MAJOR
CHANGES TO TAXATION OF SPLIT-DOLLAR INSURANCE ARRANGEMENTS
If you have a split-dollar insurance arrangement with one of your
key employees, the Internal Revenue Service (IRS) has recently issued
final regulations regarding the tax treatment of these arrangements
that are significantly different from the older rules. If an arrangement
is currently in place the tax effect to the employee may be different
now and decisions may need to be made prior to January 1,
2004 regarding whether to continue the arrangement. If you
are considering implementing a new arrangement, you should seriously
consider the impact of the new IRS rules.
NEW RULES ISSUED
The new rules are effective for all split-dollar arrangements entered
into after September 17, 2003 and for any arrangement that is “materially
modified” after September 17, 2003 (an important point addressed
later in this Alert). The new rules are rather complex and vary depending
on the type of arrangement you have in place. In general, the new
rules may require the employee to recognize a greater amount of taxable
income than has previously been required, including possibly being
taxed on the annual cash surrender value (CSV) build-up. It is not
an exaggeration to say that the new rules severely decrease the attractiveness
of split-dollar insurance arrangements.
EFFECT ON PRE 9/18/03 ARRANGEMENTS
Any arrangement in effect before September 18, 2003 and not “materially
modified” can still use the old rules regarding the taxation
of split-dollar insurance plans. In general, the old rules require
treating premium payments made by the employer as either a loan to
the employee (with all the tax consequences) or as providing an economic-benefit
equal to the annual term life insurance cost taxable to the employee.
If the employer is deemed to be providing the benefit of the term
life insurance cost, the CSV build up is taxed to the employee when/if
it is “made available” to the employee, which under the
old rules usually will not happen unless the arrangement or policy
is terminated.
“MATERIALLY MODIFIED”
As mentioned above, if an existing arrangement is “materially
modified” after September 17, 2003, it is subject to the new,
mostly unfavorable taxation rules. What is considered “materially
modified” is not clearly defined in the new rules and is undoubtedly
going to be the source of much confusion. Accordingly, extreme care
should be taken before making any change to an existing plan. Current
arrangements should be reviewed to re-evaluate whether to continue
them (warning – terminating existing arrangements can
also have adverse tax consequences).
TAXATION OF CSV AND SAFE HARBOR
It is clear that under the new rules, if the employer is the owner
of a split-dollar policy, the employee is required to be taxed on
the annual increase in his/her share of the CSV either currently or
on termination. The old rules are not as clear, but it appears as
if the employee’s share of the CSV will be taxable to him/her
if the arrangement is terminated and the policy is transferred to
the employee. For arrangements entered into before January
28, 2002, there is a safe harbor provision that may save
a substantial amount of taxes if the arrangement (not the policy)
is terminated before January 1, 2004. This
safe harbor will allow the arrangement to be terminated without the
CSV being taxed to the employee and in general, will make sense if
the policy is an older, mature policy with a CSV large enough to allow
the corporation to be paid back for its share of premiums paid and
to cover the cost of future premiums. This safe harbor, along with
others provided for in the new rules, are rather complex and should
be reviewed and discussed with us and your insurance representatives
before undertaking any action.
SARBANES-OXLEY
One final issue to briefly touch upon is the effect of Sarbanes-Oxley
on split-dollar arrangements. In general, Sarbanes-Oxley provides
strict rules regarding loans made to key executives by corporations.
This area is yet another reason to re-examine existing split-dollar
arrangements and to proceed with extreme caution prior to implementing
new arrangements.
The complexities of the new split-dollar rules, the adverse tax effects
that are possible, and the January 1, 2004 safe-harbor deadline for
possibly terminating arrangements make re-examining the effectiveness
of any split-dollar arrangement a must. Due to the highly technical
regulations that have been issued, if any of the circumstances discussed
in this Alert apply to your situation, your insurance representative
should be contacted as soon as possible to discuss how your particular
arrangement may be affected.
If you wish to discuss any of the information covered in this Alert
in
further detail, contact Charles Marston or Rich Pacella at (724) 934-0344
or cmarston@srsnodgrass.com
or rpacella@srsnodgrass.com
.
