The Strategist
1st Quarter 1996 - Volume 3 Issue 1
Thanks to all of you who have written or
called with compliments about our newsletter. All of the information contained
in The Strategist is original information.
We do not subscribe to any service or
reproduce any material from outside sources. The information contained in these
newsletters is designed to educate and inform our readers. If you have a
question about a particular matter, please do not hesitate to call or write.
On Monday, January 29th, the IRS released a
technical advice memorandum (TAM 96 04001) which may impact many individuals
that have entered into what is known as a split dollar agreement. First, a
little history.
For over 35 years, the IRS has allowed and
approved an arrangement known as split dollar. Split dollar is an arrangement between
two parties, an employee (usually an executive) and their employer
(corporation). The two parties agree to share (split) the cost of a life
insurance policy for the benefit of the executive. Generally, the corporation
pays most, if not all, of the premium. The death benefit less the premiums paid
by the corporation is received income tax free by the executive's
beneficiaries.
The IRS has previously indicated that when
an employer and employee enter into an arrangement like this, the employee
receives a taxable benefit equal to the value of the premium that the insured
executive is relieved from having to pay.
For years our office has been encouraging
our clients to consider split dollar arrangements. In essence, the corporation
pays most, if not all, of the premium and the executive pays a very small
portion of the premium generally equal to the term charge for one year term
insurance on the policy.
There are two forms of split dollar
agreements. One form is endorsement method split dollar where the corporation
owns the policy and endorses a specified amount of the death benefit out to the
executive or to a trust established by the executive. The second form is
collateral assignment split dollar where the executive or a trust created by
the executive owns the policy. The corporation, by advancing premiums, has a
lien against the policy equal to the premiums it has paid.
When owned by an irrevocable trust, split
dollar is a very valuable tool for providing an inexpensive manner in which to
fund estate taxes. Technically, the corporation has provided what amounts to an
interest-free loan in the form of premium payments to cover life insurance that
insures the executive. Typically, the arrangement is between a trust
established by the executive and the corporation. In this circumstance, the
trust receives the total death benefit less the premium payments advanced by
the corporation. These proceeds are then used to pay estate taxes. The IRS has
issued numerous revenue rulings on split dollar life insurance and the taxation
of split dollar life insurance. The three key revenue rulings on split dollar
life insurance are Revenue Ruling 64-328, Revenue Ruling 66-110, and Revenue
Ruling 78-420.
The technical advice memorandum (TAM)
released by the IRS in late January affects collateral assignment split dollar.
The IRS has indicated in their TAM that if the cash value of the policy is in
excess of the corporation's cumulative premiums paid then the executive has
taxable income in that year equal to the cash surrender value that is in excess
of the amount that is returnable to the corporation. Further, if an irrevocable
trust established by the executive is the actual owner of the policy, the
executive is deemed to have made a gift equal to the increase in cash surrender
value in excess of the corporation's lien.
Let's look at two examples. In the first
case, let's assume that the executive enters into a collateral assignment split
dollar agreement with the corporation whereby the corporation agrees to pay the
entire premium of $10,000 per year. The executive will report as income the
economic benefit that the executive receives according to the insurance
company's one year term cost. Over 10 years, the corporation may have advanced
$100,000 toward the policy.
Let's assume that because of dividends and
policy values, that the policy no longer requires further premium payments.
Also, assume the cash surrender value increases from $100,000, in year 10, to
$110,000 in year 11. According to the IRS, the executive has just received
$10,000 in compensation in addition to the normal economic benefit. Their
reasoning is that the executive, at that point, has the right to cancel the
split dollar agreement, repay the corporation the $100,000 owed to the
corporation and therefore, the executive can surrender the policy for a net
$10,000 gain.
Let's look at another example. Assume the
same policy, costs $10,000 per year. However, in this situation the executive contributes
$1,000 per year toward the actual premium payment and the corporation
contributes $9,000 toward the premium payment. After 10 years, the corporation
would have a $90,000 security interest in the policy which is equal to their
total premium advancements. The executive has paid $10,000 toward the policy.
This is where I believe the TAM has been inaccurately interpreted by many
people.
The TAM in question involved the executive
reporting as income each year the economic benefit. The executive never
contributed to the policy and therefore never established any basis.
If the cash surrender value between the 9th
and 10th year went from $90,000 to $100,000, does the executive pick up an
additional $10,000 of compensation in the 10th year? I do not believe so. Why?
Because, instead of reporting the economic benefit or insurance company's term
cost (the $1,000 per year) as income, the executive has actually paid this
toward and has established a basis in the policy ($10,000 over 10 years).
A second potential problem with this ruling
is that the IRS has always indicated and acknowledged that the cash surrender
value build-up in a life insurance policy is not subject to current taxation.
In this particular situation, the executive is making premium payments.
Therefore, the IRS has technically found a way to tax the inside tax-free
build-up of cash surrender value in a life insurance policy. I think this is
incorrect.
The IRS has always taken the position that
no portion of a split dollar agreement provided by the employer is tax
deductible to the employer. However, in stating that the increase in cash
surrender value over the corporation's total premium payments is taxable to the
employee as income under Section 83, the IRS must also allow a tax deduction by
the employer equal to the amount included in the employee's income.
What does all of this mean? In my opinion it
means the IRS is going after certain forms of split dollar agreements that were
abusive. Split dollar agreements in which there is no sham transaction to
transfer substantial value to the employee should be left alone. For over 35
years, the IRS has recognized the benefit of split dollar agreements but may be
in the process of reversing themselves.
It is important to note that this was a technical
advice memorandum not a published revenue ruling. No court has yet reviewed
this issue so this issue will remain unresolved for now. Also, this TAM dealt
with a very unusual set of circumstances which cannot be fully explained here.
However, even if the IRS wins their position
that this is a taxable event, we believe we have developed a manner to avoid
this taxation. If you are involved in a split dollar agreement that is a
collateral assignment split dollar agreement, give our office a call and I will
explain what I believe is a valid method to avoid the taxation of this cash
value build-up.
This ruling does not affect endorsement
method split dollar. This ruling only affects collateral assignment split
dollar agreements.
As a reminder that we offer every year, if
you haven't made your annual exclusion gifts for 1996 (the $10,000 you can give
to any individual without incurring a gift tax), consider making the gifts now.
Remember, once the $10,000 gift is made, those dollars are immediately outside of
your taxable estate.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1996 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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