IRS changes taxation of split-dollar insurance

James F. McLeod practices employee benefits, tax law and wealth strategies law at Lathrop & Gage L.C. in Springfield.

Since 1964, a type of program known as "split-dollar insurance" has been used by employers to assist employees with purchasing life insurance. Under this approach to premium funding, the employer has paid the insurance premiums and has recovered the cumulative premiums paid upon the death of the employee or upon surrender of the policy for its cash value. Until now, this method of funding insurance premiums for the employee has been treated as an employee benefit.

The Internal Revenue Service first began attacking split-dollar insurance in 2001 with Notice 200110. In this notice, the IRS began describing two new split-dollar arrangements, one of which would serve as an interest-free loan to the employee under the interest-free loan rules of the Internal Revenue Code. In 2002, the IRS created provisions dealing with split-dollar insurance, Notice 2002-8. This notice provided real guidance to the taxpayer for dealing with existing split-dollar insurance plans. The proposed regulations were finalized in September.

Employer-owned policies

Notice 2002-8 permits two alternative tax schemes. The first tax scheme was to treat the premiums paid by the employer as an interest-free loan to the employee. Under the interest-free loan rules, interest on the loan is treated as compensation to the employee each year. The employee is also treated as having paid the interest to the employer. If the employer continues to pay the premium payments on the insurance policy, the amount of the loan will increase from year to year, which increases the additional compensation deemed to have been paid to the employee.

Employee-owned policies

The second approach permitted under Notice 2002-8 is an economic benefit analysis, which means that the employee has received a benefit equal to the one-year term cost of the insurance annually. The term rates used under the economic benefit analysis will increase as the employee ages. Because of the increasing term rates, most split-dollar life insurance policies will be surrendered before the employee's death unless the employee dies before reaching retirement age.

Many of the insurance policies used as a part of split-dollar insurance arrangement will eventually have a cash value greater than the amount of the premiums paid by the employer. Under the economic benefit approach, if the policy is surrendered during the employee's lifetime, the employee is treated as having taxable income equal to the difference between the cash surrender value of the life insurance policy and the cumulative amount paid by the employer.

Regardless of who owns the policy, until Dec. 31, 2003, there are three ways to restructure split-dollar life insurance arrangements in order to obtain the tax treatment desired for future years.

Option 1 Terminate the split-dollar arrangement. This will require the premiums paid by the employer to be repaid.

Option 2 - Restructure the policy as an employer-owned policy so that the employee gets the economic benefit tax treatment.

Option 3 Restructure the policy as an employee-owned policy with a collateral assignment to the employer so that the employee gets the interest-free loan tax treatment.