Split dollar is used for many reasons, such as family income needs and estate liquidity. The primary purpose of analyzing a possible split-dollar application can be tied to one principle—putting the party best able to pay in the position of a “premium provider.”
The technique, however, may be used between a corporation and an employee, a corporation and a shareholder or director, a partnership/LLC and a partner/member, between two or more individuals, or between two or more entities. Last month, we outlined the endorsement method of implementing split dollar; we will now describe collateral assignment split dollar.
Under collateral assignment split dollar, the employee is the owner of the contract and the insured. The employer may pay part or all of the premium for the insurance contract. In turn, the employee assigns the cash value or the premiums paid back to the employer and the insurance contract serves as the collateral for the premiums paid. Thus, 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. The transaction is tax leveraged as well because this strategy is often used when the employer is in a lower tax bracket than the employee.
The split-dollar regulations recently passed by the IRS have substantially changed collateral assignment split dollar. Although there are many changes, the scope of this article is limited to a review of the basic definition of a split-dollar arrangement and how the ongoing premiums paid by the employer are treated. What was once a nontaxable loan has become a taxable loan.
The final regulations
The final IRS regulations generally define a split-dollar arrangement as any arrangement between an owner of a life insurance contract and a nonowner where:
- One of the parties pays (directly or indirectly) all or part of the premiums
- At least one of the parties who paid premiums is entitled to recover all or any portion of those premiums
- Such recovery is to be made from, or is secured by, the proceeds of the life insurance
This definition excludes any arrangement to which the only parties are the owner of the life insurance contract, and the insurance company acts only in its capacity as issuer of the life insurance contract. This definition also excludes keyman life insurance where the employer owns the life insurance contract and the employee has no rights in the life insurance contract.
Split-dollar plans must treat the premiums paid by the employer as loans.
If two or more owners are listed, and each does not have, at all times, all of the incidents of ownership of an undivided interest in the contract, the first owner listed is the owner for tax purposes. The final regulations also add attribution rules for compensatory (employer-employee split-dollar) arrangements. In a compensatory split-dollar plan, the employer is treated as the owner of the life insurance policy if the policy is, in fact, owned by: a member of the employer’s “controlled group,” a Sec. 402(b) “secular trust,” a grantor trust (including a “rabbi trust”), or a Sec. 419(e)(1) welfare benefit fund.
The new collateral assignment arrangement under the final regulations provides that split-dollar plans must treat the premiums paid by the employer as loans. If a split-dollar loan does not provide for sufficient interest, the loan is a “below-market loan” for purposes of Sec. 7872.
In short, for income tax purposes, the below-market loan is recharacterized as a loan bearing interest at the applicable federal rate (AFR) and the stated interest rates. The owner is deemed to have received this amount from the nonowner and is then deemed to have paid this amount back to the nonowner lender as interest due. The timing, amount and character of the deemed transfers, and the AFR, are determined by the nature of the relationship between the owner and nonowner and the terms of the loan. The deemed interest payment by the owner will generally not be deductible for federal tax purposes.
The repayment obligation under a split-dollar arrangement is typically on a nonrecourse basis. Under the new regulations, this results in the repayment obligation being deemed a contingent payment. Contingent payments are subject to unfavorable assumptions in testing for adequacy of loan interest.
“Contingent payment” status can be avoided if the parties provide a written representation with respect to the loan that a reasonable person would expect all payments under the loan to be made. Both parties execute the representation letter no later than the last day of the tax year for the borrower or lender (whichever is earlier) when the first split-dollar loan was made, and then file it with the tax return.
The typical split-dollar loan arrangement would be characterized as a “demand loan.” Each calendar year that a split-dollar demand loan is outstanding, the loan is tested to determine if the loan provides for sufficient interest. A split-dollar demand loan provides sufficient interest for a calendar year if the rate is no lower than the blended annual rate provided by the IRS.
The blended rate is the average of the January and July short-term AFR rates.
A “term loan” is any loan that is not a demand loan. If the loan is a term loan, a key issue for any practitioner will be to determine how the loan interest is taxed. Essentially for many term loans, the loan interest will be taxed under the original issue discount tax rules. These rules are complex. In laymen’s terms, this means that the amount of interest over the term of the loan will essentially be discounted to present value and taxed all at once in the first year of the arrangement.
This may be very disadvantageous. For certain split-dollar term loans, including those payable upon the death of an individual, those conditional on the future performance of substantial services by an individual, and gift split-dollar loans, the forgone interest is determined annually, similar to a split-dollar demand loan (although the AFR is determined as if the loan were a term loan).
Essentially, any forgone interest on the loan is treated as income to the employee.
The key change
So the key change for split dollar with respect to collateral assignment arrangements has been the change in the treatment of the premiums paid by the employer on behalf of the employee. This is now considered a loan. Essentially, any forgone interest on the loan is treated as income to the employee. Still, for employees who may not have sufficient cash flow to fund insurance policies, a loan from an employer to fund the life insurance purchase may be advantageous and may have several uses in employee benefit planning.
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 email@example.com. Contact Landsberg at 614-249-3756 or at firstname.lastname@example.org.
(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.)