Steve Leimberg's Employee Benefits and Retirement Newsletter
Subject:IRS NOTICE 20001
- 10 MAJOR EQUITY SPLIT DOLLAR
NOTICE!!!
Due to technical difficulties, you may receive this MOST IMPORTANT NEWS RELEASE TWICE!
It is well after midnight
and I’m about to go through over 20 pages of rather complex material.
So please understand that in
the rush to get this extremely important information out to you, my commentary
is one of first impression - and I and other members of the LISI team will be
providing extensive follow-up.
NOTICE: Because of the great
importance of this notice, you have our permission to share it freely and
reproduce it - but only in its entirety.
Steve Leimberg
EXECUTIVE SUMMARY:
The IRS has issued a Notice
that announces it is reviewing (a) the federal income tax treatment of
employer-employee split dollar as well as (b) split dollar arrangements
involving compensation to non-employees, (c) split dollar economic benefits to
corporate shareholders, and (d) split dollar arrangements involving gifts
(which I am interpreting as possibly including private split dollar).
The Service stated that
Notice 2001-10 is intended to do three things: (1) clarify prior rulings, (2)
provide interim guidance until more permanent guidance is issued, and (3) serve
as a notice and request for comments from practitioners - which doubtlessly it
will receive.
In a nutshell, under this
Notice, every payment made by an employer in a split dollar arrangement must be
treated as either (1) a loan, or (2) an employer investment, or (3) currently
taxable compensation income to the insured employee.
FACTS:
The IRS begins Notice
2001-10 with a review of the history of the income taxation of split dollar
agreements - including the role of Rev. Rulings 64-328 and 66-110. It quickly concludes that none of these
directly addresses the modern form of equity split dollar. It defines equity split dollar as an
arrangement under which - due to the fact that the employer’s interest in the
policy’s cash value is limited to the aggregate amount of its premium payments
- the employee derives the entire economic benefit of any positive return on
the employer’s investment. (Again,
although the ruling speaks to employer-employee relationships, the IRS makes it
clear that it believes the same principles govern the income tax treatment of
split dollar in other contexts).
The IRS states that the
employee is, under the equity split dollar plan described in the paragraph
above, deriving a valuable economic benefit which goes beyond the life
insurance protection he/she is also receiving.
So the Service concludes it is necessary for the covered employee to
account for - and pay tax on - that additional benefit. That taxation should follow the contractual
positions and actions of the parties.
SECTION 83 INCOME:
If the contractual
arrangement giving rise to the equity split dollar arrangement is based on an
employer-employee relationship and if what the parties intended is a transfer
of property (beneficial interest in cash values) from employer to employee,
Code Section 83 applies. This could
take the form of a single transfer or a series of transfers - depending on the
facts. In any event, the employee would
have currently reportable income under Code Section 83.
Up to this point, it all
seems relatively straight-forward. But
here’s where the fun begins.
SECTION 7872 INCOME:
The IRS goes on to say, the
substance of the agreement will determine whether or not there has been a
transfer of property under Code Section 83.
If, from inception, the employee was intended to be the beneficial
owner, than the IRS may treat the transaction as a series of loans from the
employer to the employee.
Here, the Service states,
“Assuming there is reasonable and bona fide expectation the employer will
receive repayment of its share of the premiums AT A FIXED AND DETERMINABLE
FUTURE DATE (emphasis added), than the arrangement may IN CERTAIN CIRCUMSTANCES
(emphasis added) be properly treated as the acquisition of a life insurance
contract by the employee with the proceeds of a loan or series of loans from
the employer to the employee, secured by the life insurance contract, rather
than an arrangement whereby the employer acquires ownership of the life
insurance contract and provides economic benefits to the employee thereunder.”
The result of such a
characterization would be that the split-dollar arrangement would be treated as
a “compensation-related below-market loan”, i.e. one in which the interest
charged was less than the AFR (Applicable Federal) rate. The result is that
payments imputed to the “borrower” would be treated as currently taxable
compensation income. The Service
quickly forecloses the argument that Code Section 7872 (which deals with
below-market loans) is inapplicable to split dollar arrangements - if the
arrangement in question is in fact a loan.
CURRENT TAXATION UNDER ONE
THEORY OR ANOTHER:
So at this point, the IRS is
saying that the employee’s annual increase in wealth under equity split dollar
may be taxable currently under Code Section 83 or it may be currently taxable
under Code Section 7872 - depending on the intent of the parties as evidenced
by the split dollar agreement as well as any other relevant facts and
circumstances.
VALUATION OF INCLUSION:
The IRS then addresses the
antiquated P.S. 58 tables and states that those rates
are clearly out of date and
inappropriate. They no longer
approximate the real cost of term insurance.
According to the Notice this has lead some taxpayers to over-report income. And the Service notes, the abuse of the word
“may” wording has led some taxpayers to understate income. Specifically, the IRS points to the use of
the obviously inappropriate P.S. 58 costs in so called “Reverse Split Dollar”
arrangements and states that in reverse split dollar where the P.S. 58 table
was used, the value of policy benefits allocated to the employer were
overstated - resulting in the understatement of the income the employee should
have reported.
SUBSTITUTE RATES OUT - NEW
TABLES IN:
The Notice then tackles the
“substitute” or “alternative” term rates, i.e., the use of one year term
policies issued by insurers, the so called “published term rates.” The Service expresses concern that such
rates may not be realistically available to all standard insureds. (It’s saying in a polite way that it didn’t
like some of the games that were being played). Nor, states the IRS, was there any practical way to prove that
all standard insureds could obtain the substitute rate. Finally, on this issue, the IRS feels it was
unfair that the reportable rate could easily vary from taxpayer to taxpayer if
different taxpayers were insured by different insurers.
The upshot of the commentary
in the preceding paragraphs is that the IRS, to “ease administrative burdens,
minimize disputes, and provide greater assurance that similarly situated taxpayers are treated the same,” that for
both split dollar and for situations involving life insurance in qualified
retirement plans, a new table (or new set of premium rate tables) should be
used. That table is described below and
will soon be published in LISI archives.
PICK YOUR POISON:
So, pending further taxpayer
feedback to the IRS and guidance from it, here are
the interim guidelines and
general rules:
The parties to an equity
split dollar agreement can characterize it as EITHER Section 83 income or as a
loan (or series of loans) from the employer.
O.K. That’s not totally accurate.
Actually, Notice 2001-10 says that the parties can characterize the
employer’s outlay ANY WAY THEY WANT.
Of course, there’s a BIG
BUT:
First, the characterization
must be ESSENTIALLY CONSISTENT with the realities of the arrangement.
Second, that
characterization must have been FOLLOWED by the parties from the time the split
dollar agreement took affect.
Third, the parties must
FULLY ACCOUNT FOR ALL ECONOMIC BENEFITS received by the parties - in a manner
that follows from the way the parties have characterized (transfer of property
or loan) the transaction.
BELOW-MARKET LOAN TREATMENT:
If the parties CHOSE to
treat equity split dollar as a loan or series of loans - AND if they MEET ALL
THREE TESTS described above - than Code Section 7872 will govern. This means:
(1) No additional income
will be charged to the insured employee for the term insurance protection.
(2) The policy’s cash value
will not be taxable to the employee under Code Section 83.
All bets are off, however,
and the employee WILL have additional reportable income under these two
concepts - if the employee doesn’t pay off the loan according to the schedule
in the agreement.
An employee - even if he/she
meets all the above tests - can still have additional income - under Code
Section 72 - for DISTRIBUTIONS ACTUALLY RECEIVED UNDER THE CONTRACT.
WHEN LOAN TREATMENT DOES NOT
APPLY:
What if the tests above are
not met or if the parties decide what really is occurring is something other
than a loan or series of loans? If the
parties have not - consistently -
treated the arrangement as employer loans, they will be treated as if they chose
a “non-loan” treatment.
What’s that mean?
First, the parties must
fully account for all the economic benefits the employee receives in accordance
with the chosen non-loan - or default non-loan - characterization. (The use of the term, “parties” seems to be placing some reporting
responsibility on the employer). Here,
Rev. Rulings 64-328 and 66-110 are used - not alone - but TOGETHER WITH the
parties’ characterization AND TOGETHER WITH the general tax principles upon
which those rulings are based. (That implies to me that the IRS is not about to
be hamstrung by taxpayer’s literal reading of the facts in those rulings.)
More specifically, if loan
treatment is not chosen or is unavailable:
(1) The employer will be
considered to have obtained beneficial ownership in the policy through its
premium payments (presumably regardless of whether or not the employee or third
party such as a trust actually and initially applied for the policy), and
(2) The employee will have
currently reportable compensation income each year - under Code Section 61 -
for the term insurance coverage (reduced, of course, by premium payments the
employee makes), and
(3) The employee will have
currently reportable compensation income each year for any dividends (or
similar benefits) received directly or in the form of additional policy
benefits - under Code Section 61, and
(4) The employee will have
currently reportable compensation income each year for any substantially vested
interest acquired in the policy’s cash value (reduced, of course, by any
consideration paid by the employee for that interest).
TIME OUT - MAYBE:
Until the IRS issues further
guidance, it will not treat an employer as having made a currently taxable
Section 83 transfer – SOLELY because INTEREST AND OTHER EARNINGS on the policy
cash value exceeds the amount repayable to the employer under the policy. If the IRS at some later date decides
interest or other earnings are subject to Section 83, THAT income will be taxable
only from the date of such guidance and onward. It will NOT be taxable retroactively. (The IRS seems to be saying, it may use Section 83 to cause the
employee to be taxable - but ONLY to the extent the employee is enriched with
employer dollars – and NOT - unless it changes its mind - taxable on the
earnings and interest ON those dollars.)
TAXATION WHERE TRANSACTION
NOT CONSISTENTLY TREATED AS LOAN:
As long as a split dollar
arrangement (apparently ANY split dollar arrangement) remains in effect and it
hasn’t been consistently treated by the parties as an employer loan, than:
(1) the covered employee has
currently reportable income under Section 61 for the term insurance coverage
(technically the net amount at risk) (Reduced by premiums the employee has made
toward that coverage or reduced by any taxable income the employee had to
report because of dividends received or credited as well as any income
reportable under Section 83). (If such
an allocation is necessary, the IRS has agreed to accept any REASONABLE METHOD
for determining the allocation - or will accept a pro-rata allocation (which
will probably be the one selected in most cases for certainty and
simplicity). In other words the
portion of the death benefit generated by employer and employee dollars can be
determined based on relative payments.
(2) To the extent an
employer makes a premium (or other) payment but receives no beneficial interest
in the policy nor has a reasonable expectation of receiving repayment (through
proceeds or otherwise), the insured employee will have currently taxable
Section 61 income equal to the entire payment.
NEW TABLE:
Notice 2001-10 revokes Rev.
Rul. 55-747. That means P.S. 58 rates
are no longer the standard for measuring the economic benefit received by an
insured for the net amount at risk payable to the insured’s beneficiary.
Exception: P.S. 58 rates can
be used as in the past for taxable years ending on or before December 31, 2001.
Table 2001: The Notice
provides a new table - with rates substantially lower than the P.S. 58 rates -
based on Section 79 regulations. (Extensions are provided for ages below 25 and
above age 70).
SUBSTITUTE RATES STILL
POSSIBLE - BUT:
Even with the new Table
2001, substitute rates, i.e. the insurer’s one year published term rates for
standard risks, can still be used. In other words, in valuing the net amount at
risk, a taxpayer may still substitute for the table rates the insurer’s lower
PUBLISHED PREMIUM RATES AVAILABLE TO ALL STANDARD RISKS FOR INITIAL ISSUE ONE
YEAR TERM INSURANCE - but only if the following “no playing games” tests are
met:
First, the insurer must let
people who apply for term insurance know about the
availability of the lower
rates.
Second, the insurer must
regularly sell such insurance - at the
lower rates - under its regular distribution channels.
Third, the insurer can’t
more commonly sell term insurance at higher rates to individuals considered
standard risks.
One other little catch: The
Notice makes it clear that this ability to chose substitute rates may not last
forever. With respect to term contracts
issued after March 1, 2001, the IRS makes no assurance that the substitute
method will be available after the later of (a) December 31, 2003 or (b)
December 31 of the year the IRS publishes further guidance. We’ve been warned!
Bottom line? We’ve got a complex, confusing, potentially
harsh, and certainly difficult to explain new ballgame. The IRS has given itself lots of room to
interpret things here - and the power to define the word is the power to rule
the world.
LISI will be publishing the
new tables soon. And we’ll be providing
feedback and commentary from some of the top split dollar experts in the
country.
Meanwhile, stay tuned to
this station for fast, frank, and incisive analysis.
HOPE THIS IS HELPFUL.
Steve Leimberg
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Copyright 2001 LISI
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