Over the past 30 years, split dollar plans have been a very popular fringe benefit that closely held and publicly traded businesses have made available to owners and executives. Split dollar subsidized the purchase of permanent life insurance that was used to deal with a variety of planning issues owners and executives commonly encountered.
In it's most basic form, split dollar was used to replace the owner/executive's income for the surviving spouse and children. In slightly more complicated arrangements, split dollar was used to fund survivorship life insurance policies designed to pay federal estate taxes, and was also used to pay the premiums on life insurance used to fund "buy-sell/business succession" agreements.
The term "split dollar" is somewhat confusing and doesn't accurately describe how the arrangement really works. Split dollar isn't a type of insurance policy, but rather is an agreement between the policy owner and the premium payor that describes the rights and obligations of each party to the arrangement. Many things are typically "split" in a split dollar agreement, but the most common, and important, are which party pays the premiums, and how the policy's death benefit and cash values are split.
Going back to 1964, the tax treatment of split dollar plans was fairly well settled in the eyes of the IRS. Under Revenue Ruling 64-328, the executive didn't have to take the corporation's premium payments into income, but rather paid income tax each year on the "economic benefit" provided under the plan. Because the economic benefit for a permanent policy was calculated using what essentially were term rates, the cost to the executive was very low in many if not most cases.
In the 1980's, compensation planners focused not only on the policy's death benefits, but also the significant cash values that could be accumulated in a permanent life insurance policy. At about this time, so-called "equity" split dollar plans came into vogue because the executive's "split interest" in the policy included not only a significant portion of the death benefit but also a significant share of the policy's cash values. Split dollar plans were attractive to corporations because they could be used to attract and retain key people. And because the split dollar agreement ensured that the corporation always received its premium payments out of the death benefit in the event the executive died, or out of the cash value if the executive lived and the agreement was terminated, it was quite easy to see why split dollar became such a popular fringe corporate fringe benefit.
Starting in 1996, the IRS began to take a closer look at the tax treatment of split dollar plans. After issuing two Notices, one in 2001 and another in 2002, the IRS issued a comprehensive set of proposed split dollar regulations on July 3, 2002. The proposed regulations and Notices make it clear that there are now three sets of rules that apply to split dollar plans, and each depends upon when the plan was established.
Split dollar plans established prior to 1.28.2002 ("old" split dollar plans) enjoy one set of rules. Arrangements established after 1.28.2002 but before the proposed regulations become final ("transitional split dollar plans") must follow another set of rules, and arrangements established after the regulations become final ("new" split dollar plans) must follow another set or rules. While at first glance these rules may seem very complex, the Service has provided some clear "safe harbors" that need to be carefully considered.
Since there are thousands of "old" split dollar plans already in place (i.e., those plans established prior to 1.28.2002), let's review the rules that apply to those plans. For arrangements entered into before 1.28.2002, the IRS has said that participant's have the option of using the insurer's term rates, the so-called Table 2001 rates. Additionally, government's PS58 rates to measure the economic benefit may be used in a compensatory arrangement.
If the "old" plan is an "equity" split dollar arrangement and was entered into before 1.28.2002, the IRS has essentially provided split dollar participants with what some planners are calling a "tax relief" program. If these arrangements are terminated before 1.1.2004 or are re-drawn as a loan transaction, the IRS has indicated that it will not assert a taxable transfer under IRC Section 83. Some commentators believe that it is possible that the IRS may assert a transfer under IRC Section 101 or a transfer tax provision of the Internal Revenue Code.
Some planners have developed what are being termed split dollar "rescue" programs that are designed to help answer the question: "what should I do with my existing plan?" In some cases, the policy arrangement is "rolled-up" back to the corporation, and a "1035 exchange" occurs. In other "rescue" programs, the policy is sold to a defective life insurance trust by means of a balloon note and a "1035 exchange" occurs.
Many who never had a split dollar plan may be wondering if the good times are essentially over and it's too late to get in on the game. For "new" plans (i.e., those established after the regulations become final), the IRS is making the tax treatment dependent upon who owns the policy. If the executive is designated policy owner, the IRS will treat the employer's premium payments as a series of loans that are taxed under the below market interest rules of Section 7872. For "transitional" plans (i.e., those established after 1.28.2002 but before the proposed regulations become final), another set of rules applies.
If all of this seems complicated, it can be. However, the key to understanding what to do with "old" plans, and whether it makes sense to establish a new plan (before or after the regulations become final) is to utilize the services of an expert who can spreadsheet model the various options for you. Because the choices are so vast, and the comparisons so detailed, spreadsheeting is the only effective means to make informed choices about what to do with old, transitional and new plans.
For more information on executive compensation, see the Encyclopedia of Private Equity, Chapter 7 Table of Contents and subscribe to the most comprehensive source on private equity and venture capital available.
About The Author
Jeffrey R. Shearman is a registered representative and investment advisor representative of Sagemark Consulting, a division of Lincoln Financial Advisors offering insurance through Lincoln affiliates and other fine companies. This information should not be construed as tax advice. You may want to consult a tax advisor regarding this material as it relates to your personal circumstances.