Split-dollar life insurance is perhaps the most frequently used form of permanent life insurance as an executive compensation benefit. Although split-dollar arrangements are not limited to the employer-employee relationship, they are almost always formed in this way. Split-dollar life insurance plans have a long and varied history. The first IRS rulings on such arrangements were issued in the l950s, but many new types of split-dollar arrangements have been developed since then to adapt to changing tax laws and the needs of the insured executives. The following discussion summarizes several forms of split-dollar arrangements. However, it is important to note that there are numerous variations within each arrangement and that the general rule is almost the exception in actual practice.

Split-dollar life insurance plans split a life insurance policy�s premium obligations and policy benefits between two individuals or entities. The parties to a split-dollar agreement are normally an employer and employee. The two parties share the premium costs while the policy is in effect, pursuant to a prearranged agreement. At the death of the insured or the termination of the agreement, the parties split the policy benefits or proceeds in accordance with their agreement. Plans must meet minimal reporting and disclosure compliance requirements. Most of the administration is handled by the insurer.

Split-dollar plans are an excellent fringe benefit option for a closely held corporation since the plans can be limited to a select group of shareholder-employees and other key personnel. Depending on the employer�s and employee�s tax brackets, split-dollar plans in a group term carve-out might be a viable alternative to a Sec. 162 plan. Since the corporation�s tax bracket and the amount of compensation provided to shareholder-employees are largely in the control of the shareholder-employees, selecting the appropriate executive life insurance arrangement can be made optimally at their discretion.

The owner of the underlying policy in a split-dollar plan can either be the employer or the insured-employee. Under the endorsement method the employer owns the policy and has primary responsibility for premium payment. The employer�s share of the benefits is secured through its ownership of the policy. The insured designates the beneficiary for his or her share of the death proceeds, and an endorsement is filed with the insurer stipulating that the beneficiary designation cannot be changed without the insured�s consent.

Under the collateral assignment method the insured is the policyowner and has premium payment responsibility. The corporation loans the employee the corporation�s share of the annual premium, and the corporate amounts are secured by the assignment of the policy to the corporation. The corporation receives its benefits as assignee of the policy at the earlier of the employee�s death or the termination of the split-dollar plan.

Since a split-dollar plan is most often provided as a fringe benefit, the taxation of split-dollar life insurance varies depending on the type of split-dollar plan, but it is based on the general premise that the employee is taxed on the economic benefit that he or she receives annually from the plan.

In Rev. Rul. 64-328, C.B. 1964-2, the IRS ruled that the tax consequences of the basic split-dollar plan are the same regardless of whether the plan is designed under the endorsement or collateral assignment method. The economic benefit is the pure insurance element, measured by the cost of one-year term life insurance conferred on the insured during the year. The term cost is the employee�s share of the amount of protection in a given year multiplied by the term rate for the employee�s attained age. In Rev. Rul. 66-110, C. B. 1966-1, the IRS has also ruled that the term cost is the lesser of the PS 58 rates (see table 12-3) or the insurance company�s standard rates for a one-year term policy. Any contributions made by the employee to the split-dollar plan can be applied against the economic benefit to reduce the taxable cost of the plan.

Of course, the many variations of split-dollar life insurance may cause other taxable benefits to be conferred on the employee. For example, the employer might pay all or part of the employee�s share of the premium. In addition, policy dividends that benefit the employee by providing cash, additional insurance, or reduction of the employee�s premium will be taxable to the employee.

Even though split-dollar plans are included in the category of welfare benefit plans, most of the ERISA requirements are not applicable. Split-dollar plans are definitely exempt from the ERISA vesting, funding, and participation rules generally applicable to qualified plans. It is possible that the requirements of establishing an ERISA claims procedure and appointing a plan fiduciary can also be avoided. To qualify for such an exemption, the split-dollar plan must provide benefits paid exclusively from insurance contracts and either be (1) a plan for a select group of management and highly compensated employees or (2) a small welfare benefit plan having fewer than 100 participants at the start of the year. Since split-dollar plans are generally established by closely held corporations to limit participation to shareholder-employees and key executives, the plans will generally qualify for these exemptions. At a minimum the employer must provide plan documents to the Department of Labor on request.

In traditional split-dollar plans a corporation and an employee split a life insurance policy covering the life of the employee. The corporation contributes an amount equal to the annual increase in the cash surrender value, while the executive pays the remainder of the annual premium. The death benefit is split between the participating executive and the corporation as follows:

The split-dollar plan will not provide the corporation with a current income tax deduction even if the employee incurs taxable compensation. Thus the corporation has to use taxable income to contribute its share of the premium.

This traditional arrangement makes sense under the current tax setting only in certain circumstances. It should generally not be used for shareholder-employees of a closely held corporation unless the executive�s marginal income tax rate exceeds the corporation�s marginal rate. Otherwise, the taxable corporate income contributed to the plan will be subject to higher rates. If the participating shareholder-employees are in a lower bracket, it makes sense to use a Sec. 162 bonus arrangement. A Sec. 162 plan will provide a corporate tax deduction for the full amount of the bonus and meet the objective of providing the shareholder-employee with an individually owned unencumbered life insurance policy. From a tax standpoint, the bonus amount could have the effect of reducing the corporation�s taxable income to zero if all corporate income is paid out as compensation. In any instance, the earnings required to pay the bonus payments to the shareholder-professionals will be taxed at a lower bracket in the hands of the shareholder-employee than they would in the corporation�s.

For business corporations, the traditional split-dollar arrangement continues to make sense in most instances. The corporate tax structure permits corporations to retain income at favorable rates. The corporate income tax rates will be generally lower than individual rates. In addition, the new 36 percent and 39.6 percent marginal brackets applicable to individuals makes the corporate tax rate lower at higher levels of income. Since the retained income of a closely held corporation is, within limits, subject to the control of the shareholder-employees, the corporation�s taxable income may be reduced to this favorable level through payment of deductible salaries and bonuses to the shareholder-employees and other key executives (if the "reasonable compensation" tests can be satisfied). The retained amounts of income taxable at lower corporate brackets can then be used for corporate contributions to a split-dollar plan covering a few shareholder-employees. Thus the use of corporate taxable income for a nondeductible split-dollar expenditure will be less costly from a tax standpoint than paying fully taxable bonuses to shareholder-employees that will incur 36 percent or 39.6 percent income taxes.

The class of employees to be covered by the split-dollar plan is another important consideration. If coverage under the plan will extend beyond the shareholder group, the split-dollar plan may be more favorable from the corporation�s standpoint than an executive bonus plan. This is particularly true if younger executives covered by the plan do not stay with the current employer for their entire working careers. Under these circumstances, the corporation may not want to permanently lose its contributions, as occurs in an executive bonus plan. The split-dollar plan will provide the corporation with a return of its actual contributions (possibly also including a return on the invested funds), reducing its charge to earnings for providing the plan. Of course, it may be possible to design a dual plan with an executive bonus plan for shareholder-employees and split-dollar coverage for junior executives. Generally speaking, split-dollar plans are more favorable when a lower corporate cost is indicated by such factors as the desire to cover a group larger than the shareholder-employees.

An equity split-dollar plan is particularly popular from the employee�s perspective because excess cash surrender value (CSV) builds up for the benefit of the employee during the split period. The plan works as follows:

As with other split-dollar variations, the equity method involves careful consideration of all corporate goals, including the reduction of taxes. One obvious advantage of this arrangement is that the corporation receives all its contributions back. This is important for a closely held corporation in which the actual corporate outlay must be minimized, particularly if the plan covers executives outside the shareholder group. In addition, the corporation will not show a profit on its interests in the plan, and the potential impact of the corporate AMT will be avoided.

Some of the federal income tax implications with equity split-dollar plans cannot be ignored. First, the employee must provide the annual term cost (or PS 58 cost) with after-tax dollars. Again the corporation receives no federal income tax deduction for its contribution to the plan. One method of reducing the employee�s outlay and coincidentally providing the corporation with a valuable tax deduction is to provide the employee with a bonus equal to his or her annual contribution to the plan. A zero-tax bonus can be used to provide the employee with the full necessary after-tax funds to pay his or her annual contribution. The bonus arrangement is more valuable when (1) the corporation is in a higher tax bracket than the participating employee and (2) the plan is limited to shareholder-employees.

A more significant issue is the tax at the time the equity split-dollar plan terminates and the employer is repaid. Past plans were often set up to terminate at the employee�s retirement. At this time there is some question about the taxation of the transfer of the policy to the employee. Since excess CSV has accrued to the employee�s benefit, will the transfer of the policy result in current income taxation to the employee under Sec. 83? Sec. 83 provides that transfers of property in exchange for services rendered represent gross income in the year the property is transferred. Private letter rulings on this issue involve the use of the endorsement method in the split-dollar plan. In these rulings the IRS determined that the transfer of excess CSV to the employee at the rollout date was a taxable event similar to the removal of the substantial risk of forfeiture of nonqualified deferred-compensation benefits. If the employee�s access to the CSV is deferred until a future date (for example, retirement), the removal of the restrictions at that time will result in an immediate and substantial income tax liability to the employee for the CSV in excess of his or her basis. This may cause substantial tax liability in one year depending on the circumstances.

Will the transfer be subject to Sec. 83 if the collateral assignment method is selected? The IRS recently gave an unfavorable answer to this question in TAM 9604001. The amount of the annual increase in the CSV in excess of the premium paid by the corporation under a collateral assignment equity split-dollar plan was treated as income to the executive under Sec. 83 in this ruling. The IRS reasoned that the corporation had a right to be repaid only its premium contribution. Thus, the excess buildup in the CSV was a transfer of property to the executive in the tax year because there were no forfeiture possibilities. This ruling has been highly criticized by commentators and the insurance industry, and it may be reconsidered by the IRS. However, until the IRS changes its current position, equity split dollar would seem to create additional income taxes for the participating executive.

As discussed above, the tax implications of a transfer can be minimized by having the rollout occur earlier in the policy period to reduce the excess CSV buildup taxable to the employee. In the alternative, the plan rollout can be permanently avoided, and the employee can receive an interest in the CSV limited to the extent of his or her contributions. A frozen split-dollar plan is a variation of this idea. A frozen split-dollar plan is a rollout in which the employer is not repaid, but the employer retains a frozen interest in its share of the policy when the split-dollar plan terminates. This will avoid the possibility of a Sec. 83 transfer until the plan terminates. The employee should be able to take policy loans to the extent of his or her contributions after the plan is frozen with no current income tax liability.

As an alternative to equity arrangements for providing substantial retirement benefits to executives through the split-dollar medium, reverse split-dollar (RSD) plans have achieved recent popularity. In the RSD variation, the corporation and executive roles are reversed. The basic form of RSD involves the payment of the pure insurance portion of the premium by the corporation. The measure of the corporation�s premium share depends on the variation of RSD selected. The executive pays the balance of the premium. The corporation�s share at the employee�s death is the pure insurance proceeds. The plan is designed for individual ownership of the policy by the executive (or a third party), and the executive retains all rights in the policy other than the corporation�s death benefit. At some point in the future, usually the executive�s retirement, the plan is terminated and the executive receives the policy unburdened by the employer�s right to the death benefit.

The RSD plan is designed to meet some specific goals and should be used only when circumstances indicate. First, there should be a corporate need for the pure insurance on the executive�s life. For example, the corporation may use the death proceeds as key person indemnification, to fund a stock redemption or to fund a death-benefit-only (DBO) plan. Since the corporate need ceases when the executive retires, the temporary nature of the RSD plan is appropriate. Of course, the split-funding nature of the policy helps hold the cost down for the executive who receives a substantial CSV benefit at retirement when the corporation�s interest terminates. The RSD plan is a good alternative to a traditional rollout or equity split dollar when these client objectives must be met.

The RSD plan appears to illustrate quite favorably. However, there are a couple of major tax problems with the plan as it is often illustrated. One critical decision that must be made is the amount that the corporation will be required to pay for its right to the death benefit. Initially, many such illustrations showed the corporation paying the actual PS 58 cost (or some variation of PS 58 cost funding) for the amount of its death benefit coverage each year. The variations on the PS 58 funding involved a level premium averaging of the PS 58 cost over the term of the split period. The use of averaged PS 58 cost funding was favorable to the executive since it involved substantial prefunding of the plan by the corporation. First, as discussed earlier, PS 58 costs are usually significantly higher than the actual term insurance cost charged by the insurer. Second, because of the leveling effect, contributions by the corporation in the early years were higher than required. This prepayment and compound interest resulted in the corporation�s contribution to fund some, if not all, of the executive�s CSV build-up. In some illustrations of RSD, the executive pays nothing (or nearly nothing depending on the type of life insurance policy) for his or her interest in the ordinary life contract.

These optimistic illustrations were relying upon earlier IRS split-dollar rulings using PS 58 costs to value the economic benefit to the employee for ordinary income tax purposes. The theory behind these illustrations was that the employer was paying a "fair price" (as defined by the IRS) for its share of the death proceeds. In addition, since the executive was the owner of the policy, the thinking was that the termination of the plan at the executive�s retirement did not result in a taxable transfer since the corporation did not own the policy and thus had nothing to transfer.

The actual taxation of this arrangement is unclear at this point, but it appears that leveled PS 58 (or even actual PS 58 funding) might be a dangerous approach for federal income tax purposes. Although there are no rulings on the subject, several commentators have observed that the IRS could treat the annual increase in CSV caused by any employer overfunding of the plan as ordinary income to the employee under Sec. 61. Of course, this may not be a terrible result since the corporation should get a corresponding tax deduction for any amounts included in the executive�s income. This tax benefit may outweigh the tax burden to the executive under the new rate structure applicable to corporations and individuals. Nevertheless, to avoid this controversy, many illustrations currently show the employer paying no more than the actual term insurance costs for the pure death benefit coverage.

To avoid a taxable transfer, the executive should maintain current individual rights in the life insurance policy so that no substantial restrictions exist that will terminate at the executive�s retirement. The executive should also have a basis in the policy that is equal to any contributions he or she actually makes. Recall that the IRS has stated in previous rulings that it will treat a split-dollar arrangement according to its substance rather than its form. Therefore even though the executive is the owner of the policy in the RSD plan, a taxable transfer could be deemed to occur if (1) restrictions lapse at some point in the future and (2) the corporation has somehow enhanced the executive�s interest in the policy above the executive�s basis.

RSD is a useful arrangement in some circumstances if the income and estate tax problems can be avoided. There are many circumstances in which the corporation needs temporary life insurance coverage on a shareholder-employee or key executive. In addition, the ordinary life insurance policy received unencumbered at retirement is a valuable and popular asset to the employee. Recall from previous discussions that RLR plans are limited generally to $50,000 of postretirement coverage. In an RSD plan postretirement coverage is unlimited and, what�s more, the executive has current access to a substantial growing CSV.

As with executive bonus plans, a split-dollar carve-out arrangement can be designed to meet the corporation�s objective of providing substantial levels of life insurance coverage for key executives in addition to coverage under the company�s group term life insurance plan. Split-dollar plans are exempt from the Sec. 79 nondiscrimination requirements, along with most of the reporting and disclosure compliance applicable to many other types of fringe benefit arrangements. Furthermore, split-dollar arrangements allow corporate employers to discriminate freely in the class of employees participating (and in the level of benefits provided). The discrimination can eliminate all but shareholder-employees and other key executives from coverage. In addition, a split-dollar plan will provide an individual permanent life policy that offers postretirement coverage greater than the $50,000 maximum in qualified plans. It has the dual advantages of giving select executives low-cost permanent life insurance coverage and giving the employee an incentive to continue with the corporation.

Nondiscriminatory group term life coverage should still be adopted (or continued) if this coverage is otherwise desirable for the employer. Remember, Sec. 79 provides significant tax advantages to both the employer and employee. The split-dollar carve-out alternative is simply one method of providing excess (discriminatory) life insurance coverage to shareholder-employees and other key executives without running afoul of nondiscrimination rules. The individuals participating in the split-dollar carve-out should still be covered under the group term life insurance plan, but their coverage should be limited to $50,000, or permissible nondiscriminatory level of death benefits, if greater. If cost is a concern and the corporation does not need to provide life insurance to a broad class of employees, it should avoid the Sec. 79 plan.

The estate tax implications of traditional split-dollar life insurance plans are well established. If estate liquidity will be a concern for the executive participating in a split-dollar plan, some kind of third party ownership�the executive�s spouse or an irrevocable trust�should, in lieu of the insured, enter into the split-dollar arrangement with the employer at its inception.

The majority shareholder in a split-dollar arrangement faces a more difficult problem. It is imperative for the majority shareholder to avoid corporate incidents of ownership in the split-dollar policy since these will be attributed to him or her if the proceeds are not deemed payable to the corporation. IRS rulings have made it clear that corporate incidents, such as the ability to borrow from the policy, should be avoided in a traditional split-dollar arrangement between the corporation and a majority shareholder. If corporate incidents of ownership are attributed to the majority shareholder, the death proceeds will be includible in the insured�s gross estate, regardless of whether or not a third party actually held the insured�s interest in the split-dollar agreement. Practitioners therefore generally recommend collateral assignment of the policy if a majority shareholder is involved.

One solution to avoid inclusion in the majority shareholder�s estate is for the participant to create an irrevocable trust to enter into the split-dollar agreement with the corporation. The trust would collaterally assign the policy to the corporation to secure the corporation�s share of the death benefit (limiting the corporation�s rights to merely being repaid by the trust). It is unclear at this point, however, whether this design will avoid inclusion in the majority shareholder�s estate under the attributed-incidents rule of the tax code. The safest solution is to effect a rollout of the policy to the trust as soon as practical.

Estate tax concerns about RSD plans�designed for the insured-executive to own the policy from its inception�have been alleviated somewhat by a recent private letter ruling. The existing law requires the entire proceeds to be includible in the insured�s estate at his or her death including the death proceeds payable to the corporation. Thus RSD has the potential for creating a huge estate liquidity problem for a participant. However, the IRS has ruled that the amount payable to the corporation is a deductible debt of the estate and will not create additional estate tax. That is, the corporation�s death proceeds share will be included in the insured�s gross estate for tax purposes, but the estate will receive a deduction for the amounts payable to the corporation.