Janet Glasser (a pseudonym) joined her family’s business, Glasser Medical Supply Company, as a sales rep in 1990. Her father, Evan, who had founded the company in 1959, was pleased with Janet’s decision but knew she had a lot to learn about the company and the industry. He also expected her to earn the respect of others in the company by working her way up through the corporate ranks.
One year later, tragedy struck when Evan suffered a debilitating stroke that left him both physically and mentally incapacitated. Janet realized she was not yet ready to take the reins and recognized her dependence on the company’s senior management team. Matt Snyder had been with the company for many years and, except for Evan, was its most senior executive. Janet knew it was critical for Matt to remain with the business through the unanticipated upheaval and beyond. To encourage him to stay, she needed to devise a financial incentive.
Janet sought help from the company’s financial advisers, and together they developed a long-range incentive plan that provided Matt with substantial life insurance coverage and supplemental retirement income. But the plan that worked so well for them in 1991—a split-dollar life insurance arrangement—last year became subject to new Internal Revenue Service regulations, which place additional restrictions on such arrangements and increase the cost involved.
The split-dollar solution
Split-dollar life insurance is not a type of insurance product but rather a method of funding premium payments on cash value insurance policies. Under such a plan, the costs and benefits of a life insurance policy are “split” between two parties. In the typical employer-employee arrangement, the employer generally advances premiums due on a cash value policy on the life of the employee, who designates a beneficiary. The employer is ultimately repaid for the premium advances through the proceeds of the policy on the employee’s death or out of the cash value of the policy if it is terminated before his or her death.
In Matt Snyder’s case, Glasser Medical Supply purchased $4 million of permanent life insurance for Matt at an annual premium of $50,000. The company agreed to pay most of the premium, while Matt would pay a small portion equal to the “economic benefit” that he received. This benefit would be measured by the cost of equivalent term insurance. Any cash value in excess of the premiums paid by Glasser would accrue to the benefit of Matt, but it was not considered current taxable income to him. Upon Matt’s retirement, he could borrow from the policy’s cash value to repay Glasser for the interest-free “advance” of the premiums paid over the years.
The company’s cost to provide this incentive was the loss of the use of the premium payments until Matt’s retirement. The cost to Matt was the relatively small portion of premiums he paid (which Glasser also agreed to provide through an annual bonus payment).
Matt remained with the company and provided his industry expertise, stability and guidance to Janet in the aftermath of her father’s illness and beyond. As a result, the family business was able to survive the unexpected and untimely departure of its owner and founder.
Over the past 40 years such split-dollar arrangements became very popular because of their favorable tax benefits. An insured employee received funding for a life insurance policy with a small cash outlay, and he ultimately had access to the net policy cash values without incurring an annual tax liability on the equity buildup. When irrevocable trusts were used, sizeable amounts of insurance proceeds could be removed from the insured’s estate at a relatively small transfer tax cost.
IRS attacks on split-dollar plans
In the years following the establishment of Glasser Medical Supply’s arrangement with Matt, the IRS began to challenge some of the favorable tax consequences of such plans. Although these arrangements have been effectively used for many years, split-dollar life insurance is not mentioned anywhere in the Internal Revenue Code. Much of the basis for the taxation of such plans was developed through a series of revenue rulings, which began more than 40 years ago. A 1964 revenue ruling was the first to mention the term “split-dollar.” In this ruling, the IRS held that the insured participant in a split-dollar arrangement had received an economic benefit. This benefit was to be valued using the cost of one-year term insurance in an amount equal to the death benefit payable to the insured’s beneficiary. The term insurance rates referred to in this ruling were known as PS-58 rates.
A favorable environment continued for a number of years. A ruling in 1966 modified the way taxes are calculated on a split-dollar plan by allowing an alternative based on an insurer’s published rates. In 1978, an IRS ruling held that an employee makes a gift to a third-party owner and beneficiary of the policy (such as an irrevocable life insurance trust) to the extent of the reportable “economic benefit.” This resulted in much smaller gifts and gift taxes to the employee than if the full premium payment were required to be used. Many estate and gift tax planning techniques were enhanced or made possible with split-dollar arrangements.
In 2001, the IRS indicated it would be clarifying the rulings regarding split-dollar arrangements. A series of notices and proposed regulations since 2001 have culminated in final regulations issued in September 2003 on the taxation of split-dollar arrangements for the purpose of federal income, employment and gift taxes. The rules have dramatically changed. They generally increase the amount that participants must include in taxable income during the term of the split-dollar arrangement. This is especially true for equity arrangements like the one entered into by Glasser Medical Supply and its key employee. The final regulations are effective for split-dollar arrangements instituted after Sept. 17, 2003. (Certain “grandfathering” and “safe harbor” provisions apply to arrangements entered into before this date, unless they are materially modified.)
Split-dollar plans are generally structured in one of two ways. Under collateral assignment arrangements, a non-owner of the policy (typically an employer) pays the premiums on a policy owned by the insured or the insured’s designee. The premium payer receives a security interest in the policy as collateral for the cumulative premium payments. In an “equity” version of this arrangement, similar to the Glasser Medical Supply plan, the employer is entitled only to a premium reimbursement. Any “excess policy equity,” such as cash surrender value in excess of this premium reimbursement, is paid to the owner or his designee. However, in a non-equity version of this type, the non-owner is entitled to receive the larger of its cumulative premiums or the cash surrender value. The owner receives only life insurance protection. Collateral assignment plans have often been used by family and other closely held businesses to provide benefits to controlling shareholders and other owner-employees. Estate planners have also found such plans valuable when it’s important to exclude life insurance from an estate.
Endorsement arrangements are another type of split-dollar plan. In this situation, the policy owner (employer) pays the premiums but provides the death benefit to the non-owner’s beneficiary. These plans have often been established to provide executive employees with supplemental compensation-related benefits.
Effects of the new regulations
The final regulations include a broad definition of split-dollar arrangements. Insurance transactions that previously were not considered split-dollar plans may now be included under these new restrictive regulations.
The arrangement is treated as an “economic benefit” under endorsement-type plans in which the owner (e.g., the employer) is considered to be providing economic benefits to the non-owner (employee). Depending on the relationship of the parties, the benefit will be considered a gift, capital contribution, dividend income or compensation. In the past, this benefit was generally limited to the cost of current life insurance protection for the non-owner. This benefit must now be valued using new tables with significantly higher rates. In addition, the policy cash values to which the non-owner has current access (to the extent not previously accounted for), plus the value of any other economic benefit, must now be reported as taxable income on an annual basis.
Loan treatment is now required for collateral assignment arrangements whereby the owner and non-owner of the split-dollar life insurance policy are considered, respectively, as borrower and lender. The non-owner is considered to be making an interest-bearing loan to the owner for each premium payment. If interest is not provided, the new regulations require that it be imputed under federal guidelines.
It is essential for every existing arrangement to be reviewed in light of the new regulations. Although “grandfather” provisions may apply, it is prudent to evaluate an exit strategy before cash values, age or premium rates make existing plans cost-prohibitive because of the potential for increased tax cost. Furthermore, since the new regulations apply to plans that are materially modified, it is very important that no significant changes be made to existing plans.
Split-dollar arrangements have long been considered sophisticated planning devices because of their legal, tax and insurance complexity. As mentioned above, the new regulations place additional restrictions and costs on split-dollar arrangements. It is unlikely that any new equity-type collateral assignment plans will be established. However, other types of split-dollar arrangements may still be very attractive tools for family businesses seeking fringe benefits for key executives, and they also continue to be useful for estate planning and business continuation planning. Because of the split cost of these plans, insurance can be purchased that would otherwise be unaffordable. In the aftermath of these latest regulations, it is important to have any existing or new arrangements very carefully analyzed.
Donna J. DeFilippi, CPA, CSEP, is a tax partner with Sisterson & Co. LLP, a professional services and consulting firm in Pittsburgh that has served family businesses for more than 75 years (djdefilippi@sisterson.com).