Eleven years ago, the IRS adopted new regulations governing the taxation of split-dollar life insurance arrangements (SDAs) entered into after September 17, 2003. SDAs entered into before that date—unless materially modified after that date—are grandfathered, governed by prior administration rulings and cases. If plan administrators don't maintain the plans as prescribed in the regulations, or materially modify the plan, they risk having the equity in the policy (the cash surrender value in excess of principal) recognized and taxed.
Several key developments demand that plan administrators periodically reevaluate the plan to ensure that they remain compliant. Gain in the policy would be taxable at ordinary rates if the SDA is terminated while the insured is still living. Prior to the new regulations, a typical SDA might have been structured as follows:
1) An employee would acquire a life insurance policy to be financed by the employer under an SDA.
2) The employer often would pay all the premiums and, under the SDA, was entitled to receive upon termination of the SDA the lesser of cumulative premiums paid or cash surrender value.
3) The employee would retain any equity in the policy if termination occurred during the employee's life.
In 2003, the IRS revised its position on equity SDA. The IRS concluded the increases in the cash surrender value in excess of the employer's contributions under an equity arrangement represented a taxable benefit to the employee in addition to the value of the insurance protection received.
Plans entered into before September 17, 2003, would not have equity taxed as long as the employer and employee continued to treat the SDA as they had in the past and the plan was not materially modified. If the plan continues until the death of the insured, built-up gain will not be taxed upon payment of the proceeds.
Faced with the possibility of growing equity, many plan administrators and their advisors opted to terminate equity split-dollar plans. Some, however, chose to continue to maintain these plans.
Three key external conditions make it critical to reexamine the wisdom of continuing grandfathered equity split dollar plans:
1) Rapid equity growth due to market performance: For split-dollar arrangements using variable life insurance, if returns have been largely positive, there is potential for the amount of taxable equity to be high.
2) Escalating economic benefit costs: For equity split-dollar plans that continued in effect under the economic benefit regime described in the new regulations, the employee annually must include the ever-increasing economic benefit (term cost).
3) Difficulty in maintaining compliance with IRS guidance: In addition to the conditions prescribed in the regulations for maintaining grandfathered treatment, many plans were affected by the passage of IRC Section 409A and its regulations in December of 2004, which raised the possibility of taxation of equity. If the employer and employee modify the SDA to comply with the conditions of 409A, they risk taxation of gain in the policy. Further, Sarbanes Oxley, which prohibits loans to directors and executive officers of public companies, applies to certain split-dollar arrangements.
In light of this reality, grandfathered equity split-dollar plans must be periodically reviewed with appropriate tax and legal counsel. In some cases, it may be the best course of action to consider terminating the arrangement—even if it results in the current income taxation of accumulated equity.
Jeri Turley is a principal of BCG Companies, a member firm of M Financial Group based in Richmond, Va. Alan Jensen is a partner in the global law firm of Holland & Knight. Matthew Pressler is director of Advanced Markets & Sales Support for M Financial Group.
