SPLIT DOLLAR LIFE INSURANCE

Split dollar insurance was an arrangement between an employer and employee under which the policy benefits were split and the costs (premiums) were be split. Under the basic plan, the employer paid that part of the annual premium that equaled the current year’s increase in the cash surrender value of the policy and the employee paid the balance, if any, of the premium. Changing IRS regulations, however, will probably spell the demise of these plans.

VARIATIONS OF SPLIT DOLLAR

Split dollar insurance plans were attractive to employers because they allowed a company to discriminate in rewarding executives and key employees. The employees benefited by acquiring more life insurance protection than they might have been able to purchase on their own. The employee also enjoyed complete portability of the policy should employment terminate.

A number of variations developed in the premium payment methods of split dollar policies. The most direct and common means was for both employer and employee to pay the required proportionate share of the premium. Another way was for the employer to pay the entire premium. With this latter method, however, the employee’s portion of the death benefit was then considered a current economic benefit and constituted taxable income to the employee. Taxable income was measured by the lesser of the government’s PS 58 table costs or the insurer’s lowest published one year term rate for standard risks.

One common method of eliminating out-of-pocket expense to the employee was to “bonus-out.” In other words, pay the employee’s cost (single bonus) or the cost plus the tax on the cost (double bonus). Under either bonus arrangement, the employer would receive a tax deduction for bonus payments as compensation paid, provided the employee’s overall compensation qualified as “reasonable” according to IRS guidelines.

By using the split dollar method, the company could show its share of the policy’s cash value on its balance sheets. The firm also was assured a return of the invested capital upon either the employee’s death or termination of the policy. This was done using a collateral assignment. The employer could also arrange to recover the premiums paid plus interest from the policy’s cash value, although most would seek only a refund of their payments.

The insured employee usually had the right to designate the beneficiary of the portion of the policy proceeds not payable to the employer. The employee’s possession of this right was an “incident of ownership” and, therefore, caused the beneficiary’s portion of the proceeds to be included in the employee’s gross estate for the purpose of determining federal estate taxes.

Upon termination of a split dollar arrangement, the owner would either continue the policy in force or surrender it. Often the contract was “rolled out” to the employee after seven or more years. The employee could continue the payments and retain the full death benefit or take the policy on a paid-up basis for a reduced amount.

Split dollar policies were also used to either fund a deferred compensation agreement, initially or when cash accumulations become significant. The employer’s cost of such an agreement could be drastically reduced while the individual received the added benefit of permanent competitive life insurance protection at relatively low cost.

CHANGING REGULATIONS

However, the tax treatment of split dollar arrangements is in a state of transition. The Internal Revenue Service has said that it intends to publish regulations regarding the tax treatment of split dollar arrangements.

The proposed regulations will tax parties to split dollar arrangement under one of two mutually exclusive regimes. Under one regime, the economic benefits of the split dollar arrangement will generally be treated as transfers to the employee. Under the other regime, payments by an employer to an employee will generally be treated as a series of loans to the benefited party.

These same principles are expected to govern the tax treatment of split dollar arrangements in other contexts, including arrangements that provide benefits in gift and corporation-shareholder contexts.

These regulations will be effective for arrangements entered into after the date of publication of the final regulations and existing plans have only until January 1, 2004 to dissolve or make appropriate changes.

Source: Tax Facts 2003, National Underwriter Company
www.irs.gov