Two key points emerge from a preliminary analysis: (1) P.S. 58 rates can no longer be used in calculating economic benefit. After a brief phaseout period, P.S. 58 rates are to be replaced by a new IRS table based on Group Term Table I rates. And (2) One-year term rates may still be used, however with new limits. One-year term rates must be based on a policy actually offered and sold. The notice also provides that the IRS may withdraw permission to use one-year term rates in the future.

Furthermore, equity split-dollar arrangements can be taxed in one of two ways: Either as an interest-free loan, in which case split-dollar rules do not apply; or as split dollar.  If split-dollar treatment applies, economic benefit must continue to be recognized as under current rules. Also, equity buildup in the policy is taxed to the employee under Section 83 of the Internal Revenue Code. The timing of this taxation is not clear.

What Next?

The IRS has requested guidance and comments on issues discussed in the Notice as well as related issues such as 1) measuring the economic benefit on survivorship policies and 2) whether multiple tables based on factors other than age should be considered.

"At this point, it is too early to tell the long-term impact," says Mark West, JD,CLU, Director Individual Advanced Markets at Principal Life Insurance.

"The good news is there is no need for making changes immediately.  It is early in the year, so advisors, who may be in a busy tax season, have time yet this year to sort out the ongoing impact with clients to determine whether current plan design meets their needs."

What Planning Techniques Are Available?

"Each client case will have to be reviewed individually to determine the best planning technique," says Patti Bell CPA, assistant director, Individual Advanced Markets at Principal Life.  "Two options, (1) Combining split dollar and a Selective Executive Retirement Plan or (2)  Bonus plan with a two-policy approach may be successful plan designs.  We'll continue to look at these and other possible plan design modifications including IRC Section 83b elections and financial analysis of loan treatment for existing and new plans."

Here, in question-and-answer format, are additional details:

Q: What impact does IRS Notice 2001-10 have on split dollar plans?

A: IRS Notice 2001-10, is intended to 1) clarify prior rulings; 2) provide interim guidance before more permanent guidance is issued and 3) serve as a Notice and a request for comments from practitioners.  The Notice starts out by providing an overview of the history of the income taxation of split dollar agreements including the foundation for most split dollar plans, Revenue Rulings 64-328 and 66-110.  After providing this framework, the IRS concludes that these rulings do not adequately address equity split dollar plans that are being marketed today.  This Notice focuses primarily on employer/employee arrangements but states that the same principals would generally apply to other arrangements.  The primary areas discussed in the Notice are measuring the economic benefit and the treatment of equity split dollar plans.  Two theories discussed in this Notice include Section 83 and Section 7872.  Section 83 provides taxation to an employee upon the transfer of property by an employer without a substantial risk of forfeiture.  Section 7872 provides the tax treatment for below market loans.

Q: How is the tax result in this Notice different from the position taken by the IRS in TAM 9604001?

A: The taxation of collateral assignment equity split dollar has always been a gray area.  Up to this point, there has been very little guidance from the IRS on the tax treatment on the excess cash value, which accrues to the benefit of the employee.  This Notice is an attempt to clarify the tax treatment on that portion of an equity split dollar plan.  There have been three primary theories of taxation on this type of arrangement. 

a. One position is the equity build up (at least to the extent the equity build up exceeds the premium contributed by the employee) is taxable to the employee as property transferred under Internal Revenue Code Section 83, unless employee forfeiture provisions are built into the agreement.  Generally, this would mean taxation of any equity belonging to the employee as it accrues within the policy.  This is a position taken by the IRS in Technical Advice Memorandum 9604001.  The IRS appears to take a similar approach in this Notice although informally the Service has stated that Section 83 taxation occurs at rollout/termination of the agreement rather than as it accrues. 

b. Another view is there is no taxation of equity build up regardless of forfeiture provisions until there has been an Internal Revenue Code Section 72 or 7702 taxable distribution under the life insurance contract.  This would generally occur upon cash surrender of the contract or at the point where withdrawals exceed basis.  Under this theory, tax isn't triggered until distributions are taken because the employee always owned the policy.

c. A third position is the equity build up is taxable in a lump sum upon termination of the split dollar agreement during the life of the employee/insured when all rights in the contract vest in the employee.  This is the position taken in Private Letter Ruling 7916029 and 8310027.  It should be noted, however, both of these rulings dealt with endorsement split dollar plans which required a change of ownership from the employer to the employee at the time the agreement was terminated. 

It is clear from the position taken by the IRS in Notice 2001-10 the Service wants to pursue taxation under Section 83, but until contrary guidance is given, the Service's informal position is that taxation would occur at rollout.

Q: Does this Notice impact all split dollar plans?

A: The impact of this Notice varies based on the plan design.  For example, an endorsement split dollar plan and collateral assignment plan where the employer controls all of the cash value is only impacted by the measuring of the economic benefit.  A Section 83 issue only arises when either the policy is transferred under an endorsement arrangement or the collateral assignment is released and the employee controls the cash value going forward.  Prior to this Notice, the same result occurs under those plan designs since the employee didn't control any equity in the policy.  Under the Notice, economic benefit is measured using either Interim Table 2001 or the issuing insurance carriers qualifying one year term rates.

Under an equity split dollar plan in addition to potentially using a different measure of the economic benefit using either Interim Table 2001 or the company term rates, the employee is considered to receive an economic benefit on any positive return created by the employer's premium payment.  As a result, the IRS provides in this Notice the payment must be treated as either 1) a loan; 2) an employer investment; or 3) currently taxable compensation to the insured/employee.  As a result, this additional benefit will either be taxed under Internal Revenue Code Section 7872 or Section 83. 

The major impact on reverse split dollar plans is that the higher P.S. 58 rates can not be used and as a result the employer would be paying a smaller portion of the premium which will result in additional taxable income for the employee.  It is important to keep in mind, however, the additional taxable amount bonused to the employee will be a deductible expense to the employer. 

Q: How does the Notice effect equity split dollar?

A: The parties to an equity split dollar can treat the agreement either under Section 83 as a taxable transfer or as a loan or series of loans from the employer under Section 7872.  However the parties choose to characterize the arrangement, such characterization must be essentially consistent with how the plan is being managed.  In addition, the parties must have followed that arrangement from the time the split dollar agreement took effect and the parties must be sure to fully account for all economic benefits received by the parties in such a way that is consistent with transaction in its entirety.

In the event the parties choose to treat the equity split dollar arrangement as a loan or series of loans, the result will be imputed income which will be taxable to the employee.  On the positive side, it also means:  1) the employee will not be responsible for paying the economic benefit or including that amount in income each year; 2) the employee will be treated as the owner of the policy and there would not be a transfer under Section 83 of any of the cash value accruing to the benefit of the employee.  In the event the employee does not pay off the loan in accordance with the agreement, reportable income will be due.  It is important to keep in mind even if the employee meets the tests described above, there could be additional income tax to them under Internal Revenue Code Section 72 or 7702 for any distributions from the policy actually received under the contract that are in excess of the employee's basis in the policy. 

If the transaction is not treated as a loan either because the parties have chosen not to treat it as a loan transaction or the parties have failed to do so consistently, the transaction will be treated as split dollar.  The result is the parties will be required to 1) fully account for the economic benefit received by the employee; 2) the employer is treated as having a beneficial ownership in the policy; 3) the economic benefit charge reduced by any premium payments made by the employee will be taxable to the employee;  4) if dividends or similar benefits are received directly or in the form of additional policy benefits it will also be taxable to the employee; 5) the employee will be taxed for any substantially vested interest acquired in the policy's cash value reduced by any contribution paid by the employee for that interest in the policy.

The IRS goes on to provide that until it issues contrary guidance, they will not treat the employer as making a currently taxable Section 83 transfer solely because interest and other earnings from the policy cash value is in excess of the amounts due to the employer under the agreement.  On a positive note, the IRS has provided in the event they decide that interest or other earnings are subject to Section 83 and taxed each year as the value grows, that taxation will only occur going forward and will not be retroactive.  The Notice is somewhat confusing because it is not clear on what a "substantially vested" interest is and how that coincides with the position of not taxing the equity position as it grows from year to year.  It does seem clear, however, at the point the employee would access or have the ability to have full control over the policy value, a taxable event would occur.  Informally, IRS representatives have stated that "substantially vested" means at the time of rollout.

Q: What should you do if you have clients with existing equity split dollar arrangements?

A: The first thing to do is to notify your client there has been an IRS Notice issued which provides interim guidelines for dealing with equity split dollar plans..  Based on the timing of the Notice, any reporting required for the calendar year ending December 31, 2000, will be under the same approach the taxpayer has used in the past.  The timing of the ruling will allow additional time for you to work with the client to look at what steps, if any, need to be taken to meet the client's current objectives. Part of the process will be to evaluate whether the plan should be treated as a loan or as split dollar.  Most existing plans will fall under the split dollar rules. A second step is to determine whether there is any employee equity. Although this equity does not appear to be taxable while the split dollar agreement is in force, it may be recognized as taxable income at rollout/termination of the agreement during the life of the insured.  In the event the current design is no longer effective for the client, there are a variety of planning opportunities that can be considered going forward.

Q: How does the Table 2001 rates compare with the current P.S. 58 rates?

A: The IRS acknowledges the current P.S. 58 tables are clearly out of date and inappropriate for use because they no longer provide a realistic cost of term insurance.  The new table of rates, Interim Table 2001, provides rates which are substantially lower than the P.S. 58 rates and are based on the Section 79 group term rates.  The rates are extended to provide for ages below age 25 and through age 99. 

Here are some comparisons of the P.S. 58, Table 2001.

	P.S. 58	Interim Table 2001
40	$4.42	$1.10
50	9.22	2.30
60	20.73	6.51
70	48.06	20.62

Q: Does this Notice have any impact on reverse split dollar plans?

A: This Notice confirms the IRS is concerned that under a reverse split dollar arrangement, when employers are paying for the right to "rent" the death benefit using the P.S. 58 rates, the employer is overpaying for that right.  In effect, the result is the employee is benefiting from the employer's payment without being taxed.  By eliminating the P.S. 58 rates as a way to measure the cost of insurance, the leverage created in a reverse split dollar plan is minimized.  Going forward, the employer could terminate the reverse split dollar agreement and stop "renting" the death benefit.  Additional premium bonused by the employer from that point forward would be deductible by the employer and taxable income to the employee.  In the alternative, the reverse split dollar arrangement could continue with the employer paying a smaller portion based on the Interim Table 2001 rates with the remainder of the premium being bonused to the employee.  In working with clients that currently have reverse split dollar plans, it will be important to evaluate which option is most appropriate for them. 

Q: How does the Notice impact private split dollar plans?

A: Private split dollar was not specifically addressed in the Notice, but the IRS position appears to be the issues raised would generally apply to all split dollar plans not just employer/employee arrangements.

In a private split dollar arrangement, the insured spouse typically gifts the economic benefit to the irrevocable trust.  Based on this Notice the gift would now be based on Interim Table 2001 or our one year term rates.  In most situations, our one year term rates are used.  If the plan design follows existing private letter rulings on private split dollar, the spouse advancing premium is entitled to receive all cash value not just premiums advanced so in those situations the equity split dollar guidance does not apply. 

If the private split dollar plan does use an equity split dollar approach, a logical extension of the Notice would be that the equity portion would be treated as a gift at rollout.

Q: When presenting a new split dollar plan, how should the tax issues be positioned?

A: Since it is not a settled issued, it is important your client be aware of Notice 2001-10.  In presenting a split dollar plan, it is important potential tax issues created by this Notice be fully disclosed to the client.  A reasonable approach is to show both a comparison of one year term rates and the Interim Table 2001 rate.

Q: What is effective date of the Notice?

A: The Interim Table 2001 rates are treated by the Service as interim rates and must be used in place of P.S. 58 table rates for tax years ending on or before December 31, 2001.  In other words, P.S. 58 rates may continue to be used for this calendar year.

Insurers' one year published term rates for standard risks can continue to be used.  Most of split dollar plans use one year term rate to measure economic benefit.  After December 31, 2003, the IRS will only allow a company's term rate to apply if:  1) Insurer generally makes the rate known to person's who apply for term insurance; 2) Insurer regularly sells term insurance at that rate through its regular distribution channels; 3) Insurer doesn't typically sell term at a higher rate for standard risks.

The IRS has also provided that for policies issued after February 8, 2001, there is no assurance the Insurer's one year term rates may be used after 2003.  In the short term this means the conservative approach is showing split dollar using the Interim Table 2001 rates to illustrate economic benefit.

Q: What planning techniques are available?

A: Combine split dollar and a Selective Executive Retirement Plan (SERP) - A traditional split dollar/SERP arrangement should accomplish the objective of delaying taxation until retirement and also provide a preretirement income tax free death benefit for the employee's beneficiary.  This type of arrangement can be set up as an endorsement split dollar or a collateral assignment with the employee assigning all cash value to the employer.   In either case, the employee would have the right to name a beneficiary for his or her portion of the death benefit.  The employee would also be responsible for either paying the economic benefit or tax on the economic benefit.  Bonuses to the employee can provide for his or her share of the economic benefit.  In addition to the split dollar agreement, the employer and employee would also enter into a SERP agreement.  During the working years the split dollar plans would provide a death benefit and at retirement the split dollar arrangement would be terminated.  The policy value would remain a general asset of the company and could be used to help informally fund the SERP arrangement.  The benefits paid out under the SERP plan would be deductible by the employer and taxable to the employee.

Bonus -- Two policy approach -- If the employer is interested in recovering costs associated with establishing a bonus arrangement, a separate key person policy could be added.  For example, if the employer is providing a bonus plan, the company can purchase a policy to provide key person coverage to recover some of the costs associated with providing the bonus.  The key advantage of the bonus arrangement to the employer is the current tax deduction on the bonused amount.  Current employer tax savings and the ability to structure the policies without building additional cash value to accomplish the split dollar rollout should help provide the dollars to purchase the key person coverage.

Other possible plan design modifications include IRC Section 83b elections and financial analysis of loan treatment for existing and new plans.  We will provide additional information in future communications.

Send comments to information@smartpros.com.

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