curtailed. The impact of these rules is less significant if you have a non-equity arrangement-i.e., all you get under the arrangement is term life insurance coverage, including paid-up additions.
What are split-dollar life insurance arrangements?
The final regs, which are effective for split-dollar arrangements entered into or “materially modified” after September 17, 2003, provide two mutually exclusive regimes for taxing these arrangements: the economic benefit regime and the loan regime. Under the economic benefit regime, the premium-paying owner of the life insurance contract is treated as providing economic benefits to the non-owner with an interest in the contract. Under the loan regime, the premium-paying non-owner of the life insurance contract is treated as loaning premium payments to the owner.
Split-dollar life insurance arrangements
More favorable rules govern split-dollar arrangements entered into before, and not materially modified on or after, September 18, 2003. If you have a pre-September 18, 2003 arrangement, it is very important that you avoid inadvertently subjecting the arrangement to the final regs by materially modifying it. The final regs do not define what a “material modification” is; they simply provide a list of some examples of non-material modifications.
If you have a pre-September 18, 2003 arrangement, then IRS will not impose additional taxes if you continue to treat and report the value of the life insurance protection provided to you as an economic benefit included in your income, and you do not access the cash value of the policy. And if you have an equity arrangement that was entered into before January 28, 2002, then you will not be taxed on the net equity increases in the policy upon termination of the arrangement, provided you treat the arrangement as a series of loans from your employer to you. However, there’s a potential problem in relying on this safe harbor if your employer is a public corporation.
Sarbanes-Oxley Act and Split-dollar life insurance arrangements
The Sarbanes-Oxley Act of 2002 bans public corporations from making most kinds of loans to their executive officers and directors. It is unclear whether this Act applies to public corporations making premium payments under split-dollar arrangements. IRS says, in the introduction to the final regs, that the answer to this question is up to the Securities and Exchange Commission (SEC). A further complication arises because some split-dollar arrangements may be subject to the Code Sec. 409A rules, under which deferred compensation is included in current income unless the plan meets detailed requirements. Code Sec. 409A may apply to policies structured under the endorsement method, in which the employer owns the policy but the employee can name the beneficiary. If the employer irrevocably promises to pay premiums in future years, the arrangement may be considered a nonqualified deferred compensation plan. Amending the plan to comply with Code Sec. 409A may present its own problems, because this may be a “material modification” that will make the split-dollar arrangement subject to the less favorable post-September 17, 2003, split-dollar regs discussed above.