Recent IRS Notice On Tax Treatment of 
Split-dollar Life Insurance Arrangements

On January 9, 2001, the Internal Revenue Service ("IRS") issued Notice 2001-10 relating to the taxation of split-dollar life insurance arrangements and providing interim guidance on the tax treatment of such arrangements pending publication of further guidance. This Notice was not well received by the insurance industry. On January 3, 2002, the IRS issued Notice 2002-8, which revokes Notice 2001-10.

A split-dollar arrangement allows two parties to acquire a life insurance policy on the life of one of the parties and "split" the benefits and obligations of the policy. A split-dollar arrangement is often entered into by and between an employer and employee but is not restricted to the employer–employee context. For ease of discussion, this estate planning bulletin will assume that the arrangement is entered into by and between an employer and an employee. The split-dollar arrangement will:

• provide that the employer will pay all (or part) of the policy premiums

• describe who can borrow against the policy (and exercise other policy rights)

• address how the cash surrender value of the policy will be divided between the employer and the employee in the event of a lifetime cancellation of the policy or the split-dollar arrangement

• state how the death benefit will be divided between the employer and the employee’s beneficiary if the employee dies during the term of the split-dollar arrangement

There are many ways to document and structure a split-dollar agreement. The two most popular methods are:

• the collateral assignment method where the employee owns the policy and executes a collateral assignment that evidences the employer’s rights to benefits under the policy during the term of the arrangement

• the endorsement method where the employer owns the policy and executes an endorsement that evidences the employee’s rights in the policy

Notice 2002-8 not only revoked Notice 2001-10 but also stated that the IRS intends to publish comprehensive proposed regulations governing the federal tax treatment of split-dollar life insurance arrangements. Notice 2002-8 outlines rules expected to be included in the forthcoming proposed regulations, and provides guidance on the valuation of current life insurance protection under split-dollar life insurance arrangements, qualified retirement plans and employee annuity contracts. The rules of Notice 2002-8 are more liberal than those in Notice 2001-10, provide more certainty for existing arrangements, and allow some current split-dollar participants to bail out without adverse tax consequences.

The IRS, at some future date, will issue proposed regulations on the federal tax treatment of split-dollar arrangements. Thereafter, final regulations will be issued following a comment period. The proposed regulations addressing the federal tax treatment of split-dollar life insurance arrangements will be effective for arrangements entered into after the date of publication of final regulations. It is expected that the proposed regulations will establish two regimes as to split-dollar life insurance arrangements. The identity of the policy owner now determines whether or not a split-dollar life insurance arrangement fits under one regime or the other. It is unclear how co-owned policies will be treated under this Notice 2002-8.

• Code Section 61: If the employer is the owner of the policy, the applicable regime will be Code Sections 61 and 83 (i.e. economic benefit). In an employment-related split-dollar life insurance arrangement, if the employer is formally designated as the owner of the life insurance contract (commonly known as an endorsement split-dollar plan), then according to Notice 2002-8, the value of current life insurance protection and other economic benefits provided to the employee will be taxable under Code Section 61. Code Section 61 provides that the economic benefit received pursuant to the split-dollar arrangement will be taxable income to the employee for each year of the existence of the split-dollar arrangement.

• Code Section 83: A transfer of the life insurance contract to the employee will be taxed under Code Section 83. Code Section 83 provides that when there is a transfer or deemed transfer of the life insurance policy to the employee, the employee has taxable income equal to the fair market value of the life insurance policy (typically its "cash surrender value"). The Notice does indicate, however, that there will be no current taxation under Section 83 solely because the cash surrender value exceeds the premiums paid by, and to be repaid to, the employer, despite the IRS’s indication in TAM 9604001 that such taxation could be imposed.

• Codes Sections 1271 – 1275 and 7872: If the employee is the owner of that policy, the applicable regime will be Code Sections 1271-1275 and Section 7872 (i.e. loan treatment). If the employee is formally designated as the owner of the life insurance contract under a split-dollar arrangement (commonly called a collateral assignment split-dollar plan), then according to Notice 2002-8, the proposed regulations will treat premiums paid by the employer as a series of loans by the employer to the employee if the employee is obligated to repay the employer, whether out of contract proceeds or otherwise. Where applicable, the loans will be subject to original issue discount ("OID") rules or the below-market interest rules of Code Section 7872. These rules provide that if the loan does not require adequate interest, interest income will be imputed on the loan and treated for income tax purposes as having been paid and received by the parties to the loan. If the employee is not obligated to repay the employer-paid premiums, then these amounts will be income to the employee at the time the premiums are paid. The IRS states that the same principles are expected to govern the federal tax treatment of split-dollar life insurance arrangements in other contexts, including gift and corporation-shareholder contexts.

Before the issuance of "Further Guidance," Notice 2002-8 provides interim guidance for valuing current life insurance protection as discussed below: (Further guidance may consist of the proposed regulations when issued, although the IRS leaves the door open to issuing additional notices prior to the proposed regulations.)

1. Under current law without consideration of Notice 2002-8, the lower of the insurer’s published premium rate available to all standard risks for initial issue one-year term insurance or the PS 58 rate is used to determine the value of current life insurance protection. If a split-dollar life insurance arrangement is entered into before January 28, 2002, the employer and employee may continue to use the PS 58 rates; however, few split-dollar arrangements require valuation based on PS 58 rates, which generally produce valuations higher than use of the insurer’s actual term insurance premium rates. What is a "split-dollar life insurance arrangement entered into before January 28, 2002?" The signing and notarization of an agreement prior to January 28, 2002 is probably not sufficient. It will also be necessary for the life insurance policy to have been issued.

2. For arrangements entered into before the effective date of Future Guidance, taxpayers may use the premium rate table set forth in Table 2001, outlined below, to determine the value of current life insurance protection on a single life under a split-dollar life insurance arrangement. The Table 2001 rates are much lower than P.S. 58 rates for insureds of all ages. The IRS says that taxpayers should make appropriate adjustments to these premium rates if the life insurance protection covers more than one life, but they do not state how the rates should be adjusted. This might be the case, for example, where a policy used in the split-dollar arrangement paid benefits only on the death of the second of two insureds.

3. For arrangements entered into before the effective date of Future Guidance, taxpayers may continue to determine the value of current life insurance protection by using the insurer’s lower published premium rates that are available to all standard risks for initial issue of term insurance. However, for arrangements entered into after January 28, 2002 and before the effective date of Future Guidance, for periods after December 31, 2003, the IRS will not consider an insurer’s published premium rates to be available to all standard risks who apply for term insurance unless (i) the insurer generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer, and (ii) the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurance normal distribution channels. Therefore, it appears that with respect to arrangements entered into before January 28, 2002, the insurer’s lower published premium rates can be used, and the additional two requirements otherwise required after December 31, 2003 need not be met. If the two additional requirements after December 31, 2003 are applicable and are not met, Table 2001 must be used to determine the value of the insurance protection.

Notice 2002-8 also provides guidance on the federal tax treatment of split-dollar arrangements entered into before the publication of final regulations, as discussed below:

1. Where the employer owns the insurance contract, for so long as the value of current life insurance protection under a split-dollar policy is treated as an economic benefit provided to the employee and repaid, the IRS will not treat the arrangement as having been terminated resulting in a taxable transfer of equity to the employee, regardless of the level of the remaining economic interest that the employer has in the life insurance contract.

2. The parties to the split-dollar arrangement may elect at any time to treat premium or other payments by the employer as loans. In these cases, the IRS will not challenge reasonable efforts to comply with the OID and below-market interest rules. (The application of those rules can be avoided by charging a market loan rate.) Existing arrangements can be converted to a loan if all payments made by the employer from the inception of the arrangement (reduced by any repayments to the employer) are treated as loans entered into at the beginning of the first year in which those payments are treated as loans.

3. For split-dollar life insurance arrangements entered into before January 28, 2002, that have not been modified under which an employer has made premium payments and has received or is entitled to receive full repayment of all of its payments, the IRS will not assert that there has been a taxable transfer of property (such as the excess of the cash surrender value of the policy over advances by the employer) to a benefited person upon termination of the arrangement if:

1. the arrangement is terminated before January 1, 2004, or

2. for all periods beginning on or after January 1, 2004, all payments by the employer from inception of the arrangement (less any repayments) are treated as loans for federal tax purposes, and the parties report the tax treatment consistent with this loan treatment. Any payments by the employer not previously treated as loans must be treated as loans entered into at the beginning of the first year (which will, in most cases, begin on January 1, 2004) in which the payments are treated as loans.

In summary, all split dollar life insurance arrangements should be reviewed immediately. It may be best to convert such split dollar life insurance arrangements to loan arrangements between the employer and employee or terminate such split dollar life insurance arrangements prior to January 1, 2004. At your request, we will be glad to meet with you to discuss the effects of IRS Notice 2002-8 on your split-dollar arrangements.

This bulletin has been prepared jointly by the Estates, Trusts and Exempt Organizations Section and the Tax Section of Poyner & Spruill, LLP. Contributing editors include: Mark Edwards, Craig Dalton, Bill Belcher, Pearl Doherty, Laura Urich, Frank Meadows and Tom Norris.

If you have any questions regarding this bulletin, please contact Craig Dalton at (919) 783-2943 or craigdalton@poynerspruill.com.

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Table 2001

Interim Table of One-year Term Premiums 
For $1,000 of Life Insurance Protection