Split Dollar Plans—Who’s Paying for that Life Insurance?
Why is This Topic Important to Wealth Managers? This blogticle discusses the general properties as well as taxation of the traditional split dollar plan. It is intended to provide both a review of concepts and refresher of a planning opportunity.
Split dollar insurance is an arrangement generally between an employer and an employee under which the policy benefits are split, and the costs (premiums) may be split. Split dollar plans can also be set up between corporations and shareholders (“shareholder split dollar”) or between parents and their children (“private split dollar”).
Under the traditional plan, the employer pays part of the annual premium equal to the current year’s increase in the cash surrender value of the policy and the employee pays the balance, if any, of the premium. From this basic concept, hybrid plans have evolved; for example, “employer pay all” plans under which the employer pays the entire premium, and level contribution plans under which the employee pays a level amount each year.
If the employee dies while the split dollar plan is in effect, the employer receives from the proceeds an amount equal to the cash value of the policy or at least its premium payments (under a basic plan), and the employee’s beneficiary receives the balance of the proceeds.
It is no secret to wealth managers that split-dollar life insurance arrangements can be a key feature incorporated into executive compensation packages. Beginning in 2001, transitional guidance on the valuation of split-dollar life insurance arrangements was provided in the form of notices and proposed regulations in anticipation of final regulations which were adopted in 2003.
How are the current regulations applied regarding this arrangement?
Under the final regulations issued September 17, 2003, the tax treatment turns on who owns the split-dollar policy. If the executive owns the policy, the employer’s premium payments are treated as loans to the executive. Consequently, unless the executive is required to pay the employer interest on the loan at or above the applicable Federal rate (AFR), the executive will be taxed on the difference between the AFR interest and the actual interest. Verify that the rate of interest being charged is at least AFR.
If the employer is the owner of the split-dollar policy, the employer’s premium payments are treated as providing taxable economic benefits to the executive. The economic benefits include the executive’s interest in the policy’s accessible cash value and current life insurance protection.
The final split-dollar regulations apply to any split-dollar life insurance arrangement “entered into” after September 17, 2003. The term “entered into” is defined in 1.61-22(j)(1)(ii) of the regulations. Under section 1.61-22(j)(2) of the regulations, an arrangement entered into on or before September 17, 2003 that is materially modified after September 17, 2003 is treated as a new arrangement entered into on the date of the modification, and is subject to the final regulations.
Section 1.61-22(j)(2)(ii) of the regulations provides a non-exclusive list of changes that are NOT considered material modifications.
See Tax Facts Q 3793 What is reverse split dollar and how is it taxed? for a discussion of reverse split dollar plans.
Tomorrow’s blogticle will discuss issues surrounding year-end planning preparation.
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