A traditional split-dollar arrangement involves the employee buying a permanent life insurance policy and the employer paying for that part of the premium equal to that year’s increase in the cash surrender value. The employee pays the balance. If the insured pays an amount toward premiums each year that at least equals the cost of what would be the premium for an equivalent term policy (determined by the IRS’s Table P.S. 58), the insured reports no income. If the employee pays less than the P.S. 58 amount, the employee is taxed on the difference. The employer can’t deduct its premium payments, but the eventual repayment of its total premiums out of cash surrender value when the employee leaves service or retires is tax free. This arrangement allows the business owner or executive to hold high-value life insurance for minimum cost.

In recent years, equity split dollar has come to dominate split-dollar arrangements. Here, life insurance with a high investment component is bought. In a typical arrangement, the employer pays the bulk of the premiums, but is repaid out of the cash value at the insured’s termination, retirement or death only the total amount premiums paid by the employer. The remaining cash value goes to the employee (and the death benefits, of course, go to the beneficiary). In short, the executive has received an interest-free loan from the employer and garnered potentially substantial investment gains.

This rise in the use of equity split dollar, and the fact that the P.S. 58 table was out of date in light of increasing life expectancy, prompted the IRS to issue new rules in this area to clarify tax obligations. While a very complicated area, here are some key points from the IRS notice.

Regardless of whether a policy is owned by the employer (under the endorsement method) or the employee (under the collateral assignment method), the investment gains in an equity split-dollar arrangement beyond the actual life insurance protection are taxable. This hasn’t necessarily been the case in the past. When that gain is taxed will depend on the arrangement.  [Financial Panning mag March 2001, p. 68]

Where the employer is expected to receive repayment of its premium payments by the employee at a “fixed or determinable future date,” the employer’s premium payments are considered a series of below-market (interest-free in this case) loans. In this arrangement, the cash-value gains build up without immediate taxation, but the employee must pay tax on the interest at the applicable federal rate.

On the other hand, if the employer’s payments are not treated as interest-free loans, with the employee paying tax on the interest, the annual gains in the cash value will be taxable as ordinary income to the employee each year or at the rollout when the employee terminates employment.

In the case of new equity split-dollar arrangements, the employer and employee can essentially choose which method they want, and the IRS will treat it that way for tax purposes as long as they follow that characterization, from inception. In the case of existing arrangements, it will be treated as one involving loans, which is usually the best method, as long as the parties have consistently followed the loan arrangement in the past and they can account for all economic benefits to the employee. If they haven’t followed it consistently, or they’ve chosen a nonloan method, then the employee will have compensation income equal to the value of the life insurance protection (reduced by payments the employee makes annually for that protection), as well as dividend income and gains in the cash surrender value of the policy.

Although the IRS ruling focuses on equity split-dollar arrangements, the notice is expected to affect other forms of split-dollar arrangements, including private split dollar. The revision of the P.S. 58 tables is also expected to affect other insurance benefits as such as life insurance inside qualified retirement plans.

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September 2001 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community.