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SPLIT-DOLLAR LIFE INSURANCE ARRANGEMENTS
Stephan R. Leimberg

The Importance of Documentation

What Was the Situation Before?

The apparent lack of IRS attention to split-dollar documentation in past years has made many planners and advisers complacent, sloppy, or even negligent. Hundreds of split-dollar agreements were established without the requisite paperwork.

What Is the Nature of the Change?

Recent cases have emphasized the importance of careful and full documentation of the split-dollar arrangement. For example, in one case, a court ruled against the taxpayer who claimed he should be taxed under split-dollar rules because of the taxpayer’s lack of any supporting documentation. The insured employee-shareholder was required to recognize income to the extent of the entire amount of premiums paid by the employer (over $700,000) instead of the (much lower) economic benefit measurement. So regardless of the policy ownership and the structure of the split-dollar arrangement, separate documentation must be created and maintained to evidence the "at arm’s length" transaction between the employer and the employee (or a third-party owner).1

1. Goos vs. Comm'r., TC Memo 1991-146. For more detailed information, readers are encouraged to obtain the author's article titled "Split Dollar, the Bifurcated Peso: Split, Rip, or Tear?" published by Matthew Bender as part of the proceedings of the 31st Philip E. Heckerling Institute on Estate Planning. Also consult Tax Planning with Life Insurance, Financial Professional's Edition, publised by the RIA Group.

First, a corporate resolution should state that the Board of Directors has authorized the establishment of a split-dollar arrangement. That resolution should identify the officer(s) who is (are) authorized to execute the necessary documents on behalf of the corporation and state the corporate purpose served by the agreement.2

2. Whenever there is a change to the arrangement, there should be a corporate resolution documenting such a change.  Likewise if the agreement is terminated or when an employer-owned policy is transferred to the employee, the minutes should document the transaction.

Second, there must be a contractual agreement, and the parties should consider the following:

           Where Can I Find Out More?

Rules for Use of Insurer’s One-Year Term Rates Have Tightened

What Was the Situation Before?

Prior cases and rulings have helped us understand how far the IRS was willing to allow taxpayers to go—and how far the Service itself would go in holding to the precise letter of the law.

What Is the Nature of the Change?

A number of recent cases and rulings have shown that the IRS will strictly construe the rules pertaining to the insured’s privilege of using yearly renewable term (YRT) rates when reporting the taxable economic benefit under a split-dollar plan.

When an employee is provided life insurance by an employer through a split-dollar arrangement, according to Rev. Rul. 64-328, the insured employee is deemed to have received reportable income by virtue of the employer’s premium payment under the economic benefit theory. (Note that before 1964, under Rev. Rul. 55-713, premium payments by an employer on a policy for the benefit of an employee were considered to be interest-free loans, and not taxable.13 But the IRS changed its position in Rev. Rul. 64-328 and held that the employee was taxable each year for the life insurance protection received as a result of the employer’s premium payment.)

13. A split-dollar agreement between an employer and an employee entered into on or before November 13, 1964, is not subject to the economic benefit theory, and the employee's insurance coverage is income tax free. Bagley vs. United States, 348 F.Supp. 418 (D. Minn. 1972). Rev. Rul. 64-328, 1964-2, CB 11. However, if a "significant change" is made to the plan, it may cause the arrangement to be considered a new plan, and thus become subject to taxation under the economic benefit theory. Sercl vs. United States, 684 F.2d 597 (8th Cir. 1982), rev'g and remanding 538 F. Supp. 460 (D.S.D 1981); and Ltr. Rul. 7832012.

Current split-dollar arrangements are not considered to be interest-free loans but rather as an employee benefit under which the covered employee must realize taxable income each year. Even if the arrangement is technically a "collateralized" loan from an employer to an employee, and even though an interest-free loan now generates taxable income to the employee under IRC Sec. 7872, the IRS is still adhering to the economic benefit theory of Rev. Ruls. 64-328 and 66-110.

According to Rev. Rul. 64-328, the amount of the reportable ordinary income is equal to the one-year term insurance benefit received by the insured. This amount is based on the "net amount at risk," that is, the "pure death benefit" payable to the employee’s beneficiary, which is then multiplied by the applicable rate under the PS 58 table,14 and then offset by any premium payment provided by the employee.15

14. This is the government's schedule of term insurance rates (also used to compute the reportable economic benefit received when permanent life insurance is purchased inside a qualified plan), which is based on the probability of death. Thus the rates (and therefore reportable income) increase as the insured grows older.
15. This ruling is important because it recognizes a split-dollar arrangement as something other than a loan from the employer to the employee. The employee is not contractually bound to repay the employer from any asset other than the cash values or policy proceeds, so the employer's premium payment is a form of an "investment."

Although not mentioned in the ruling, if an employer provides benefits other than the "net amount at risk" insurance coverage, those additional benefits are also taxable (presumably measured by the extra premium cost). For example, employer-paid waiver-of-premium, accidental-death benefit, or term riders costs would be reportable by the insured as additional income.

The 1964 ruling anticipated other design variations and stated that the same income tax result (that is, income taxation of the employee based on the pure insurance payable to his or her named beneficiary) would occur regardless of the form (for example, collateral-assignment or endorsement method) in which the transaction was cast if it resulted in a similar benefit to the employee.16

16. See also Rev. Rul. 76-274, 1976-2 CB 278.

Rev. Rul. 66-110, 1966-1 CB 12 expanded on the 1964 ruling by addressing the taxation of dividends, additional benefits, and the use of the insurer’s annual renewable term rates in lieu of the PS 58 rates. According to the 1966 ruling, based on the concept that employer dollars are generating policy values, dividends used for the benefit of the employee are taxable and currently reportable as ordinary income.17 For instance, when income is paid to the employee in cash or used to purchase one-year term insurance payable to the employee’s beneficiary, the actual amount of the dividend is includible in the employee’s income. This ruling also states that if an employer provides benefits in addition to the "net amount at risk," those additional benefits are also currently taxable. The most obvious examples are employer-paid waiver of premium, the cost for accidental death benefit, or term riders. The employer-paid premiums would be additional reportable income by the employee—assuming the employee has the right to name his or her beneficiary(ies).

This 1966 ruling anticipated that the IRS might not keep its PS 58 rates either current or realistic and provided that in calculating the economic benefit cost, the employee may use either the PS 58 rates or the insurer’s yearly renewable term rates, if lower. In fact, the insurer’s YRT rates are almost always significantly lower than the government’s PS 58 table rates. But Rev. Rul. 66- 110 required that certain tests must be met for an insured to use the substituted lower rates.

Recent cases have focused on these anti-abuse rules:

When a split-dollar arrangement is between an employer and a third-party owner (such as a spouse, an adult child, or an irrevocable life insurance trust), the insured employee (and not the third-party owner) is subject to income tax on the value of the economic benefit.19

19. Rev. Rul. 78-420, 1978-2 CB 67 (situation 2); Ltr. Rul. 8003094. But see Rev. Rul. 79-50, 1979-1 CB 138, which involved a corporation and a nonemployee shareholder. In this situation, the value of the insurance protection was treated as a dividend to the shareholder under IRC Sec. 301(C).

If a life insurance policy on a third-party nonemployee (such as an employee’s spouse) is subject to a split-dollar arrangement between a corporate employer and an employee policyowner, the economic benefit is attributable to the employee.20

20. See Rev. Rul. 78-420, 1978-2 CB 67, TAM 7832012, and Sercl vs. United States, 684 F.2d 597 (8th Cir. 1982). The same result occurs when the policy is used to fund a cross-purchase buy-sell arrangement. The shareholder-employee who owns the policy on his or her coshareholder's life will be taxed on the economic benefit—because he or she is relieved of the obligation of having to pay the entire premium.

Taxation of a survivorship (second-to-die) policy is not specifically covered in any IRS rulings. When both insureds are alive, the calculation of the economic benefit is (probably) based on the so-called PS 38 rates instead of the PS 58 rates.21 These rates are much lower than the individual PS 58 rates, because they are based on the probability that both insureds would die within a 12-month period. After the first death of the joint insureds,22 while there is no authority on point, if one of the insureds under a survivorship or second-to-die policy dies, the PS 58 rate (or the insurer’s single-life individual annual renewable term rate, if lower) probably should be used in calculating the economic benefit.

21. Although technically there are no PS 38 rates or PS 38 Table, there is a U.S. Life Table 38 based on a 1938 CSO (Commissioner's Standard Ordinary) Table. U. S. Life Table is a mortality table, and it is the basis for interpolation commonly referred to as the PS 38 rates. This mortality table was used by the IRS actuary Norman Greenberg (in response to a request from Morton Greenberg, Counsel and Director of Advanced Underwriting, Manufacturer's Life) in converting individual PS 58 rates to what is now known as the PS 38 rates (but should technically be referred to as the "Survivorship PS 58 Rates").

While there are no published rulings or cases providing guidance in the area, the prevailing (and accepted) practice is to use the PS 38 rates and the rules outlined in the "Greenberg-to-Greenberg" letter in computing the economic benefit measurement of a survivorship-type policy subject to a split-dollar plan. PLR 9709027 seems to sanction the use of U.S. Life Table 38 (which is often called PS 38). It should be noted that the survivorship computation is not based on the "joint equal age" of the insureds, but on the age of each of the insureds.
22. It is probably best to plan on rolling out the policy after the first insured dies. The substantially increased cash values in the policy after that event would help the new sole insured carry the policy. (Some authorities suggest a provision that automatically terminates the split-dollar agreement—prior to the first death.) At roll-out, if there is a transfer for value and the partnership exception to that tax trap is used, must both insureds be partners?

"Rated" insureds— individuals who must pay an additional premium beyond the standard because of health, occupation, or avocation—present a very special tax planning opportunity. Regardless of whether the insured is in the preferred, standard, or rated class, the reportable economic benefit is unaffected. In other words, the reportable economic benefit under split-dollar is the same for all risk classifications. An insured employee who is highly rated can (and must) use the same PS 58 rate (or the insurer’s alternate one-year renewable term rates) in calculating the economic benefit as that of a preferred or standard risk insured of the same age. This circumstance creates a highly favorable tax result where the insured is for any reason classified by the insurer in a category that results in a higher-than-standard premium.

When premiums on a policy are no longer payable by either party (such as when the policy is paid up, or premiums have vanished), the employee continues to incur income taxation on the annual economic benefit received by virtue of his or her employer’s outlay—as long as the split-dollar agreement is in effect.23 Likewise, if the policy is owned by a third party such as a spouse or an irrevocable trust, the constructive gift continues to be made by the insured employee each year to the third party in the same amount and at the same time as the reportable economic benefit.

23. Rev. Rul. 64-328 contains an example of a policy on an abbreviated premium payment basis (ten-pay). The ruling concluded that even after the premium payment period ended, the economic benefit to the covered employee continued. Some commentators have suggested that the employee should give the employer a promissory note payable at death. Even assuming the employer would or properly could accept such a long-term note as payment for its interest in the policy, the impact of below-market or interest-free loan rules should be considered. IRC Sec. 7872.

Where Can I Find Out More?

Sec. 83 Has Been Applied to Equity Split-Dollar

What Was the Situation Before?

Although a few highly respected authorities had stated that the employee’s cash value build-up in an employer-sponsored equity split-dollar plan would result in current income tax, most attorneys and CPAs have either not believed that would occur, were silent, or ignored the problem.

What Is the Nature of the Change?

Equity split-dollar is essentially an arrangement in which the agreement limits the employer’s interest in the policy cash value and death proceeds to an amount equal to its premium contributions. Thus the balance of the cash value inures to or is controlled by the employee. The employee accumulates equity in the policy as the cash values exceed the amount repayable to the employer.

Why provide an employee with equity (aside from the obvious shift of wealth)? The answer is that split-dollar is a time-limited solution: At some point there must be a financing mechanism for the insured or other third-party owner to buy out the employer and pay premiums. Equity split-dollar was designed from inception to provide the employee or third-party policyowner with sufficient cash to finance the termination of the split-dollar arrangement. Cash to repay the employer comes from the policy itself. At the point where there’s enough cash in the cash value of the contract, the employee or third-party owner can use the policy’s equity to buy out the employer and continue the policy.

Equity split-dollar is typically established by using the collateral-assignment method.24 Under this ownership method, the employee is the original applicant and owner of the policy and then makes a collateral-assignment of the contract to protect the interest of the employer. If anything, the employee contributes an amount equal to the economic benefit cost. The employer contributes the balance. In many cases there is an "employer-pay-all" arrangement, in which the employee makes no contribution. The net result is that the employee has very little (if any) out-of-pocket outlay and yet reaps the equity— the benefit of any increase in the cash value over and above the employer’s interest in the policy.25

24. A split-ownership or sole-ownership method may also be used. The endorsement method is not used because the employer is the owner of the policy and the employee generally has no rights to the cash value. (Under certain endorsement split-dollar plans, the employee may have some rights to the cash value—for example, if the employer's interest is limited to the lesser of its premium payments or the cash value—but such designs are exceptions rather than the norm.)
25. For purposes of this discussion, the term equity or equity build-up refers to any increase in the policy cash value that is in excess of the employer's share of the cash value under the split-dollar plan, and not the cash value increase (that is, the inside build-up) of a policy.

Although there is no good reason (and never was) why the basic rules regarding the income taxation of an equity split-dollar plan should be ignored or differ from other split-dollar plans, there have been many issues that remain unsettled.26 The key issue is the taxation of the equity build-up that inures for the benefit of, and/or is controlled by, the employee (or a third-party owner). The pivotal questions are as follows:

Commentators on both sides of the issue continue to advance their theories (and counterarguments) regarding the taxation of the equity. The three most frequently presented theories are based on Code Secs. 61, 83, and 72 and are discussed below in detail.

Code Sec. 61 defines gross income as "all income from whatever source derived." If it is not elsewhere specifically excluded or the tax is not specifically deferred, it is both includible and currently reportable. Sec. 61 encompasses the concept of constructive receipt, which holds that income does not have to be actually received before it must be includible in income—if nothing stands between the taxpayer and the incomeand the taxpayer can get it when he or she wants it.

Sec. 61 also is the father of the economic benefit or cash equivalency theory: namely, that any measurable economic or financial benefit conferred upon an employee as compensation, whatever the form or mode, is currently includible in the recipient’s income.

When applied to equity split-dollar, Code Sec. 61 implies that the equity build-up in excess of (and attributable to) employer-paid premiums is the equivalent of compensation and should be included in the employee’s gross income as it accrues (absent—or at the point where there is no longer—a substantial risk of forfeiture). The authority for that statement rests in Rev. Rul. 64-328, which states that the employer owns the cash value interest,which provides an economic benefit to the employee even if the arrangement is cast in the form of a collateral-assignment. So even if the employee or third party is the legal contract owner from inception, in the classic split-dollar arrangement, cash values are considered employer money. Under Code Sec. 61 and Rev. Rul. 64-328, the Service could argue that the earnings on the portion of the cash value owned by the employer are, in an equity split-dollar arrangement, property that is transferred to the employee and taxable under Sec. 83.

Rev. Rul. 66-110, another of the key split-dollar rulings, is also based on Code Sec. 61. Rev. Rul. 66-110 states specifically that "additional benefits," meaning any other benefits received by the employee besides the term coverage, are currently taxable, presumably because other benefits were also generated by employer cash values. This is an argument the IRS could still use to tax an employee’s year-by-year employer-paid enhancement in wealth.

The counterpoints to this Sec. 61 theory are these claims: First, Rev. Rul. 66-110 merely amplified Rev. Rul. 64-328 by addressing the taxation of incidental benefits costs for waiver-of-premium benefits, accidental-death benefits, and so on. So it should have no application to the income tax treatment of equity.27 Second, Rev. Rul. 64-328 more directly addressed the taxation of the basic elements of a life insurance policy subject to a split-dollar arrangement. Thus taxation should be based on this ruling.28

27. Cash value increases are arguably not "incidental benefits" under the policy, but rather are an integral part of the basic policy element that provides the underlying death benefit of a life insurance policy. Proponents of this position argue that "the theoretical basis for the rule announced in Rev. Rul. 64-328 (as explained in General Counsel Memorandum 32941, November 20, 1964) does not allow for the taxation of equity cash value which makes up part of the insured's share of the death benefit on any basis other than under the economic benefit formula. To do so amounts to the unauthorized taxation of cash value inside build-up." They argue that "Code sections enacted after Rev. Rul. 64-328 was issued—such as Sec. 83 (transfer of property) and Sec. 7872 (below market loans)—don't apply to split-dollar arrangements, and if they did, would not apply in the way suggested by TAM 9604001." See Report by Association of Advanced Life Underwriters to members, November 1996.
28. In Rev. Rul. 64-328, the IRS conclusion seems to add weight to the argument for nontaxation of the "equity" because the policy at issue actually developed cash value in excess of the amount to which the employer was entitled. The ruling states that " . . . the employer is entitled to receive, out of the proceeds of the policy, an amount equal to the cash surrender value, or at least a sufficient part thereof to equal the funds it has provided for premium payments." This statement seems to indicate the recognition by the IRS of the equity build-up in the policy. See Brody, "Using Split-Dollar Life Insurance," Trusts & Estates, June 1990, p. 65; Brody and Althauser, "An Update on Business Split-Dollar Insurance," Trusts & Estates, April 1994, p. 10.

Code Sec. 83 is a very broadly drafted Code section that provides rules for the taxation of property transferred to a "service provider"29 in connection with the performance of past, future, or current services. The regulations under Sec. 61 provide that Sec. 83 applies to all compensatory transfers of property made after June 30, 1969. The presumption is that every transfer of property arising out of a direct employment relationship is compensatory. If services are performed generating a transfer of property, the cause and effect triggers Sec. 83. There need not be a direct quid pro quo. The burden of proof rests on the taxpayer. The services in question can be past, present, or future.

29. Note that the scope of Code Sec. 83 goes beyond employer-employee relationships and could apply between a corporation and its nonemployee director or independent contractor.

"Property" is broadly defined under Sec. 83 to include both real and personal property. But the term "property" excludes money—or an unfunded and unsecured promise to pay money or property in the future. Money is excluded because transfers of money are already encompassed in Code Sec. 61(a)(1), which provides for taxation of compensation for services. So reference in Sec. 83 to transfers of money for services would be redundant. The exclusion of the later is to protect nonqualified deferred compensation, which is already governed by the interplay of Secs. 61 and 451.

Sec. 83 is very specific with respect to what it calls the receipt of a "beneficial interest" in assets transferred or set aside beyond the claims of the transferor’s creditors. Money is included in the definition of a beneficial interest. So if a service provider receives as a quid pro quo of services a vested beneficial interest in property—including money—that income is currently reportable, that is, it’s both realized and recognized. The only thing that would defer immediate taxation is if the assets or funds involved were not irrevocably set aside from the claims of the transferor’s creditors. Sec. 83 is therefore a codification of the economic benefit doctrine: Once an asset is nonforfeitable by a service provider and set apart from the transferor’s creditors, it is Sec. 83 property and currently taxable.

What of the requirement that there must in fact be a "transfer"? Sec. 83 Regulations30 define the term "transfer" as a transaction in which a person acquires a beneficial ownership in property. A transfer of property does not require a physical handing over of an asset or a traceable paper trail. The key questions are, "Did the service provider receive absolute ownership rights this year that he or she didn’t have in a prior year?" and "Because of services performed, did the service provider become richer?" If so, there has been a transfer. The amount that is taxable is the excess of the value received over the value of what has been paid.

30. Reg. Sec. 1.83-3(a)(1).

The recipient’s basis in Sec. 83 property is the amount paid, that is, the value of any money or property he or she paid for the transfer plus any amounts upon which the service provider has paid tax in a prior year— the amount included in gross income.

Sec. 83(b) allows the service provider to elect to accelerate the taxable event to the date of the transfer. This action closes the transaction as to that transfer. The employee is treated as owner of that property from then on. Any subsequent appreciation of the subject of that transaction is not considered compensation but, rather, growth in the service provider’s investment.

If Sec. 83 applies and causes a service provider to be currently subject to income tax, the employer may receive a corresponding deduction. Sec. 83(h) controls the allowability, amount, and timing of that deduction. The party to whom services are provided receives a deduction equal to the amount included in the service provider’s income. The amount of that deduction is based on Sec. 162 or 212 rules. So the deduction is limited to the extent that the payment is reasonable.

Sec. 83 performs three major functions. It determines

That service provider is generally taxed on the value of such property at the time of its receipt. An exception under Sec. 83 delays that taxation if the recipient’s interest in the property is subject to a substantial risk of forfeiture. In such a case, tax does not occur until and unless the risk of forfeiture is removed. When the property is substantially vested, that is, when the recipient can take the property and run without fear of losing it, in that tax year he or she must report the entire value of the property at that time (reduced by any amount he or she paid for the property or previously reported as income).

How does Sec. 83 relate to equity type split-dollar agreements? As noted, Sec. 83 deals with property transferred in connection with the performance of services.31 Application of the pertinent parts of Sec. 83 means that the employee would be taxable each year when and to the extent that there is an increase in his or her equity, or entirely on the amount of the equity when the split-dollar is terminated and the policy is rolled out to him or her. The taxation of the equity occurs when the employee’s rights to the cash value are no longer subject to a "substantial risk of forfeiture," or when the employee can freely transfer his or her interest to a third party (without any risk of forfeiture).32 Therefore the employee is subject to taxation on the increase in his or her equity at the crossover point where the policy cash values exceed the amount repayable to the employer and the service provider begins to accumulate equity.

31. In order for personal property to be considered property for purposes of Sec. 83, it must be "funded" or "secured," that is, there must be no further action required by the employer for the income to be distributed or distributable to the employee. So the employee must have a nonforfeitable economic or financial benefit that is no longer subject to the rights of general creditors of the employer. See Minor v. U.S., 772 F.2d 1472 (9th Cir. 1985) and Childs v. Comm'r., __F.3d.__ (11th Cir. 6/11/96), aff'g 103 T.C. 634 (1994). See also Chasman, "Life Insurance: A Sophisticated Estate and Financial Planning Tool," University of Miami 22nd Institute on Estate Planning, Chapter 4 (1988).
32. IRC Sec. 83(a), and Treas. Reg. 1.83-3(e).

To the great surprise of many practitioners, this application of Sec. 83 to split-dollar is not new. In two private letter rulings, the IRS used this theory to tax the employees when the employers released their interests and rolled out the policies to the employees (albeit under some atypical fact situations).33

33. See PLR 7916029 and PLR 8310027.

Some commentators have countered the IRS holdings in the above letter rulings by pointing out that under a collateral-assignment split-dollar plan, the employee owns the policy from its inception. Therefore, they argue, Sec. 83 is not applicable since neither the policy nor the cash value increase is being transferred from the employer to the employee. They point out that the employee owned the policy from inception and has not received from the employer property that was not already owned. Instead, they insist, the principles under Rev. Rul. 64-328 should apply.34 In support of their position, they have suggested that the employer’s premium payment is like a loan to the employee. That is, if an employer were to lend funds to an employee to acquire an asset (for example, a residence), the appreciation in the asset would not be taxed until the asset was sold or disposed of. In other words, the employer has merely advanced money (premium) to the employee to purchase a life insurance policy; therefore any cash value increases are not "employer-provided," but result from an investment by the employee of the employer advances in an appreciating asset.35 Further, they contend that even though split-dollar plans are not considered interest-free loans for tax purposes, the analogy should still pertain to the appreciation element (that is, the cash value increases) of the policy.36

34. But it might be argued that the above-mentioned private letter rulings are more on point although (technically), a private letter ruling (unlike a revenue ruling) lacks any precedential authority and is applicable only to the taxpayer who requested it. Additionally, they were issued many years after Rev. Rul. 64-328; in fact, Sec. 83 was enacted 5 years after the 1964 ruling. Therefore the IRS could not possibly have considered or addressed the impact of Sec. 83 on equity split-dollar plans when it issued its "landmark" revenue ruling. But see discussion on TAM 9604001, infra.
35. It appears that this position for nontaxability can be sustained only if the money advanced by the employer is considered either as compensation (which is taxable to the employee as current income), or as a loan (which is subject to a reasonable interest rate; Sec. 7872 taxation will apply if it is below market or interest-free). But when the employer's advances (premium payments) are subject to a split-dollar arrangement (regardless of whether it is based on a collateral-assignment, split-ownership or sole-ownership method), part or all of the policy cash value increase each year is attributable to the funds provided by the employer. Therefore the employee should be taxable when he or she is enriched (in terms of the equity) by the employer's premium payments.
36. See Brody, supra. But this argument begs the following question: Are the employer-paid premiums interest-free loans (as opposed to being treated as advances subject to the economic benefit theory for taxation under Rev. Rul. 64-328)? If so, IRC Sec. 7872 should apply. In other words, should the employee be able to "pick and choose" among the various theories of taxation for the one(s) that would bolster (and successfully defend) his or her position for nontaxation?

Sec. 72 pertains to the timing of income. It states when the lifetime benefits received from a life insurance contract become taxable. This Code section governs the income taxation of all amounts received under life insurance contracts as "living" benefits, that is, cash values, dividends, premium returns, and proceeds paid during the insured’s lifetime. Under Sec. 72(e)(2)(B) (Amounts Not Received As Annuities),37 only amounts in excess of the consideration (premiums) paid by the policyowner for the life insurance contract would be taxed—and then only when actually received (that is, via surrender, withdrawal, or an MEC loan).

37. "Amounts not received as an annuity" include policy dividends, lump-sum cash settlements of cash surrender values, cash withdrawals, and amounts received upon a partial surrender of the contract. This "invisible shield" applies only "if no provision of this subtitle (other than this subsection) applies with respect to such amount." See Sec. 72(e)(1)(A)(ii). Readers of this Code section will not find a clear statement of protection of the tax-free build-up of cash values. Instead, Sec. 72 provides, in essence, that "this is when we are going to tax," and only by assuming that the same income will not be taxed twice can the reader come to the conclusion that Congress meant to provide a tax-deferred "shell" around the policy until it is "cracked open" at surrender.

By inference, we assume—because it would be unfair to tax the same income twice—that income earned inside the policy is not taxable to the policyowner during the build-up phase. Therefore, if this section is applied to equity split-dollar arrangements, any cash value (while it is accruing) should not be subject to income taxation until such time when the employee is in receipt of the cash value, and then only to the extent of the excess cash value over his or her cost basis. It is like a magic glass: income earned on the capital inside the glass will not be taxed until the owner of the glass decides to take a drink. Code Sec. 72 is therefore the law used to justify the tax deferral on the income accruing to the policyowner’s benefit inside a life insurance contract. But Sec. 72 does not specifically state that the internal build-up in a life insurance policy grows tax free. Furthermore, Sec. 72 expressly provides that Sec. 72 applies only if some other Code section does not.

This Sec. 72 theory for nontaxation is often used to refute the taxation theories based on Secs. 61 and 83 of the Code. Under standard principles of statutory construction, more specific statutory provisions take precedence over more general provisions when they overlap. Consequently it has been argued that Sec. 72 should take precedence over Secs. 61 and 83, and that any excess cash value should not be taxed until there is a surrender, a withdrawal, or an MEC loan.38

38. In contrast to Sec. 72, Secs. 61 and 83 contain much more general provisions with respect to income taxation. The former refers to all types of "restricted property," while the latter encompasses income "from whatever source derived." See Leimberg, et. al., The Federal Income Tax Law, RIA Group. Note also that the Sec. 72(e)(1) statement that provides that the internal build-up (income) is taxable when the policyowner surrenders the policy or takes an annuity applies only "if no other provision applies."

The major flaw in this line of argument is that the issue at hand is not the taxation of the "inside build-up" of a policy, or the "excess cash value" over the policyowner’s basis to which Sec. 72 is definitely applicable. Indeed, at no point does the IRS in the TAM discussed below refute the concept of the tax-deferred build-up—once money is inside the policy. The issue revolves around the taxability of the property transferred by the employer to the service provider (in most cases, the employee) as compensation for past, present, or future services. The measure of that property’s worth is the equity, that is, the excess amount of cash value over and above the employer’s interest under the split-dollar plan, which inures to, or is controlled by, the employee.

But the point of taxation is at the pour-over of employer dollars under its (split-dollar) contract with the service provider. This is an event that occurs before—and independent of—the internal build-up of cash values within the life insurance contract. For this reason, Sec. 72 has no application to income tax aspects of equity split-dollar arrangements. Instead, the taxation of the employee should be in accordance with the principles set forth in Rev. Ruls. 64-328 and 66-110. Therefore, the equity is taxable to the employee under Secs. 61 and 83.39 Stated in another way, since all cash values are originally generated by employer dollars, "any portion of the employer’s cash value set aside for the benefit of the employee and beyond control of the employer may be an additional economic benefit taxable currently to the employee if his or her right is not subject to a substantial risk of forfeiture."40

39. Substantial risk of forfeiture must be determined under a "facts and circumstances" test: Will the restriction impose a real risk such that the employee will forfeit the property if the specified condition (for example, the performance of services) are not met?
40. Chasman, "Life Insurance: A Sophisticated Estate and Financial Planning Tool," University of Miami 22nd Institute on Estate Planning, Chapter 22 (1988). Mr. Chasman feels that double counting of the employee's contributions as basis against both the net amount at risk and the cash value would be allowed.

Technical Advice Memorandum 9604001 brought all these theories to a boil. Here, the IRS clearly stated its position on the taxation of equity split-dollar arrangements.41 It concluded that the insured employee must recognize income each year to the extent of the cost of the insurance protection, plus any equity—that is, the cash value in excess of the amount needed to repay the employer for its premium payments. As a corollary, it also ruled that when the employee was taxable, there would be a gift in a corresponding amount to a third-party policyowner.

41. The TAM (dated September 8, 1995) was issued by the IRS National Office. Since its release (on January 26, 1996), it has generated much concern in the insurance world. The American Council of Life Insurance (ACLI) and the Association for Advanced Life Underwriting (AALU) have submitted their comments on the findings in the TAM to the IRS and Treasury, and requested that the TAM be withdrawn or modified.

To date, there has been no clarification or guidance from the IRS or the Treasury and there is certainly no consensus among industry experts and tax and legal professionals in their analysis of the TAM's impact on split-dollar plans. For example, see W. Raby, "Split-Dollar Life Insurance," Tax Notes, August 28, 1995, p. 1099; "Equity Split-Dollar TAM Has Insurers Shifting Gears," National Underwriter, September 2, 1996, p. 7; D. West, "How to Deal with the Split-Dollar TAM," National Underwriter, October 21, 1996, p. 7; H. Saks, "New TAM Will Likely Lead to Changes in Tax Results of Collateral Assignment Split Dollar," Estate Planning, Vol. 23, No. 4, May 1996, p. 186; H. Chasman, "Equity Split-Dollar Life Insurance under Attack by IRS," Journal of the American Society of CLU & ChFC, November 1996, p. 76; and A. Kraus, "Is There Life after Equity Split Dollar?" Personal Financial Planning, September/October 1996, p. 56.

According to the facts of the ruling, A was the chairman, CEO and a controlling (51 percent) shareholder of a holding company that owned 98 percent of a subsidiary (S). S purchased two $500,000 policies with single premium payments on A’s life. The policies were issued to a trust (T) established by A as owner. T entered into an arrangement with S to split the policy benefits, and collaterally assigned the policies to S for T’s obligation to repay S for its premium payments in the event of A’s death, termination of A’s employment, termination of the split-dollar arrangement, or surrender of the policy(ies). T would continue as owner and beneficiary of each policy (subject to the collateral assignee interest held by S), and hold all incidents of ownership. The policy dividends would be used to purchase paid-up additional insurance on A’s life. Furthermore, T would be able to borrow from the policies or pledge or assign either policy, but only to the extent that the cash value of a policy exceeded the premium amount paid by S.

Relying on Rev. Rul. 64-328 as amplified by Rev. Rul. 66-110, the IRS determined that the amount included in income by A each year the split-dollar arrangement remained effective was "the annual value of the benefit" received. This amount would be equal to the one-year term cost of the insurance protection.42 However, the IRS did not stop there. Pursuant to Rev. Rul. 66-110, any additional benefits (such as policy dividends or additional term insurance) also would be includible in A’s gross income.

42. The IRS considered the single premium payment aspect of this arrangement to be an "insignificant" difference from the typical collateral-assignment split-dollar plans. It noted that A was "in the same position as the employee in the revenue ruling [64-328] after the employer has paid the premiums on the policy for a period of 3 years."

The IRS applied Code Secs. 61 and 83 in determining the value of the benefit received by A. First, Rev. Rul. 64-328 clearly indicates that the one-year term insurance provided to A would be includible as current income under Sec. 61. Second, the IRS applied Sec. 451(a) of the Code, which requires that income be included in the tax year compensation or that other income is received by a taxpayer unless it should be reported in a different year because of the accounting method used. It determined that A would have to recognize taxable income each year. Third, Sec. 83 was applied to the facts described in the TAM, and the IRS ruled that until the cash values in the policies exceed the amounts that must be repaid to S, the only taxable income to A was the term insurance cost (based on the PS 58 table or the insurer’s one-year term rates, if lower).

However, A would report income " . . . in later years under Sec. 83 to the extent that the cash surrender values of the policies exceed the premiums paid by S[ubsidiary] because this is the amount that is returnable to S[ubsidiary]." The IRS explained its position for the application of Sec. 83 in its analysis by stating that the provisions of Sec. 83 and Sec. 61 do not alter the application of the holdings of Rev. Ruls. 64-328 and 66-110, since Sec. 83 was enacted after the revenue rulings were published.43

43. This position is consistent with the IRS findings in PLRs 7916029 and 8310027. The same rationale, enrichment of an employee through employer dollars equals current taxation even though the enrichment was in the form of increased life insurance policy cash values and the policyowner did not surrender the policy, was reflected in Young et ux. et al. v. Comm'r., T. C. Memo. 1995-379. See also "Corporation's Payment on Shareholder's Life Insurance Policies Were Constructive Dividends," The Insurance Tax Review, September 1995, p. 1359. In the Young case, the Tax Court held that the employee-shareholder, covered under a plan that enriched him through employer-provided premiums, received currently taxable income. Specifically, the Court noted that each time the employer made a premium payment, the insured employee-shareholder was enriched (through the increasing policy cash value), while the employer received no economic return whatsoever on its outlay. Although this case technically did not involve a split-dollar arrangement, there is no reason to preclude the application of the rationale to such arrangements. Incidentally, Judge Armen in Young concluded that if an employer has no right to recover any part of the payments it made and no claim to any part of the policy proceeds, the arrangement cannot be classified as a split-dollar insurance arrangement (and therefore in Young the entire amount of premium payment constituted a dividend to the insured shareholder-employees).

Assuming a worst-case situation, full enforcement of the TAM, aside from the additional reportable income and the consequent income tax, some taxpayers would be exposed to interest charges on unpaid taxes. There is the potential for penalties charged both to clients and practitioners if the income wasn’t reported and there is no substantial authority for not reporting equity build-ups. Practitioners should be asking the following questions:

"What 1099 obligation does a corporation have?"

Most authorities feel that the income tax cost of the TAM is a price that business clients would be willing to pay. But the gift and generation-skipping tax cost could be prohibitive. Prior to the TAM, the economic benefit of the term insurance was thought by many to be the only measure of the gift and GST transfer of equity split dollar. That made incredible gift and GST leverage possible. For example, compare the gift tax cost of making a $1million gift in the form of cash, stocks, bonds, or real estate to making a gift of the same value, $1million of life insurance, in the form of sufficient premiums for the donee to purchase and maintain a $1 million policy on the donor’s life. For an annual outlay of slightly more than $15,000 a year, a 40-year-old could support that much permanent coverage.

On a split-dollared basis, the gift tax cost is not based on $1 million or even $15,000 a year. It’s based only on the economic benefit reportable as income by the employee. In a worst-case scenario, in this example, that translates to less than $5,000 a year, an amount that could be totally sheltered by the donor’s annual exclusion. On a joint-and-survivor policy, the gift or GST transfer tax is even less. The point is that split-dollar provides tremendous gift and GST leverage!

After the TAM, the gift tax cost may be the term cost plus all or a portion of the build-up in the policyowner’s wealth. That would diminish the gift and GST tax leverage and turn an incredible technique into something that’s just really good or perhaps only adequate compared to alternatives. To repeat, the biggest loss if the TAM is both correct and enforced is that the same degree of "tax-leveraged trust packing" possible in the past may not be possible in the future. The ability to shift wealth essentially at both an economic and tax discount will still be possible but not to the same extent.

Those who argue against a Sec. 83 imposition claim the following:

The holding of TAM 9604001 misapplies Sec. 83 and announces a result inconsistent with the Service's ownpublished rulings regarding split-dollar life insurance. To leave the TAM unmodified would continue uncertainty in an area that is much used by taxpayers in the expectation of continued constancy by the Service with regard to these agreements. It is unfair to insinuate change in established and long standing administrative precedent by a technical advice memorandum that is flawed in its analysis and disregards substantial judicial precedent in the area of constructive receipt. The Cohen44 and Nesbitt45 cases hold that with regard to the taxation of cash build-up within a whole life policy, the owner realizes income not by the mere existence of an option to receive cash but only if the owner acts to reduce the option to cash and extracts it from the policy. So long as the cash remains in the policy, it will not be taxed.46

44. Cohen v. Comm'r, 39 T.C. 1055 (1963).   
45. Nesbitt v. Comm'r, 43 T. C. 629 (1965).
46. J. Jensen, "Equity Split-Dollar Life Insurance and TAM 9604001," Outline presented to The American College of Trust and Estate Council, Fall Meeting, Cincinnati, Ohio, Oct. 12, 1996.

The major arguments made by those who feel the TAM is wrong can be broken down into

  1. The "technical imperfection" argument
  2. The "unfair-to-tax" argument
  3. The "Sec. 72 applies" argument
  4. The "there-was-no-transfer" ("the employee always owned the contract") argument.

The "Technical Imperfection" Argument

According to the technical imperfection (and "lower-level author") argument, sloppy or less-than-comprehensive drafting—or the fact that a senior-level official did not write it—flaws the TAM. Typical comments include, "To be charitable, TAM was not really well thought out or well written." "It lacked detailed analysis." "It goes on for pages but the key statement, equity is subject to income tax under Sec. 83 of the Code, is contained in one sentence." "There is no amplification, no rationale why Sec. 83 is applied." "There’s no mention of any of the counterarguments against income taxation, particularly Sec. 72." "The reliance upon Sec. 83 is puzzling, probably misplaced" "The TAM was written by a lower-level author and not coordinated with higher-ups or other ruling branches of the IRS, particularly those who have been prominent in previous informal split-dollar discussions in the past." "The discussion of equity in the TAM was premature; there was no equity in the policy in question. During the tax years subject to audit, the policy illustration showed no equity." "The TAM doesn’t discuss the impact of the employee’s basis in the computation of taxation of future equity."

These are all accurate statements but true as they may be, none of these criticisms is very persuasive in countering the appropriateness of Sec. 83. Certainly, none rises to the level of a defensible legal argument. The key issue is, "Is the central conclusion of the TAM—that Sec. 83 applies to make the service provider currently taxable on income when equity begins to accrue—correct?"

The "Unfair to Tax" Argument

According to the "unfair to tax" argument, the IRS should be estopped from using Sec. 83 because for a long time they’ve allowed taxpayers to their detriment to rely on IRS inaction. Typical quotes include "In spite of over 30 years of change in life insurance product marketing, the IRS has been silent with respect to equity split-dollar. It would be inherently unfair, a breach of taxpayer rights, to retroactively go back on that position now. Many taxpayers have relied on the rulings and the IRS’s silence," and "The TAM ignores the marketplace impact. It was issued without any consideration of the impact upon literally tens of thousands of equity split-dollar arrangements that are in existence."

It is true that political and economic considerations often influence tax law decisions. And tax law should be fair. Planning is impossible when tax law made today is implemented retroactively. But few true authorities in this area should have been shocked by the holdings of the TAM. One noted attorney said, "Why were they surprised?" This cloud didn’t suddenly appear on the horizon. It’s been there for years. Sec. 83 has been in place for almost all that time.

Reread Rev. Ruls. 64-328 and 66-110 and it will be obvious that the IRS didn’t suddenly change its position. Rev. Rul. 64-328 doesn’t have to be refuted by the IRS for the TAM’s principles to apply. To the contrary, the IRS could easily refer back to it to argue that it is the employer’s cash value that generates the employee’s or third party’s equity. The question that should be asked is, "Who was the real source of the cash in the cash value—and why was that cash paid over to the employee-insured?"

Rev. Rul. 66-110 noted that the employee is subject to tax—not only on the value of the term insurance but also on any additional benefit received in the split-dollar arrangement. Equity the insured has this year that she didn’t have last year is certainly "another benefit." If it isn’t another benefit, what is it? Sec. 61 applies even if for some reason Sec. 83 did not.

The "Sec. 72 (It Can’t Be Taxed until Taken)" Argument

If Sec. 72 applies, as a natural corollary, Sec. 83 cannot apply. Proponents have stated, "The TAM completely ignores the previous government policy against taxing cash value of insurance policies. The original revenue ruling in this area, 64-328, did not raise the issue of taxing equity although it could have done so." "The General Counsel’s memorandum (GCM 32941) said that it was against Congressional policy to ever tax the income build-up in the cash value of insurance" "The TAM essentially would tax life insurance cash value build-up currently and that would definitely appear to be a contradiction to Sec. 72."

Code Sec. 72 expressly provides that it applies only if no other Code section does. But the zealous defense of Sec. 72 is irrelevant. It misses the point. The taxable event doesn’t occur inside the life insurance contract. Nor does the TAM adversely affect Code Sec. 72’s protection in any way. The IRS didn’t think it needed to attack the tax-deferred build-up because the taxable event occurred outside the policy itself and before the protection of Sec. 72 takes over. What is being taxed is the economic value the service provider receives each year as compensation. It is the benefit under the contract with the employer and not the life insurance contract or its cash values that is being taxed!

The protection of Code Sec. 72 remains intact—even if the TAM is correct and enforced. The IRS is arguing that the taxable event is the pouring of employer dollars into the magic glass owned by the service provider. When Congress wrote Sec. 72 into the Code, it presumed that the money inside a life insurance policy would be the employee’s aftertax money. Basis, the employee’s investment, should be recovered income tax free. Sec. 72 enables a deferral of taxation on income earned by what was assumed to be employee aftertax investment. Sec. 72 didn’t anticipate—and certainly doesn’t directly or even indirectly permit—the tax-free or tax-deferred receipt of compensatory income from an employer.

The "There Was No Transfer" Critique

"If you look at the typical collateral-assignment equity split-dollar arrangement, there would appear to be no transfer from the employer to the employee of the life insurance or of the entire insurance policy. On the surface the employee or his trust already owns everything in the policy and any future growth of equity." "The employee has owned the policy all along so nothing can be transferred. There is no transfer when equity appears. (Yet the same person stated, "If this were an endorsement arrangement—with the employer owning the policy, then equity ownership accruing to the employee or third party may very well be a transfer)."

According to this "there-was-no-transfer" argument, the form of the transaction governs. Presumably, a court would be asked to believe that since the insured or third party technically purchased the policy and was its original owner, all the future growth in that policy, no matter what the real source, should be assumed to be the employee’s aftertax dollars. Would these same authorities argue that if an insured opened a bank account in her name and her employer put cash into the account as compensation for services she rendered, she had no reportable income? It’s hard to believe a court could or would be so persuaded.

The "employee-always-owned-the-contract" argument is a mere extension of the "there-was-no-transfer" argument. "Under equity split-dollar, the employee or third party is almost always substantially vested from inception. So if Sec. 83 does apply, it would be a one-time event and have to be at the date of transfer. That would be either the date the split-dollar agreement was signed or the date the first equity appears. From then on, everything has already been transferred. The employee or third party would own the property. All future equity build-up should be protected from income taxation under Sec. 72."

Again, this "employee-owned-the-contract-from-inception" argument is an example of form without substance. Assume an individual fills out the form to purchase a mutual fund and that person’s employer makes the one and only payment to that fund this year on his behalf. How can it be argued that all future payments made by the employer to that mutual fund account were the employee’s ab initio? All future build-up inside that mutual fund account has already been transferred merely because the employee was always the owner of the account? Would a court believe that, next year, when the employer compensates that employee—by putting more money in the fund—the employee has no reportable income in that year?

There are many unresolved issues with respect to equity split-dollar agreements. One such issue is the impact of the TAM, if enforced, on types of split-dollar other than equity arrangements. In the TAM, the IRS focused on an arrangement established by a collateral-assignment method under which the policyowner (a trust) risked no forfeiture of its rights to the "equity."47 The findings in the TAM should not have any impact on split-dollar plans structured under either the endorsement method or the collateral-assignment method48 if the employee has no equityposition in the policy cash value.49

47. It should be repeated that a TAM is a private ruling such that, technically, it does not apply to other taxpayers. In spite of the fact that there are issues that remain unresolved (or not even raised) by the TAM, some tax authorities are of the opinion that the IRS conclusions are basically sound and should be sustainable if tested. Others feel that the IRS will withdraw or modify the TAM.
48. Obviously, if the policy is transferred from the employer to the employee, the employee will have to recognize income (either as compensation or dividend) in an amount equal to the policy cash value at the time of the transfer. See PLRs 7916029 and 8310027.     49.    It is very likely that reverse split-dollar arrangements will be affected by the essential principles of this TAM. See discussion on "Reverse Split Dollar," infra.

Basis is another issue the TAM did not address. Does the employee’s contribution for the term insurance protection (for example, in a "PS 58 offset" plan) provide a tax basis in the policy that would reduce (or offset) the income taxation to him or her on the equityin the policy? Arguably, the IRS will not allow the employee contribution to serve double duty (that is, to offset the economic benefit cost and provide a tax basis for the employee in the policy).50

50. The rationale is based on the fact that the economic benefit cost that is taxable to the employee is solely a measure of the term insurance; is "exhausted" in providing that protection; and has no connection with the tax basis or the policy cash value increase. See PLR 7916029. An employee's contribution under a split-dollar arrangement cannot be counted twice. But see PLR 8310027, in which the employee's taxable income was offset by his "PS 58 cost" contributions. Is the secret "allocation"?

A related issue to the question regarding the employee’s tax basis is, "How should the amount of equitytaxable to him or her be determined?" "Should it be all or a portion of the annual increases?" First, if the employee is taxed on the "equity," should the increase attributable to that portion of the equity be taxable in subsequent years? In other words, does the employee have a tax basis as a result of his or her recognition of income (to the extent of the yearly equity build-up)? It is likely that the employee will be credited with basis to the extent of taxability. Second, how is the taxable income determined if the employee contributes an amount in excess of the PS 58 cost?

Yet another unanswered issue is the extent, if any, to which an employer who is deemed to have made a Sec. 83 transfer of property under an equity split-dollar arrangement will be allowed a deduction. If the employee is taxed under Sec. 83, then the employer should be entitled to a corresponding deduction.51 It should be noted that any amount in excess of the employer’s premium payments recovered by the employer at the termination of the split-dollar arrangement would be includible as gain from appreciated property in its gross income. This would give the employer the potential for many years of deductions, albeit offset by taxable income at the conclusion of the arrangement but at a time largely in the employer’s control (or in a year that the employer could predict and plan for). At worst, the net result would be a wash for the employer—unless the taxable income to the employee is deemed unreasonable or treated as dividend (if the employee is a shareholder).

51. Treas. Reg. 1.83-6.

Counsel should be prepared to assist clients who have established equity split-dollar plans in assessing the potential tax consequences based on the results of the TAM. Obviously, clients should seek advice from tax counsel before they enter into split-dollar arrangements (including equity type plans). The potential impact of the TAM should be considered with respect to their prospective split-dollar plans.52 The following are some suggestions for counsel’s consideration. They are not all inclusive and should not be viewed as such:

Tax preparers must be concerned that the position they take has "substantial authority." Substantial authority is a degree of confidence in a tax position so high that if the taxpayer is wrong and his or her position is not sustained, the Internal Revenue Service cannot impose negligence penalties. If a position is taken that does not have substantial authority and that position is not sustained, negligence penalties could apply to both the taxpayer and tax preparer. Substantial authority is the minimum comfort level that most advisers adhere to. Whether or not there is a substantial authority position is a qualitative rather than quantitative issue. It is even possible to have substantial authority for directly conflicting positions—such as those on either side of this discussion.

"Safety" lies in a position more likely than not to be sustained on its merits. This is generally understood to be present where there is a greater than 50 percent chance of prevailing. Another standard used balances the weight of authorities for one position against the weight of authorities that support the opposite stance. Here, it’s not necessary to prove a 50 percent preponderance. In either case a mistake results in an underreporting of income or gift—and may result in an understatement of tax. In determining whether or not there is substantial authority one considers the Code, regulations, published rulings, PLRs, TAMs, and, in the appropriate situation, a well-constructed argument. Even a well-reasoned construction of the applicable Code section is placed on the scales when the Code or lower levels of authority are silent on a given point.55

55. Reg. Sec. 1.6662-4(d).

Some authorities believe there is clearly substantial authority for not reporting the employee’s buildup of equity currently—enough, in their words, and probably in most cases, to get to take a more-likely-than-not tax position. That is what a number of major accounting firms are advising their field offices in terms of how they prepare client returns and how they should advise their clients. This is also the position of counsel to the Association of Advanced Life Underwriters (AALU), who, in a letter to the president of that organization, stated, "There is no question of appropriate compliance with substantial authority." "Subject to special facts of which we are unaware, we conclude not only that federal income and gift tax returns may take the position that cash surrender value accretion does not, in an equity split-dollar arrangement of the type considered in TAM 9604001, generate taxable income or gift as there articulated, but that such position is the better one to be so reflected on such tax returns."

Is it worthwhile to create an equity split-dollar arrangement even if the TAM is both correct and enforced? A fully informed sophisticated client may look at the downsides and feel, with a proper exit strategy in place, that equity split-dollar, perhaps for some predetermined limited period of time, remains quite viable. Certainly, it can still deliver incredible leverage up to the point where it becomes taxable and even past that point for a number of years! To reiterate, at worst, all is not lost; just not quite as good as it was.

Where Can I Find Out More?

The Impact of Sec. 83 on Reverse Split-Dollar

What Was the Situation before the Change?

As is the case with split-dollar arrangments, many proponents of reverse split-dollar have either ignored basic tax principles; believe that in spite of employer enrichment of the employee, no current income is reportable; or proceed with the premise that their clients will not be "caught because of IRS ignorance or inattention."

What Is the Nature of the Change?

Reverse split-dollar (RSD) reverses the classic roles of split-dollar ownership. In the classic reverse split-dollar arrangement, the employee (policyowner) either endorses or assigns a portion of the death benefit to the employer. The two parties share the premium cost and death benefit of a cash value policy.56 Upon termination of the agreement, usually when the employee retires, the employer’s share of the death benefit reverts to the employee, who regains full control of the policy.

56. In the rare instance where the employee is not a shareholder or officer of the corporate employer, the endorsement method could violate the transfer-for-value rule—since there is a transfer of an interest in the policy to a nonexempt party in return for its premium payment (that is, a valuable consideration). Therefore the assignment method is preferable. See discussions on "Transfer for value concerns" in this section, supra; and "Additional documentation," supra.

The RSD agreement usually provides that during the term of the agreement, the employer will pay for the cost of the insurance it "receives." Typically, the amount is equal to the "net amount at risk" or the pure term protection under the policy. However, its share of the death benefit may also be a stated amount, or based on a schedule (either increasing or decreasing) agreed to by the parties. The employer’s premium share is typically based on the higher of the government’s PS 58 rates or the one-year renewable term rates charged by the insurer. The insured employee pays the balance.57

57. Since the insurers' term rates are substantially lower than the PS 58 rates, this means that the employer is invariably overpaying for the term insurance coverage. Proponents of this approach use as their authority for the employer's payment of the higher of PS 58 rates or the insurer's standard year term costs the word "may" in the classic split-dollar ruling, 66-110, allowing a taxpayer-employee to select the lower of the two.

Unfortunately, RSD is too often marketed solely as a tax-savings device, while the nontax and economic reasons for and implications of such plans are often ignored or understated. For example, the employer usually has various needs for life insurance on the employee during his or her working years, such as coverage for key person indemnification, credit obligation, and so forth. Or, it may combine the key person coverage with a death-benefit-only (DBO) plan to provide the covered employee’s survivors with a substantial benefit.58 On the other hand, the employee may need permanent insurance protection after retirement, or supplemental retirement income.

58. See Leimberg and McFadden, Tools and Techniques of Employee Benefit and Retirement Planning (800-543-0874).

If properly structured, an RSD plan may be an excellent solution to meeting the planning objectives of both the employer and the employee. But many RSD plans are established not merely to fairly share in the costs and benefits of the underlying life insurance policy, but with the major intent to benefit one party (the insured employee in the classic case) through the overly generous premium payments of another party (typically the employer) and escape income taxation on that generosity.

There have been no rulings or guidance from the IRS directly relating to the income tax issues associated with RSD.59 The main issue concerns the taxation of the employee on the cash values the employee gains each year under the arrangement. Commentators on both sides of the issue have advanced arguments in support of their respective positions. The most prevalent alternative income tax treatments of RSD are presented in the following discussion:60

59. But see "Equity Split Dollar," supra.   
60. See "Reverse Split-dollar Arrangement," supra.

Proponents for no current taxation of the employee base their arguments for nontaxation on Rev. Ruls. 64-328 and 66-110, as well as IRC Sec. 72. They claim RSD is similar to a classic arrangement, except the positions of the parties are reversed. They point to Rev. Rul. 64-328, which provides that the same tax treatment will apply " . . . if the transaction is cast in some other form resulting in a similar benefit to the employee." Therefore it could be argued that since the employer realized no income in the ruling, the employee should not realize income when their roles are reversed in an RSD plan.61

61. If the roles of the parties are reversed, would the IRS conclusions in its revenue rulings still apply to RSD?

They also argue that the employee is entitled to the cash value of the contract. According to these proponents, in Rev. Rul. 64-328, the IRS stated that "the employer provides the funds representing the investment element in the life insurance contract, which would, in an arm’s-length transaction, entitle it to the earnings accruing to that element." It also ruled that the employee in the split-dollar arrangement is provided an economic benefit that is measured by "the annual premium cost he should bear and of which he is relieved." When the employer in an RSD arrangement pays the annual cost for its term protection, and the employee pays the balance of the premium, each party’s share of the premium is the same as that which he, she, or it would pay under an arm’s-length transaction (as described in the ruling). Therefore the employee should be entitled to the "investment element in the life insurance contract" plus the "earnings accruing to that element."

The pivotal argument made by proponents of the RSD arrangement is that the IRS has specifically sanctioned the use of its admittedly high PS 58 rates. The employer in an RSD pays the term insurance cost based on the government’s PS 58 rates, which are generally much higher than the insurer’s one-year term rates. Rev. Rul. 66-110 provides that it is permissible to use either the PS 58 rates or the insurer’s term rates. Therefore the use of the PS 58 rates is appropriate. Furthermore, it is argued that the PS 58 rates have long been used to value the insurance protection furnished to a taxpayer.62

62. Rev. Rul. 64-328.

Coupling these arguments with the same type of Sec. 72 argument used in equity split-dollar plans, RSD proponents claim that since the employee owns the policy, taxation is governed by IRC Sec. 72. The policyowner is taxable only when he or she accesses the policy cash value—and then only to the extent of the gain in excess of his or her cost basis.63

63. IRC Sec. 72(e)(5). What is the employee's cost basis? Should it be his or her share of the premium, or the entire amount (including the employer's contribution)? If the employee has contributed neither actual dollars nor dollars paid for by the employer but taxed to the employee, there is no justification for giving the employee basis.

The better position is that taxation of the employee should be based on the fact situation of the RSD plan and its actual economic results. RSD is not similar to a classic arrangement since, by definition and plan design, RSD is not among the types of transactions on which the IRS based its findings in the above-mentioned revenue rulings, and the employee does not receive the same or a similar benefit. The employee in a classic split-dollar arrangement receives a large amount of death benefit at a relatively low cost, whereas, the employee in a typical RSD arrangement is provided with cash value in addition to a portion of the death benefit. In fact, the employee in Rev. Rul. 64-328 received term insurance coverage only and had no rights to the policy cash value. Furthermore, some of the RSD plans being marketed do not resemble the arrangement in the ruling. So the ruling should provide no comfort or protection.

Proponents of RSD, relying on Rev. Rul. 66-110, claim that the employer’s term cost in an RSD plan should be based on the higher of the PS 58 rates or the insurer’s one-year renewable term rates.64 It may be argued that the purpose for using the higher rates is to (artificially) reduce the employee’s premium share—especially when the majority of the death benefit is payable to the employer.

64. The operative word in the ruling is "may." As a practical matter, would the employer intentionally overpay for its term insurance coverage if it is solely for key person protection?

In Rev. Rul. 64-328, the employer contributed an amount equal to the cash value increase each year (not to exceed the total premium), and was entitled to the policy cash value; the balance was paid by the employee. However, in a typical RSD, the employer pays the term cost and the balance is paid by the employee. If the argument that the parties’ roles are merely reversed is carried to its logical conclusion, shouldn’t the employee’s share be equal to the cash value increase if he or she were to be entitled to the cash value?65

65. Some RSD plan designs require the employer to pay a levelized premium (that is, an average of its total costs) over the term of the agreement. As a result, the employee has little (if any) premium outlay. It is difficult for tax purposes to justify the employer's payments in excess of the economic benefit costs—especially in the early years.

It is logical that the IRS will conclude that the true measure of the term cost to the employer should be based on the lower (instead of the higher) of the PS 58 rates or the insurer’s term rates. Consequently the difference between the term cost (based on the insurer’s rates) and the employer’s actual premium outlay would be currently taxed to the employee under IRC Sec. 61 as "income from whatever source derived."66 The employee should be taxed if his or her share of the cash value is disproportionate to his or her premium payment. IRC Sec. 83 may be applied—that is, the cash value to which the employee is entitled is directly attributable to the employer’s contribution.67 Should the employee’s rights or access to the cash value be restricted, he or she would be taxable when such restrictions are terminated.68

66. See supra.   
67. See Young et ux. et a. vs. Comm'r., supra.     
68. PLRs 7916029 and 8310027.

TAM 9604001 does not specifically address a reverse split-dollar arrangement. However, it is likely that the IRS would take the position that the cash value inuring for the benefit of, or controlled by the employee (but generated by employer-provided premium) would be taxable to the employee (absent a substantial risk of forfeiture). The rationale is that the employee’s (unrestricted) equity position in the policy is a result of the employer’s premium payments.

Where Can I Find Out More?

More Favorable Controlling and Sole Shareholder Estate Tax Implications

What Was the Situation Before?

Many authorities had said it was possible to remove a split-dollared contract on the life of a majority or controlling shareholder from the insured’s gross estate. But the IRS had not issued any favorable rulings to this effect.

What Is the Nature of the Change?

Generally, the same rules for estate taxation of life insurance apply to split-dollar policies so that Code Secs. 2042 and 2035 are the central focus for estate tax avoidance. Under IRC Sec. 2042, the insured’s gross estate includes the amount of proceeds paid to, or for the benefit of, the insured’s estate. Proceeds are also included in the gross estate if the amount is payable to a designated beneficiary and the insured holds one or more incidents of ownership at the time of death.69

69. See D. Jansen, "Sec. 2042—From Soup to Nuts," University of Miami 29th Institute on Estate Planning, Chapter 14 (1995).

In a split-dollar arrangement, the employee is deemed to have an incident of ownership—such as the right to name or change a beneficiary or to cancel the policy—even if such a right is exercisable only in conjunction with the employer. Thus all the proceeds payable under a life insurance policy should generally be includible in the insured employee’s gross estate.70

70. Treas. Reg. 20.2042-1(c)(2). See "Endorsement Split Dollar," under section II, supra. Also, this is a major disadvantage of a reverse split-dollar arrangement; the insured employee's policy ownership will cause the proceeds to be includible in his or her gross estate even though the bulk of the proceeds is payable to the employer. Therefore the estate could be saddled with a tax liability without sufficient liquidity to pay for it (unless there is an offsetting deduction). See discussion on "Reverse Split Dollar," supra.

An insured may remove the proceeds from his or her estate by transferring the policy ownership to a third party (for example, an adult child or an irrevocable trust). Likewise, an employee (who is not a shareholder, or who owns less than 51 percent of the corporation) in a split-dollar plan may also assign all of his or her interest under the arrangement.71 However, the insured must survive for 3 years after he or she has divested all incidents of ownership; otherwise the entire proceeds will be includible in his or her gross estate for federal estate tax purposes.72

71. See discussion on "Controlling Shareholder Situation" in Leimberg, "Split Dollar, the Bifurcated Peso: Split, Rip, or Tear?" published by Matthew Bender as part of the proceedings of the 31st Philip E. Heckerling Institute on Estate Planning for different treatment when the insured is a majority or controlling shareholder.
72. See generally, Lumpkin vs. Comm'r., 474 F.2d, 1092 (5th Cir. 1973), and PLR 9026041.

Proceeds may not generate a tax in the insured’s estate if the total taxable estate (including the life insurance proceeds) does not exceed the insured’s available unified credit,73 the proceeds are payable to a spouse who is a U.S. citizen or to certain trusts for a surviving spouse in a manner qualifying for the estate tax marital deduction, or the proceeds are payable to a qualified charity in a manner qualifying for the estate tax charitable deduction.

73. In addition to the life insurance proceeds, any gift tax paid within 3 years of death will be includible in the decedent's estate.

If an insured employee owns 51 percent or more of a closely held corporation (at or within 3 years of death),74 he or she is considered a "controlling" shareholder such that the corporation’s ownership over a policy will be attributable to him or her under IRC Sec. 2042. To the extent that proceeds of a life insurance policy are payable to a party other than the corporation (or its creditors), the amount is includible in the insured’s estate rather than in the value of his or her interest in the corporation.75

74. See Rev. Rul. 90-21, 1990-9 IRB 13. The IRS based its conclusion not on whether the deceased held more than a 50 percent interest in the corporation at death, but rather on the interest held at any time within 3 years of death.
75. Treas. Reg. 20.2042-1(c)(6).

The IRS ruled on the estate tax inclusion issues in the split-dollar context on a number of occasions. Rev. Rul. 76-274, 1976-2 CB 278 considered three situations involving the insured, his controlled corporation, and a third party. In the first situation, the IRS found that the insured had incidents of ownership, and the employer’s rights (including the right to surrender and assign the policy) were of substantial importance and affected the entire policy. Consequently the proceeds were included in the insured’s estate. The employer’s rights in the second situation were restricted to borrowing against the policy up to the amount of the cash value (not to exceed its premium payments), but it was prohibited from surrendering or assigning the policy (except to the insured). The proceeds were included in the insured’s estate because of his direct ownership; but the employer’s "restricted" rights were not attributed to him. In the third situation, the employer’s rights were the same as in situation two, but the policyowner was a third party. The IRS ruled that the insured held no incidents of ownership either directly or indirectly (held by the employer, but attributed to him). Therefore none of the proceeds was included in his estate.

Rev. Rul. 79-129, 1979-1 CB 306 pertained to a "private" split-dollar arrangement between the insured and a trust that owned the policy. The insured had the right to borrow against the cash value to the extent of his premium contribution, and all other ownership rights were retained by the trust. The conclusion reached by the IRS was that the insured’s right to borrow was an incident of ownership, which caused the proceeds payable to the trust to be included in his estate.

Rev. Rul. 82-145, 1982-2 CB 213 was used by the IRS to clarify the inconsistency in its findings between the two prior rulings. It noted that the right to obtain loans against the policy is a key incident of ownership (even when it is limited in amount), which would cause the proceeds to be includible in the insured’s estate. In essence, it reversed its favorable finding under situation three of the 1976 ruling and attributed the corporation’s right to borrow as an incident of ownership to the insured.76

76. See also PLR 9037012. The unfortunate term used in the taxpayer's submission to the IRS for the ruling was that the corporation "owned" the cash value.

It appears that now, with careful planning and proper documentation of the split-dollar arrangement, estate tax exclusion may be achieved.77 The IRS should not automatically include the split-dollar life insurance proceeds in the insured’s estate merely because the insured’s controlled corporation is a party to the arrangement. For example, the death benefit from a life insurance policy on a sole shareholder was not includible in his gross estate in a fact pattern similar to a typical collateral-assignment split-dollar arrangement—except the policy was owned by the insured’s two adult sons and the repayment to the corporation was not limited to the policy cash value. The sons were personally liable to repay the corporation for its premium contribution. Alternatively, they could surrender the policy to the corporation in discharging their obligation. The IRS held that the corporation did not possess any incidents of ownership. But the IRS indicated that it might have reached a different conclusion had the policy been owned by an irrevocable trust.78

77. See S. Schlesinger and S. Ball, "Life Insurance: Taxation and Products," 52nd N.Y.U. Institute on Federal Taxation, Chapter 9.
78. The difference could be that in the case of a trust-owned policy, the only resource to the trust for repayment to the corporation would be the policy cash value or death proceeds. Therefore the IRS could argue that there was a "link" between the corporation and the policy—that is, an incident of ownership—which could be attributable to the insured sole shareholder.

It is interesting to note that the National Office never issued a formal technical advice memorandum on this particular situation. Could it be that it did not want to publish the favorable results that might encourage other taxpayers to use the similar techniques as described in the fact pattern?

PLR 9511046 involved a controlling shareholder situation. Here, the IRS ruled that the proceeds from a survivorship life insurance policy were not includible in the second-to-die insured’s estate when the policy was subject to a restricted collateral assignment under a split-dollar plan. An irrevocable trust owned a second-to-die policy on Taxpayer (T) and his spouse (S). The trustee was a third party who entered into a split-dollar arrangement with a closely-held corporation of which T and S were shareholders. Neither T nor S had any powers with respect to the trust that would be considered incidents of ownership (as defined by IRC 2042). Both spouses’ corporate interests were held in their respective revocable living trust—which upon the grantor’s death would become irrevocable and would be for the benefit of the survivor.

The split-dollar agreement provided that the corporation would be required to pay the premiums due (less any amount paid by the trust) on the policy while the arrangement was in effect. It further provided that only the trustee was permitted to obtain loans against the policy or pledge the policy for a loan, and that the corporation was prohibited from borrowing. The trustee retained all ownership rights granted by the policy. Only the trustee could surrender the policy or terminate the agreement. If the policy was surrendered or the agreement was terminated, the corporation had a security interest in the policy cash value in an amount equal to the lesser of its premium payments or the net cash value. Upon the death of the second to die of the insureds, the corporation would receive an amount of the proceeds equal to its total premium contribution. To secure the corporation’s interest, the trustee executed a collateral assignment in its favor, but the corporation could not assign its interest to anybody except the trustee (or his nominee).

The IRS conclusion was that since the corporation held no incidents of ownership in the policy or ". . . its proceeds that are paid to the trustee under Sec. 2042," or any de facto ability to force the trustee to borrow against the policy cash value, there was no attribution of ownership to the last to die of the insureds—even though the survivor would control the corporation at the time of his or her death. Consequently, the proceeds payable to the trust would not be includible in the gross estate of the last to die of the insureds.79

79. See also PLR 961017, in which a husband and wife created an irrevocable trust for the benefit of the husband's children from a prior marriage. The trustee, a bank, purchased a survivorship policy on the couple's lives and named the trust as beneficiary of the proceeds. An S corporation in which the husband held majority interest agreed to split premium dollars with the trust. The couple—through contributions they made to the trust—were to pay an amount equal to the term insurance cost of the coverage to the corporation. The couple, both shareholders of the corporation, agreed, in the event that they did not make payments directly to the trust, which was to pay the money over to the corporation, to reimburse the corporation personally to the extent that it paid their share of the premium. As an additional assurance, the agreement provides that the corporation can make payments on the insured husband's behalf and charge him with compensation income equal to the couples' share of the premium. As an additional fail-safe, the agreement provides that if neither the husband nor wife are employed by the corporation, then they must personally pay their share of the premium. These reimbursement promises were sufficient to prevent a second class of stock under Code Sec. 1361(b)(1)(D). See also PLR 9709027.

The IRS held that the corporation held no incidents of ownership in the policy—and so the majority shareholder held no incidents through his control of the corporation. Nor would the policy proceeds be included in the gross estate of the survivor of the insureds. In arriving at the "no inclusion" result, the IRS noted that the corporation could not assign its interest to anyone other than the trust and could not borrow against the policy or use it as collateral for a loan. Nor could the corporation terminate the agreement unilaterally or cancel or surrender the contract or change the beneficiary. Likewise, in PLR 9651030, the IRS held that the proceeds of collaterally assigned split-dollar policies would not be included in the insured's gross estate. There, an irrevocable trust owned three split-dollared contracts. The IRS again noted that the corporation's sole interest was to recover its outlay (or the policy cash value, if lower) and was expressly prohibited from borrowing against any part of the policies, and that the trust had the sole power to surrender or cancel the policy, change the beneficiary, revoke an assignment, pledge the policy for a loan, or borrow on the policy's cash values. It was important that all those rights were vested solely in the trustee and that the insured could not be appointed trustee.

So a split-dollar agreement—well drafted and administered—could be a device to avoid estate inclusion in a controlling shareholder situation. The key factor is the restriction placed on the corporation’s rights in the policy. To warrant inclusion, the corporation must hold incidents of ownership in the portion of the proceeds payable to a third party. In other words, the Treasury Regulations should be interpreted as meaning what they state: any incidents of ownership held by the corporation as to that part of the proceeds (that is, the part not payable to or for the benefit of the corporation) will be attributable to the decedent through his or her stock ownership. If incidents of ownership extend only to the portion of the proceeds held by or payable to the corporation, there should be no inclusion of the amount payable to a third party.80

80. See T. Commito, "Majority Shareholder Estate Taxation and Split-Dollar Plans," 42 Journal of the American Society of CLU & ChFC (January 1995); M. Weinberg, "29 Years of Sunshine, Stone Crabs, and Estate Planning Strategies," University of Miami 29th Institute on Estate Planning, Chapter 8 (1995). Although seldom appealing or practical, in some cases a reduction of ownership so that the insured is no longer a controlling shareholder should be considered.

The key to estate tax exclusion success is to specifically prohibit the corporation from borrowing against the policy and limit the corporation’s rights to merely the recovery of its premiums from the policy at the insured’s death, the surrender of the policy, or the termination of the agreement. A viable alternative is to remove all incidents of ownership from the corporation by securing its interest only by the promise of the third-party owner.81

81. See D. Jansen, "Sec. 2042—From Soup to Nuts," University of Miami 29th Institute on Estate Planning, Chapter 14 (1995). Mr. Jansen discusses "sole-owner" split-dollar arrangement, under which the insurance policy is completely owned by the third party and the corporation has no ownership, endorsement, or collateral-assignment interest in the policy. He points out that the advantage of this approach is that it creates strong arguments against the controlling shareholder estate tax problems but contains the inherent potential disadvantage of an IRS attack that there is a "forgone interest" issue.

Where Can I Find Out More?

More Guidance on the Tax Implications of Private (Family) Split-Dollar

What Was the Situation Before?

Family split-dollar has been used almost since the concept of splitting premium dollars was first conceived. But there has been little formal guidance as to how the IRS would tax the typical intrafamily arrangement.

What Is the Nature of the Change?

Although there is still no formal guidance, recent private rulings give advisers more information on probable IRS positions.

A split-dollar arrangement may be established between family members, between a trust and a family member, or between any two parties who agree to split the costs and benefits of a life insurance policy (assuming there are no prohibitions under either state law or the insurance contract itself).82 For example, a father purchases policy on son’s life and endorses the right to name the beneficiary(ies) for an amount of the death benefit in excess of the father’s premium outlay (or outlay plus a specified rate of interest). The father continues to control the policy cash value. In this case, Father is deemed to be making a gift of the "at risk" portion of the policy. The value of each year’s gift should be measured by the PS 58 rates (or the insurer’s lower term rates), and then that amount may be offset by the insured’s premium contribution.

82. See G. Slade, "Some Advanced Uses of Life Insurance in Financial and Estate Planning," N.Y.U. 53rd Institute on Federal Taxation (1994), Chapter 18.

Is the premium payment by Father a gift or a loan? Some commentators are of the opinion that the insured should have no reportable income from the parent’s premium payment—unless Sec. 7872 applies to the transaction. For instance, W purchases a policy on the life of H but immediately transfers the entire "net amount at risk" portion to an irrevocable trust she previously created for her children. She retains the cash value portion of the policy and thus she (and, indirectly, her husband, the insured) has access to those funds for an emergency or opportunity. Under a private (family) split-dollar agreement, the trustee pays the portion of the premium equal to the economic benefit that would have been reportable had the relationship been between an employer and an employee. At the death of the insured, the trustee will receive the death proceeds in excess of an amount equal to the policy’s cash value at that time. W will receive any balance, an amount designed to equate to the immediate predeath cash value. H could make gift-tax-free gifts (through the marital deduction) to W, which she could use to pay the one-year term cost portion of the premium. Assuming W in this "direct spousal split-dollar" example is not in any way a beneficiary of the trust, there should be no estate tax inclusion of the trust’s assets in her estate. If she is a beneficiary, gifts she makes, directly or indirectly, could be considered contributions to the trust, which in turn would cause her to be treated as a grantor and thus result in estate tax inclusion. The solution is for the insured to make gifts to the trust that are at least sufficient for the trustee to pay its share of the premium.

A drawback of the direct spousal split-dollar arrangement is that the presumably wealthy insured spouse’s lifetime access to cash values is dependent on continued marital harmony. Consider a "spousal trust" alternative, the creation of a QTIP trust—an irrevocable trust split-dollar arrangement with the third-party trustee of the QTIP trust authorized to invade principal for the benefit of the spouse. Although not a perfect solution, this method removes policy cash values from the absolute control of the insured’s spouse.83

83. See G. Slade, "Some Advanced Uses of Life Insurance in Financial and Estate Planning," N.Y.U. 53rd Institute on Federal Taxation (1994), Chapter 18, for a discussion of the community property implications of this technique and creative solutions to the marital discord potential.

In PLR 9636033, the IRS examined a "traditional" split-dollar arrangement between an irrevocable trust created by the insured and his spouse.84 The insured established an irrevocable trust and contributed cash to it at its inception. The trustee purchased a life insurance policy on the insured-grantor and entered into a collateral-assignment split-dollar arrangement with the grantor’s spouse. The parties shared in the premium payment, with the trust paying an amount equal to the cost for term insurance; the spouse paid the balance due from her separate property. If the agreement terminated while the insured was alive, the spouse would receive the net policy cash value; at the insured’s death, she would be entitled to an amount of the death benefit equal to the greater of the cash value or her total premium outlay.

84. See W. Wagner, "Favorable PLR on Private Split-dollar Arrangement," National Underwriter Life & Health Edition, Nov. 4, 1996, p. 8; "Payments under Private Split-Dollar Arrangement Are Not Gifts," The Insurance Tax Review, October 1996, p. 849; and "Private Reverse Split-Dollar Agreement Receives Favorable Gift and Estate Tax Ruling," Tax Management Memorandum, Vol. 37, No. 21, October 14, 1996, p. 331.

This technique provides a way for a spouse, as collateral assignee, to access the cash value of a policy owned by the other spouse’s irrevocable trust.85 The issue was whether the premium payments made by the trustee and the spouse resulted in a gift to the trust by either the insured or his spouse.86 The IRS conclusion was that no gifts were made because there was no employment relationship between the insured and the trust; hence the trustee’s premium payments were not compensatory in nature. The insured’s initial transfer to the trust was subject to gift tax; however, the insured received nothing of value, compensatory or otherwise, when the trustee made the premium payments. Thus the insured is not deemed to have made a second gift of the premium to the trust. The spouse’s consideration for paying a portion of the premium was that she would receive the cash value (or the death benefit in an amount equal to the cash value) under the policy. Since she would be reimbursed for her premium payments, they would not be deemed as gifts to the trust.

85. "Gift Tax Consequences of Private Split Dollar," Keeping Current, American Society of CLU & ChFC, Vol. 27, No. 1, December 1996, p. 53.    
86. Even though the IRS applied the principles of Rev. Rul. 64-328 in reaching its favorable conclusion in this private split-dollar arrangement, it is doubtful that the result could be applied to an employment-related equity split-dollar plan such that the insured would not be deemed to make gifts of the equity to a third-party owner. See TAM 9604001, supra.

In addition, the IRS determined that the portions of the death benefit payable to the trust and the spouse would not be includible in the insured’s gross estate since he had no incidents of ownership. The ruling repeated the typical IRS warning that no opinion was expressed as to IRC 7872 below-market interest rate loan issues. It is important to note that in order to achieve this dual favorable transfer tax result, the insured’s spouse used her separate funds to pay premiums on the trust-owned property.

Where Can I Find Out More?

S Corporations and Second Class of Stock Issues

What Was the Situation before the Change?

The IRS has always taken a reasonable view of split-dollar as an employee benefit but not a second class of stock.

What Is the Situation after the Change?

It is comforting to taxpayers that the Service has continued this trend.

At first glance, split-dollar financing of life insurance appears inappropriate as a tool for shareholders of S corporations (or other pass-through entities such as partnerships or LLCs) because they are taxed directly and therefore immediately and fully on the corporation’s earnings.87 This could mean "double" taxation for a shareholder in such an arrangement. First, he or she is taxed on the corporate income used to pay the corporation’s share of the premium, and second, the insured shareholder will be taxed on the economic benefit value received under the split-dollar plan.

87. Split-dollar arrangements are often established for key employees (nonshareholders) of an S corporation as a fringe benefit.

Yet another potential problem is the risk that the value of the arrangement might be considered a second class of stock and terminate the S election. This risk may be overcome with careful drafting.88 The IRS has privately stated that—under proper circumstances and with careful drafting—a split-dollar arrangement (even when the insured was a shareholder, and thus received a benefit that might not be provided to other shareholders)—would not be considered a "second class of stock" that would trigger a termination of the corporation’s S election.89

88. See Howard Johnson v. Comm'r, 74 T.C. 1316 (1980) and PLRs 9709027, 9651017, 9318007, 9331009, and 9309046. It is important that the third-party owners be required to reimburse the employer for the economic benefit under the policies—even after premiums end. See PLR 9651017, which held that a collateral-assignment split-dollar agreement between an S corporation and a trust does not result in a second class of stock because it does not alter the shareholders' rights to corporate distributions or liquidation proceeds. There a couple proposed to create an irrevocable trust that would hold second-to-die policies on their lives. Once the policies were in force, the corporation would pay all premiums but the couple would contribute to the trust an amount equal to the economic benefit under the policy, which would then be paid over by the trustee to the corporation. If for any reason the corporation didn't receive reimbursement from the trust, the agreement required the husband and wife personally to pay that amount to the corporation or, failing that, the husband, an employee of the corporation, was to be charged with income in the amount of the economic benefit, which would be paid by the corporation on his behalf. The Service held that the shareholders' rights to distribution and liquidation proceeds were not altered by this arrangement. (The IRS also held that since all incidents of ownership were held from the inception of the policy by the trust that the life insurance would be includible in neither insured's estate even though the husband was a controlling shareholder.
89. Read PLRs 9331009, 9318007, and 9235020 carefully. Note that the agreements required employee-shareholder contributions to the premium as well as reimbursement to the corporation of "any benefit derived from the corporation's outlay." Would the IRS still reach the same conclusion in the absence of the unusual language, or if, in fact, the insureds had not actually reimbursed the corporation? Could the IRS have then determined that the insured shareholder indeed received distribution rights that were not given to the other(s) such that the distinction between (or among) them was essentially a second class of stock?

But practitioners are urged to read PLRs 9331009, 9318007, and 9235020 carefully. Note that the agreements in all three of the rulings required employee-shareholder contributions to the premium, as well as reimbursement to the corporation of "any benefit derived from the corporation’s outlay." The IRS may not reach the same conclusion in the absence of that language. The results may not be favorable if, in fact, the insureds do not actually reimburse the corporation.

Split-dollar should be considered in an S corporation as an employee benefit for nonshareholder-employees and even for shareholder-employees if gift taxes become a major consideration in their overall estate planning process. For example, if the policy is owned by a third party (for example, an irrevocable trust) for estate planning purposes, a split-dollar arrangement can reduce (or eliminate) the amount of the gift tax.90 The reason is that the gift is based on the economic value (term cost) rather than the full premium. Under this logic, if a third-party owner enters into a split-dollar agreement with the S corporation and the plan is contributory, the insured-grantor employee-shareholder can gift to the trust an amount equal to (or in excess of) the economic benefit value, which the trustee will use to pay for the trust’s share of the premium. This amount will most likely be substantially less than the entire premium due on the policy and, as such, should create little or no gift tax (assuming the availability of the annual exclusion and/or unified credit).

90. See "Gift Tax Implications" in Leimberg, "Split Dollar, the Bifurcated Peso: Split, Rip, or Tear?" published by Matthew Bender as part of the proceedings of the 31st Philip E. Heckerling Institute on Estate Planning.

Where Can I Find Out More?

Partnerships, LLCs, and Split-Dollar Arrangements

What Was the Situation before the Change?

Even though the same income tax issues that pertain to shareholders of S corporations using split-dollar arrangements should also apply to partners in partnerships and members of LLCs, it was uncertain how the IRS would treat split-dollar in such entities.

What Is the Situation after the Change?

Taxpayers have more guidance as to how the IRS will treat partnerships and their partners and LLCs and their members with respect to the income and estate taxation of split-dollar arrangments. Essentially, as is the case with equity split-dollar, the IRS trend is to apply basic tax principles to new situations. Once again, the past provides good guidance as to the future.

For instance, in a private letter ruling,91 the IRS approved a split-dollar arrangement between a family limited partnership and its general partner—a revocable trust that owned a policy on the life of the grantor/trustee. The trust entered into a split-dollar arrangement with the partnership, under which the trust would be the owner and could exercise all ownership rights, but could not sell, assign, transfer, borrow against the policy cash value, surrender or cancel the policy, change the beneficiary designation, or change the death benefit option without the express written consent of the partnership. The premium on the policy was "split" between the parties. The trust reimbursed to the partnership an amount equal to the term cost of the insurance protection (measured by the insurer’s one-year term rates) it received, and the partnership paid the balance. In return for the partnership’s premium payments, the trust assigned the policy in its favor. As collateral assignee, the partnership would have the sole right to borrow against the policy. It also would have the right to receive a portion of the death benefit in an amount equal to the greater of the premiums paid or the cash surrender value.

91. PLR 9639053.

The IRS extended the rationale of Rev. Rul. 64-328 (employer/employee arrangement) and Rev. 79-50 (corporation/shareholder plan) to the partnership/ general partner situation, and stated that "[w]hile [the partnership/partner situation] differs from the relationships that were present in Rev. Rul. 64-328 and Rev. Rul. 79-50, the principles of those Rev. Ruls. are applicable." The IRS ruled that, since the trust contributed to the partnership an amount equal to the cost of the term insurance coverage, it would be treated as deriving no economic benefit from the split-dollar arrangement. Therefore the trust (the general partner) would not be deemed to have received a distribution from the partnership when the partnership paid the premiums.

From an estate tax perspective, there is only one private letter ruling and no cases or other direct authorities concerning split-dollar arrangements between a partnership and a third party involving life insurance on a partner’s life. The estate tax result turns on whether or not the "partnership entity theory" is strictly applied. If so, even if a partner is a managing or controlling partner, incidents of ownership should not be automatically imputed.92

92. See PLR 9623024, which held that life insurance proceeds will not automatically be includible in the gross estate of an insured partner. To keep the proceeds out of the insured's estate, this ruling implies that it is important to be sure the proceeds are not subject to the debts or other obligations of the insured's estate, that the policies were not pledged as collateral by the partner, that the deceased partner's estate would include the value of his or her proportionate share of the partnership (which itself received the insurance proceeds), and that the insurance was purchased and held for a partnership purpose. The IRS referred to controlling shareholder regulations for guidance.

Practitioners should assure that the firm has significant business or investment activities apart from and unconnected with the ownership of the life insurance or the IRS may use a "pass-through" or "aggregate" rather than entity level approach, thus viewing proceeds as having been constructively distributed to the individual partners (and, in the case of a deceased partner, to his or her estate). See D. Jansen, "Sec. 2042—From Soup to Nuts," University of Miami 29th Institute on Estate Planning, Chapter 14 (1995), and D. Cornfeld, "Partnership as a Panacea for Life Insurance Problems (Penicillin or Placebo?)," University of Miami 29th Institute on Estate Planning, Chapter 15 (1995).

Where Can I Find Out More?

A Warning and a Conclusion

The January 2, 1997, issue of the Daily Tax Report, Taxation, Budget and Accounting, stated that according to Treasury Department Benefits Tax Counsel Mark Lwry, "The IRS is considering issuing guidance on split-dollar arrangements in response to an increasing number of inquiries by tax attorneys and CPAs. The IRS is concerned with a wide variety of abusive practices and inappropriately aggressive sales practices that create a competitive disadvantage for those unwilling to engage in them."

Although some practitioners have asked that the IRS be lenient on past and current transactions, others have urged the government not to be lenient on aggressive transactions that have "pushed the edge." Lwry stated, "In developing any guidelines, we will of course carefully consider the extent to which it may or may not be appropriate to provide retroactive or transitional relief for past or existing transactions or arrangements that are not abusive and that reflect a reasonable interpretation of the law."

Lwry didn’t state when the guidance might be released. Nancy Marks, IRS deputy associate chief counsel of Employee Benefits and Exempt Organizations, stated that nothing may be released until later in 1997, or possibly 1998, because of the complexity of the issue and the IRS’s desire to act in as neutral a manner as possible. Marks is quoted as saying that "the IRS will not rush the issue to avoid creating inadvertent constraints by the way the guidance is phrased." She said, "This is something we would like to accomplish in 1997, but I am not sure if that is possible."

There is no more cost-effective and certain means of creating and shifting large amounts of wealth than life insurance. For many of our clients, life insurance is an unequaled means of providing liquidity, leveraging the annual gift tax exclusion and unified credits, and replacing wealth. It is a vehicle that provides the psychological freedom for an individual to spend and enjoy more of his or her other wealth currently.

Split-dollar arrangements often meet an estate liquidity problem of a shareholder-employee with corporate rather than personal dollars used to provide life insurance premiums. Aside from this obvious and highly important "premium assist," split-dollar’s major advantage as an estate planning tool is its incomparable income, gift, and generation-skipping transfer tax leverage:

Viewed in this sense, split-dollar can be thought of as a supercharged wealth transfer vehicle for enriching a future generation at the lowest possible overall cost. (There are no probate, administrative, or other transfer costs associated with split-dollar).

It is precisely because the benefits of split-dollar arrangements are so very appealing that we must be sure our clients understand the downsides and make their decisions about life insurance without illusions as to the tax and economic aspects of the transaction.

Determining the edge of the split-dollar envelope is much like the study of geometry; they both start with theorems of pristine simplicity—and gradually progress to caverns of complexity. The trick, in analyzing any complex transaction, however, is to reduce it to its basic components—and attempt to reconcile the results with fundamental principles. If dollars seem to move in circles, or if benefits appear to shift—without tax consequences, one had better illuminate the transaction with traditional tax tenets and common sense, because, if for no better reason, this is the crucible that the service and the courts will apply.94

94. "The Evolving Edge of the Split-dollar Envelope," G. Quintiere & G. Needles, Benefits Law Journal, Vol. 9, No. 1, Spring 1996.

The TAM’s IRS Sec. 83 argument is sound; if it were tested in court, the IRS would prevail in both equity and reverse split-dollar situations. Therefore we must not let our clients go into a split-dollar arrangement if we don’t know how we are going to get them out.

Having given these warnings, it is important to remember that the concept of split-dollar, used judiciously, remains a sound, creative, and cost-effective way to help clients pay large life insurance premiums—and shift huge amounts of wealth at the least possible gift, estate, and GST tax cost. Even equity and reverse split-dollar, used properly, will continue to have their place in the planning process.

Planners should apply a three-question, dispassionately objective acid test to split-dollar in general, equity split-dollar in particular—and to every other estate planning tool or technique:

First, ask, "What are the pros and cons of the viable alternatives?" Split-dollar, for example, is not the only way to finance needed life insurance—and certainly not a reason, by itself, to purchase it. So the question that must be asked is, "In my client’s situation, is split-dollar better, just as good as, or worse than other ways to finance the needed coverage?

Second, ask, "Which tool or technique—or combination of alternatives—will provide the most for the client and the client’s family—at the least possible cost—and is most certain to actually work?" What will the client implement and be comfortable with?

Third, ask, "What if . . . ?" "What if the client does nothing?" How important is the need for liquidity, leveraging, or wealth replacement? Who will lose—and how much will be lost—if nothing is done and no life insurance is purchased?

Where Can I Find Out More?

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