By Brett W. Berg, J.D., LL.M., CLU, ChFC
and Richard D. Landsberg, J.D., LL.M., RFC, APM

Many advisors we meet ask us about split dollar and what is happening with this technique. Split dollar is still viable and it is important for advisors to know the basic issues. Split-dollar life insurance is not a product. It’s a method for financing the acquisition of a life insurance policy. By using split dollar, it is possible for the employer to pay all or a substantial part of the premium on a life insurance policy on behalf of an employee, thereby minimizing the economic and tax cost to the employee. The employee is able to acquire permanent life insurance at a very low cost, i.e., the transaction has been economically leveraged for the insured. Companies typically use two main types of split dollar techniques—endorsement split-dollar and collateral assignment split dollar. Let’s take a look at the first technique—the endorsement split dollar. The endorsement method Where the endorsement split-dollar method is used, the employer owns the life insurance policy and is typically entitled to all of the cash value in the policy. The employer is also the beneficiary and is entitled to recover the cash value from any death benefit. The balance of the death benefit over and above the cash value is made available to the employee’s beneficiary through an endorsement.

During the arrangement, the employee is taxed on the value of the life insurance protection provided. The value of the life insurance is an economic benefit taxed as ordinary income. At termination of the arrangement, any transfer or “rollout” of the policy to the employee will make the cash values taxable income as a transfer of property to the employee. That treatment is stipulated by Section 83’s “transfer-in-connection-with-the-performance-of-services” compensatory transaction rule.

With split dollar, the transaction has been economically leveraged for the insured.

Originally, the economic benefit of a life insurance policy was measured by the P.S. 58 rates issued by the Treasury Department of the U.S. government. Then the IRS issued Revenue Ruling 66-110, which permitted the use of an alternative rate to measure the value of life insurance protection of the economic benefit. In that ruling, the IRS said taxpayers could use the insurer’s published one-year individual term rates to measure economic benefit. The ruling further provided that to use the insurer’s lower term rate, the term policy that is the basis for the rate must be “available to the general public” and the rate of the issuing insurance company, and not one of its subsidiaries.

New rules
Now, we are operating under some new rules. On Sept. 11, the IRS issued new final regulations governing split dollar. With regard to the endorsement split-dollar method, the new rules seek to clarify and update how the value of life insurance protection is valued. In general, taxpayers must use Table 2001 (group term rates).

Taxation: access to cash values
One important issue raised by the regulations involves tax consequences under which the employee has access to cash values during the arrangement. Under regulations proposed by the U.S. Treasury Department and the IRS, employees would report not only the value of economic benefit but also the value of any cash surrender value to which the employee has access.

According to those regulations, an employee has access to any portion of the cash value in two situations. First, an employee has access when the cash value is directly or indirectly accessible by the employee. Second, an employee will be considered to have access when the cash surrender value is inaccessible by the employer-owner or by the creditors of the employer.

In summary, the government regulations that took effect Sept. 17 appear to be very broad. Direct or indirect access to cash surrender values will be found if the employee can withdraw, surrender, borrow, assign, pledge or have the cash values subject to legal attachment.

Taxation: value taken from the contract
On a related issue, the regulations provide for the taxation of the value taken from the contract and made available to an employee. With respect to any amount taken or received by the employee from the life insurance policy, the regulations create a constructive distribution taxable to the employer-owner as ordinary income. Then the amount received from the contract by the employee will be treated and taxed as if received from the employer (e.g., as compensation, dividend or gift, depending upon the facts and circumstances of each case). The amount of compensation, gift or dividend reportable by the employee will be reduced by any amount previously taken into income by the employee as economic benefit or an amount the employee may have paid for the economic benefit.

At termination of the arrangement, nothing has really changed. Where the employer-owner transfers the entire policy, or a portion of the policy, to an employee, the employee will be taxable on the fair market value of the policy less any consideration paid for or already taken into account on the equity of the policy. In a compensatory employer-employee situation, the employer will be entitled to a deduction for the amount included in income by the employee at rollout.

When to use the endorsement method
The endorsement method is generally used when an employer-employee relationship exists and the employer desires control over the policy, its cash values and other ancillary policy rights. Under this method, the employee simply has the equivalent of term insurance protection that is provided as an employee benefit.

What the future holds for the endorsement method
Even though the new rules and regulations change certain tax consequences of the arrangement, the basic structure of the endorsement method remains intact.

The endorsement method is fairly straightforward. Final regulations retain the rules of taxation under economic benefit theory. Taxation upon transfer of a contract is determined by relationship. If the nonowner of the policy is the employee, and the owner of the policy is the employer, the transfer will be treated as taxable compensation.

The need for the endorsement method to finance life insurance as an employee benefit still exists in many cases. For these reasons, it appears that endorsement split dollar will continue to be alive and well.

Brett W. Berg is director of advanced sales, and Richard D. Landsberg is senior advanced sales consultant for Nationwide Financial in Columbus, Ohio. You may reach Berg at 614-677-7874 or at bergb@nationwide.com. Contact Landsberg at 614-249-3756 or at landsbr@nationwide.com.

(This is the first of two articles regarding the current and future status of split-dollar arrangements. Part 2 will appear in an upcoming issue. Neither Nationwide nor its representatives provide legal or tax advice. Readers should consult with their attorney or other professional advisor for answers to their specific questions.)

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