Clients with split-dollar insurance arrangements must make important decisions this year.

A split-dollar insurance arrangement is an agreement between business partners or even family members to share the costs and benefits of a cash value life insurance policy. Typically, the split-dollar arrangement is used in an employer-employee relationship. The arrangement may be collateral assignment in nature (the employee or a trust created by the employee owns the policy and assigns an interest in the policy's cash value and death benefit to the employer to secure repayment of the employer's cumulative premium payments), or endorsement in nature (the employer owns the policy and endorses the death benefit in excess of its cumulative premium payments to the employee's beneficiary). Split-dollar arrangements may be used in private companies or public companies. The private company arrangements must be acted upon in the immediate future to deal with income and gift tax issues. The public company arrangements must be acted upon in the immediate future for the same tax issues, but must also take into account the loan prohibition rules of the Sarbanes-Oxley Act.

The collateral assignment split-dollar arrangement is the typical equity type arrangement subject to IRS focus in its recent actions. The IRS has issued various guidance (including notices and proposed regulations) on the taxation of equity split-dollar arrangements and is expected to issue final regulations later this year. Until such final regulations are issued and most probably thereafter, IRS Notice 2002-8 should serve as guidance on split-dollar arrangements established prior to January 28, 2002.

Clearly the IRS is looking to impose new standards on new split-dollar plans relating to the income tax consequences. Therefore, all future split-dollar arrangements should be analyzed in light of the IRS focus in the proposed regulations and ultimately the final regulations expected soon.

For pre-January 28, 2002 split-dollar insurance arrangements, Notice 2002-8 allows two options to permanently avoid tax on the equity on termination of the split-dollar collateral assignment arrangement. First, the split-dollar arrangement can be terminated by January 1, 2004 and the employer can be repaid the premiums it previously paid. Note that termination of the arrangement is not termination of the underlying insurance policy because if the policy itself is terminated, the policy owner incurs ordinary income taxation for the excess cash value over the policy owner's tax basis. Accordingly, this option is really only attractive where there is substantial equity and sufficient cash value to pay back the employer and keep the policy in force.

Second, the split-dollar arrangement can be converted to a loan arrangement by treating all employer premium payments (past and current) as loans to the owner of the policy (the employee or a trust) and charging appropriate interest. The collateral assignment against the policy is released. Again, the arrangement must be converted to a loan before January 1, 2004.

Failure to timely elect one of the two options could lead to the equity value being treated as reportable taxable income to the employee upon termination of the plan. Furthermore, where the employee's interest in the policy is owned by an irrevocable insurance trust as is often the case for estate tax planning purposes, the equity could be treated as a taxable gift by the employee if the split-dollar plan terminates after January 1, 2004.

The options outlined above assume that the underlying insurance policy is not terminated. Canceling or terminating the underlying insurance policy always triggers income tax at ordinary income tax rates on the amount of the gain (cash value minus basis). For some split-dollar arrangements, this may be another option to consider. Alternatively, if the policy is intended as a death benefit only and the parties do not ever intend to terminate the plan and "roll out" the cash value during the employee's lifetime, the parties may utilize the new term cost rules and the employee should not have reportable income from the equity build-up since the policy remains in place until the insured's death. However, in this situation, the employee must be prepared for the increasing taxable economic benefit for each premium paid by the employer. In any event, the drawback of a split-dollar insurance plan is that the portion of the premium taxable to the employee (the term cost) increases significantly as the employee gets older. That is why many of these plans are terminated, the premiums are repaid to the company and the employee gets the excess equity.

Clients should not make any modification of a pre-existing split-dollar arrangement or any significant withdrawal from the insurance policy without first consulting counsel and tax advisors. Failure to consult professionals prior to modifying a pre-existing split-dollar plan could lead to a loss of the two options discussed above for pre-January 28, 2002 grandfathered arrangements and significant withdrawals from an existing insurance policy could trigger taxable income.

Public companies with split-dollar arrangements have another issue to consider. The Sarbanes-Oxley Act of 2002 prohibits public companies from making loans to its executive officers and directors and most frequently split-dollar arrangements are entered into with the executive officers of public companies.

There has been much discussion but no definitive guidance from the SEC on whether collateral assignment split-dollar plans will be treated as loans to the executive officers. Even split-dollar insurance arrangements existing prior to the Sarbanes-Oxley Act may be impermissible going forward since each premium payment by the employer may be treated as a new loan.

Therefore, a public company may only be able to convert the collateral assignment plan into an endorsement plan option and transfer the policy to the company. However, changing the plan to an endorsement plan could possibly be a material modification thereby losing the grandfathered tax benefits for collateral assignment split-dollar plans. This includes higher reportable income to the employee each year equal to the economic benefit being measured under new IRS tables as well as the value of any other economic benefits provided to the employee, including the value of the cash value to which the employee has current access.

While the public company contemplates its options, the employer should suspend any further premium payments and have the policy cash value used to continue the policy, or have the executive officer pay the premiums. Again, however, do not amend the split-dollar agreement to enable the company to make the premium payments without first consulting legal and tax advisors.

The foregoing is intended as a summary of split-dollar insurance issues. Please contact Ted Tashlik or Brenda Crandell if you have specific questions or would like to discuss this important matter in greater detail.