Split-Dollar Life Insurance

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					AUGUST 2003



       Split-Dollar Life Insurance
       After 40 years of little change, the Internal Revenue Service plans to begin treating split-
       dollar life insurance policies differently—significantly increasing tax bills for many
       policyholders.

       Split-dollar plans are an important financial-planning tool often used to provide deferred
       compensation for corporate executives, as an estate-planning tool for high-net-worth
       individuals, or for other long-term planning purposes. Historically, the benefits from these
       plans, an important component of many executive compensation arrangements, have
       triggered little or no taxes. Beginning the first of next year, the potential tax liabilities will
       increase significantly.

       The IRS changes go into effect Jan. 1, 2004. This means there is still time for current plan
       owners to obtain an analysis of their potential tax liability and make any necessary changes.
       However, policy owners need to act quickly.

       Split-dollar plans are highly customized, so there are no rules of thumb to help easily
       determine how each plan will be treated or what taxes the IRS might levy. To assess the best
       course of action and to estimate the potential tax liabilities, each plan owner first needs an
       individualized, carefully reviewed evaluation. Then, the recommended solution must be
       executed. It’s a time-consuming process that needs to be complete before the IRS-mandated
       deadline.

       Some solutions for existing plans include:

                •    Create an exit strategy, if this type of plan is no longer appropriate under the
                     new tax treatment
                •    Restructure the plan to improve its tax efficiency
                •    Convert the plan to a loan arrangement before the Jan. 1, 2004 deadline
                •    Leave the current plan intact




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Only by reviewing the specific details of each plan, can the tax consequences be considered
and the best solution determined. Those contemplating a new split-dollar policy should seek a
thorough legal review of the proposed plan and may want to execute it before the final
regulations are issued. Determining the best course of action, for both existing and
proposed plans, requires careful examination.


What Should You Do?
We’ve prepared the attached summary, which provides greater detail about the myriad of
issues surrounding the new tax regulations’ impact on different types of split-dollar plans.
This summary is based on the government rulings and proposed regulations, as well as
Ratner, Zipse & Liemberg, “Prop. Regs on Split-Dollar Impose Tax on Shifts of Wealth,”
Estate Planning, Nov. 2002, pg. 547 and “Planning Under the New Split-Dollar Life
Insurance Prop. Regs,” Estate Planning, Dec. 2002, pg. 603, and Brody, Richey and Baier,
386-3rd T.M., Compensating Employees with Insurance, A-57.

                                                        Summary Table of Contents


Split-Dollar Arrangements – A Primer ........................................................................................................................................3
Terminology ................................................................................................................................................................................3
Non-Equity Split-Dollar – the employee receives only a death benefit .....................................................................................3
Chronology ..................................................................................................................................................................................4
Effective Dates ............................................................................................................................................................................5
Tax Law .......................................................................................................................................................................................6
Notice 2002-8 Summary ..............................................................................................................................................................7
The Service, in Notice 2002-8......................................................................................................................................................7
Proposed Regulations – The Basics............................................................................................................................................8
Proposed Regulations: Taxation Under the Economic Benefit Regime ..................................................................................9
Example 1 .................................................................................................................................................................................. 10
Example 2 .................................................................................................................................................................................. 11
Proposed Regulations: Taxation Under the Loan Regime – Basics ....................................................................................... 12
A. Proposed Regulations -Split-Dollar Demand Loans................................................................................................................... 12
B. Proposed Regulations Split-Dollar Term Loans ......................................................................................................................... 13
C. Proposed Regulations - Split-Dollar Loans – Waived, Cancelled or Forgiven Interest.................................................................. 14
D. Proposed Regulations - Transfer Tax Implications .................................................................................................................... 14
Summary of Proposed Regulations................................................................................................................................................ 14
The Safe Harbor - What Needs to be Done Before January 1, 2004? ....................................................................................... 14
What Should be Done - Endorsement Arrangements .............................................................................................................. 15
Collateral Assignment Plans - Variations.................................................................................................................................. 16
Collateral Assignment Arrangements – The Problem ..................................................................................................................... 16
What Should Be Done - Collateral Assignment Arrangements........................................................................................................ 16
Gift Tax Implications – Collateral Assignment Arrangements ........................................................................................................ 17
Questions .................................................................................................................................................................................... 18


For a thorough individual analysis and evaluation of the potential tax implications for your
plan, please contact any of our group members listed at the end of this Alert. We can help
you to navigate the intricacies of split-dollar life insurance polices, and the impact of the
pending legislative and tax changes.




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Split-Dollar Arrangements – A Primer
Split-dollar life insurance arrangements come in a variety of shapes and forms. In essence, a
split-dollar arrangement is a cost sharing plan. In a typical arrangement, the employee
contributes a portion of the policy premium for a cash value life insurance policy that is
equivalent to the pure insurance (death benefit) portion of the policy, or recognizes such
amount as imputed income (bonus). The employer pays the remaining portion of the
premium, and the employer is reimbursed for this outlay out of the policy’s cash surrender
value at the insured employee’s termination or retirement, or out of the policy’s death
benefit proceeds at the employee’s death. Any remaining portion of the cash value goes to
the employee, and the remaining death benefit proceeds go to the beneficiary of the policy.
The rights and obligations of the two parties are memorialized in a split-dollar agreement,
and the policy is used to collateralize the employer’s payment of the premiums.
Economically, the old rules allowed the employer to make a non-taxable interest free loan to
the employee, and allowed the employee to receive significant life insurance protection at a
much reduced cost. For estate tax planning purposes, oftentimes the employee transferred
his or her interests in the policy to an irrevocable life insurance trust, which allowed for
leverage of gift tax on policy premiums and avoidance of estate tax on the death proceeds.


Terminology
Non-Equity Split-Dollar – the employee receives only a death benefit

Equity Split-Dollar – the employee receives both a death benefit and an interest in the
policy’s cash surrender value

Rollout – the unwinding of the split-dollar arrangement upon termination of employment,
retirement or some other point. Generally, the policy is designed to accumulate enough cash
value to fund the rollout and provide for future premiums post-retirement. Thus, policy
cash value (in excess of the obligation to repay the employer’s premiums) at rollout provides
a clear economic benefit to the employee.

Endorsement Split-Dollar – the employer owns the policy and pays the premiums. The
employee designates a beneficiary for the amount of death benefit in excess of the greater of
the cash value or premiums paid. The employee is taxed on the economic benefits derived,
based on the value of the life insurance protection.

Collateral Assignment Split-Dollar – the employee owns the policy and gives the employer a
collateral assignment of the policy to secure payment of the employer’s premium advances.
At retirement or death, the employer recovers the premiums paid out of the policy’s cash
value or its death proceeds.

Private Split-Dollar – a split-dollar arrangement found most often in a family context, in
which a donor “funds” the premiums of a life insurance policy owned by a life insurance
trust (with children or other family members as beneficiaries).

Reverse Split-Dollar – an arrangement in which one party who has rights to the pure
insurance protection utilizes, according to the IRS, inappropriate valuation tables or other
techniques to confer benefits, such as enhanced cash value build-up, to another party while
also avoiding significant gift tax.


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Irrevocable Life Insurance Trust (ILIT) – a trust, usually for family members, that is
designed to hold the “incidents of ownership” of a life insurance policy (the power to
change the beneficiary, borrow from the cash surrender value, etc.) in order that the policy’s
death benefits are not included in the grantor-decedent’s taxable estate.


Chronology
1955      Revenue Ruling (Rev. Rul. 55-713) characterized a split-dollar
          arrangement as an interest free loan equal to the employer’s advances.
          The ruling held that the employee was taxable on the forgone loan interest.

1961      A case (Dean 35 TC 1083) held that an employer could lend money to
          an employee on an interest free basis without taxation to the employee.

1964      The IRS revoked its 1955 ruling in light of Dean and in Rev. Rul. 64-
          328, held that the employee should be taxed on the economic benefit
          received – the value of the term insurance protection using so-called P.S.
          58 Tables that greatly exaggerated the value of the term protection.

1966      The IRS, after receiving criticism on the mandatory use of the P.S. 58
          Tables, held in Rev. Rul. 66-110 that an employee may use the lower of
          the P.S. 58 Tables or the insurer’s generally available published yearly
          renewable term insurance rates, plus any other “economic benefit” of
          the arrangement, in arriving at the taxable amount.

1978      In a split-dollar arrangement between an employer and a third party
          such as an ILIT, the value of the life insurance protection that is treated
          as taxable income to the employee, is also deemed a transfer by the
          employee to the ILIT as a taxable gift under Rev. Rul. 78-420.

1984      In 1984, the Dean case was overruled by the Supreme Court in
          Dickman (465 US 330). Congress also enacted Section 7872, which
          deals with below market loans, and treats an employer’s interest free
          loan to an employee as taxable compensation.

1996      Out of the blue, the IRS, in Private Letter Ruling 9604001, held that
          increases in a policy’s cash surrender value, over and above what was
          required to be paid back to the employer at termination, retirement or
          death (advances), were considered taxable income to the employee (i.e.
          the economic benefit of the increase in “equity”).

2001      Notice 2001-10 provided interim guidance on all types of split-dollar
          arrangements. The IRS released Table 2001, dealing with the value of
          one-year term insurance, which had rates lower than the P.S. 58 Tables
          but generally higher than the “generally available market costs” of term
          insurance. The Notice also required the parties to consider a split-dollar
          arrangement as taxable either as:




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          • an economic benefit of term insurance plus increases in policy equity;
          • an interest free loan, or
          • a bonus, for the full amount of the premium.
         Notice 2001-10 clearly indicated an intention to tax the equity in a
         collateral assignment plan, expressed concern with reverse split-dollar
         arrangements and abolished the use of the P.S. 58 table to value
         insurance protection.

2002     The Treasury & IRS jointly released Notice 2002-8 in January 2002 and
         Treasury released Proposed Regulations in July 2002, again revamping
         the rules set forth in Notice 2001-10 and earlier rulings and providing
         for a “safe harbor” period ending at the end of 2003 (see below).

2002     The Corporate Auditing Reform Act (Sarbanes-Oxley), signed into law
         on July 30, 2002, makes it a criminal offense for a publicly traded
         corporation to make loans to officers and directors, with no specific
         exemption for equity collateral assignment split-dollar arrangements.

2002     Notice 2002-59, issued August 16, 2002, was designed to stop the use of
         reverse split-dollar arrangements, by stating that the use of techniques to
         understate the value of policy benefits enjoyed by a third party (such as
         ILIT) distort the income, employment and gift tax consequences of the
         arrangement and is not permitted by published guidance.

2003     Treasury released additional proposed regulations in May dealing with
         the valuation of economic benefits under split-dollar arrangements.

January 1, 2004

         The safe harbor period under Notice 2002-8 ends and the new
         rules for pre-January 2002 arrangements are implemented.


Effective Dates
1. Arrangements entered into before January 28, 2002 are governed by Notice 2002-8, or if
desired by the taxpayer, the Proposed Regulations.

2. Arrangements entered into after January 28, 2002 and before the Final Regulations are
issued are covered by another set of rules (Notice 2002-8 supplemented by the Proposed
Regulations, Notice 2002-59 and other interim guidance).

3. Arrangements entered into after Final Regulations are published will be covered by a
third set of rules, based on the Final Regulations.




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Tax Law
The following tax law is pertinent to split-dollar arrangements

        •    Section 61 – a taxpayer must include in taxable income “all income from
             whatever source derived.” The cost of life insurance protection is taxable
             under Section 61.
        •    Section 83 – governs the taxation of a transfer of property to a service provider
             (such as an employee) in connection with the performance of services. The
             excess of the fair market value of the property received over the amount paid is
             included in the service provider’s income (in the first year such rights are non-
             transferable). When a policy is transferred, the cash surrender value is
             considered property for purposes of this section.
        •    Section 163(h) – disallows personal interest expense as a deduction.
        •    Section 264 – disallows a deduction for life insurance premiums if the taxpayer
             is directly or indirectly a beneficiary under the policy.
        •    Sections 1271-1275 – covers original issue discount (OID). Lenders must
             recognize income as ratably received over the term of the loan (accrued based
             on the debt instrument’s yield to maturity) even though not actually received.
             The borrower reports the excess of the loan’s face amount over the “imputed
             loan amount” as income (i.e., compensation) in the year the loan is made.
        •    Section 7702(f)(7) – provides a definition of “life insurance” for tax purposes.
             Among other matters, a reduction in benefits within the first 15 years of a
             policy is closely scrutinized, with a forced taxable distribution of cash value the
             result of failing the complex definitional tests set forth in the provision. For
             this reason, split dollar arrangements are generally designed to “rollout” in the
             sixteenth year of the policy.
        •    Section 7872 – provides rules for below market loans (i.e., the stated interest
             rate is less than the applicable federal rate (or AFR), a rate that changes
             monthly) based on the term of the loan.
                        o    A section 7872 demand (gift) loan’s forgone interest is treated
                             as transferred from the lender to the borrower and then re-
                             transferred from the borrower to the lender as interest – on the
                             last day of each year the loan is outstanding.
                        o    A Section 7872 term loan – the lender is treated as having
                             transferred (on the day the loan is made) the excess of the
                             amount lent over the present value of all payments required
                             under the term of the loan, and is treated as re-transferred by
                             the borrower to the lender as OID over the term of the loan.
                             Taxation is accelerated to the inception of the loan (an
                             unattractive trait), when contrasted with a demand loan.




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Notice 2002-8 Summary
Notice 2002-8 was designed to provide interim guidance before Final Regulations are
published. The Notice provides for several “safe harbors” for existing (pre-January 28,
2002) arrangements and provide guidance for post-January 28, 2002 and pre-Final
Regulations arrangements.

The Service, in Notice 2002-8

         •   Revoked Notice 2001-10, which set forth interim guidance on split dollar
             arrangements
         •   Outlined the basic principles behind the subsequently released Proposed
             Regulations - see below
         •   Provided interim guidance on the valuation of current life insurance protection:
                         o   Notwithstanding the revocation of Rev Rul 55-747, parties to a
                             pre-January 28, 2002 split dollar arrangement can continue to
                             use the P.S. 58 rates to value current life insurance protection (if
                             the contractual arrangement between the parties provides for
                             their use).
                         o   For arrangements entered into before Final Regulations are
                             published, a new rate schedule, Table 2001 (as originally
                             published in Notice 2001-10) can be used to value current life
                             insurance protection.
                         o   For arrangements entered into before Final Regulations are
                             published, parties to a split dollar arrangement may continue to
                             use an insurer’s lower published premium rates (for standard
                             risks) in valuing the current life insurance protection. However,
                             for post-January 28, 2002 arrangements, the so-called
                             “published rates” must be “real” – actual advertised rates that
                             are actually sold to individuals who apply for term coverage.
Notice 2002-8 also set forth the following guidance
        •    A transfer will not be deemed to have occurred solely because the earnings
             credited to the cash value of a policy cause the cash value of the policy to
             exceed the amount due to the party who advanced the premium (e.g., the
             employer) - Thus, the annual increase in cash surrender value is not subject to
             current taxation to the employee.
        •    The IRS will not treat an arrangement to have been terminated (which gives rise
             to a taxable transfer of property) so long as the parties continue to treat and
             report the value of the life insurance protection as a taxable economic benefit.
        •    If the parties treat previous payments as loans, the Service will not challenge
             reasonable efforts to comply with the OID rules and the below market interest
             rules of Section 7872, so long as all payments from the sponsor from inception
             of the arrangement are treated as a loan entered into as the first day of the year
             in which loan treatment commences.




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        •   For pre-January 28, 2002 arrangements in which a sponsor has made premium
            payments and is entitled to receive full repayment of all its payments – the
            Service will not assert a taxable transfer of property upon termination of the
            arrangement if:
                         o   The arrangement is terminated (rolled-out) before January 1,
                             2004 (thus, the policy equity will forever escape income tax), or,
                         o   For all periods beginning on or after January 1, 2004, all
                             payments by the sponsor (from inception of the arrangement)
                             are treated as loans for income tax purposes and each party
                             reports the tax treatment of the loans consistent with loan
                             treatment under the OID rules and Section 7872 below market
                             interest rules.

Proposed Regulations – The Basics
The proposed regulations define a split-dollar life insurance arrangement as any arrangement
(other than a group term life insurance plan) between an “owner” of a life insurance contract
and a “non-owner” of the contract under which either party pays all or part of the
premiums, and one of the parties paying the premiums is entitled to recover all or any
portion of those premiums and such recovery is to be made from, or is secured by, the
proceeds of the contract – a very broad definition indeed!

A special (broader) rule applies to compensation arrangements. Under the special rule, a
split-dollar arrangement is any arrangement between an owner and a non-owner of a life
insurance contract under which the employer pays, directly or indirectly, all or any portion of
the premiums and the beneficiary of all or any portion of the death benefit is designated by
the employee or is a person whom the employee would reasonably be expected to name as
the beneficiary. The policy need not be security for the outlay or a source of repayment
under this special rule. Apparently, this special rule is designed to be a catch-all for
“strategies” that don’t call themselves split-dollar arrangements in an attempt to avoid the
new regime.

Under the Prop. Regs, the “owner” is a person named in the contract as a policy owner.
Shared ownership arrangements will now be treated as split-dollar arrangements. A “non-
owner” is any person having any direct or indirect interest in the contract. For example, if
an employer named an employee’s spouse as a beneficiary on a policy on the life of an
employee, the employee would have an indirect interest in the contract and would be a
“non-owner.”

There are two exemptions to the rule that the person named as the policy owner is the
“owner.” Both involve situations in which only term insurance is provided (non-equity
policies). First, in a traditional non-equity split-dollar arrangement, the employer – not the
employee who is the policy owner will be treated as the owner. Second, a donor is treated as
an owner in an arrangement between a donor and donee (i.e., an ILIT) if the only economic
benefit to the donee is term insurance. This allows the use of a restricted collateral
assignment arrangement for estate planning purposes in a controlling shareholder (more
than 50% ownership interest) situation, without requiring that the arrangement be accounted
for as a loan.


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The proposed regulations set forth two mutually exclusive regimes for taxing split-dollar
arrangements:
         •   A loan regime for collateral assignment arrangements – the employer (the non-
             owner) of the policy is treated as lending the amount of its premium payments
             to the employee (the owner of the policy) or an ILIT formed by the employee.
         •   An economic benefit regime for endorsement arrangements – the value of
             economic benefits provided to the employee is the sum of (a) the cost of
             current year life insurance protection, (b) the amount of policy equity (cash
             value) that the employee has access to, and (c) the value of any other economic
             benefit.
         •   The proposed regulations – apply to split-dollar arrangements entered into
             after the final regulations are published in the federal register and to previous
             arrangements materially modified after that date.
         •   Both the owner and non-owner are required to consistently account for all
             amounts under the arrangement – no matter which regime applies.

Proposed Regulations: Taxation Under the Economic Benefit Regime
Under the economic benefit regime, the value of the economic benefits of the arrangement
is treated as transferred from the owner to the non-owner (but is reduced by any amounts
paid as consideration by the non-owner to the owner). In a compensation arrangement, the
employer is considered to make a transfer of the economic benefits of the contract to the
employee. In a family context, the grantor is the policy owner, and the ILIT has the right to
name the beneficiary, so the grantor is deemed to make the transfer of economic benefits to
the ILIT.

The relationship between the owner and the non-owner will determine the tax
consequences. In an employer-employee relationship the transfer is compensation; it could
be a dividend where a majority shareholder-employee is involved; it is a dividend where a
non-working shareholder is involved; and it is a gift in a non-compensation situation.

An example contained in the most recent release of proposed regulations illustrates the
taxation of an endorsement split-dollar life insurance arrangement under the economic
benefit regime. It is not surprising that the proposed regs are similar to the Services’ view as
set forth in the 1996 Ruling noted above. In sum, the value of the economic benefits
provided to the non-owner for a year equals the cost of life insurance protection plus any
cash value to which the non-owner has access, plus any other economic benefit provided to
the non-owner. Note that the non-owner has “access” to any portion of the policy’s cash
value that is directly or indirectly accessible by the non-owner, inaccessible by the owner, or
inaccessible to the owner’s general creditors.

The examples are as follows:




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Example 1

        Facts. In year 1, employer “R,” and employee “E,” enter into the equity split-
        dollar life insurance arrangement. Under the arrangement R pays all of the
        premiums on the life insurance contract until the termination of the arrangement
        or E’s death. The arrangement also provides that upon termination of the
        arrangement or E’s death, R is entitled to receive the lesser of the aggregate
        premiums paid or the policy cash value of the contract and E is entitled to receive
        any remaining amounts. Under the terms of the arrangement and applicable state
        law, the policy cash value is fully accessible by R and R’s creditors but E has the
        right to borrow or withdraw the portion of the policy cash value exceeding the
        amount payable to R upon termination of the arrangement or E’s death. To fund
        the arrangement, R purchases a life insurance contract with constant death benefit
        protection equal to $1,500,000. As of December 31 of year 1, the policy cash
        value equals $55,000 and R has paid $60,000 of premiums on the life insurance
        contract. As of December 31 of year 2, the policy cash value equals $140,000 and
        R has paid aggregate premiums of $120,000 on the life insurance contract. As of
        December 31 of year 3, the policy cash value equals $240,000 and R has paid
        $180,000 of premiums on the life insurance contract.

        Analysis. Under the terms of the equity split-dollar life insurance arrangement, E
        has the right for year 1 and all subsequent years to borrow or withdraw the portion
        of the policy cash value exceeding the amount payable to R. Thus, E has current
        access to such portion of the policy cash value for each year that the arrangement
        is in effect. In addition, because R pays all of the premiums on the life insurance
        contract, R provides to E all of the economic benefits that E receives under the
        arrangement. Therefore, E includes in gross income the value of all economic
        benefits provided to E under the arrangement.

        Results for year 1. For year 1, E is provided $0 of policy cash value (excess of
        $55,000 policy cash value determined as of December 31 of year 1 over $55,000
        payable to R). For year 1, E is also provided current life insurance protection of
        $1,445,000 ($1,500,000 minus $55,000 payable to R). Thus, E includes in gross
        income for year 1 the cost of $1,445,000 of current life insurance protection.

        Results for year 2. For year 2, E is provided $20,000 of policy cash value ($140,000
        policy cash value determined as of December 31 of year 2 minus $120,000 payable
        to R). For year 2, E is also provided current life insurance protection of $1,360,000
        ($1,500,000 minus the sum of $120,000 payable to R and the aggregate of $20,000
        of policy cash value that E actually includes in income on E’s year 1 and year 2
        income tax returns). Thus, E includes in gross income for year 2 the sum of
        $20,000 of policy cash value and the cost of $1,360,000 of current life insurance
        protection.




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          Results for year 3. For year 3, E is provided $40,000 of policy cash value ($240,000
          policy cash value determined as of December 31 of year 3 minus the sum of
          $180,000 payable to R and $20,000 of aggregate policy cash value that E actually
          included in gross income on E’s year 1 and year 2 federal income tax returns). For
          year 3, E is also provided current life insurance protection of $1,260,000
          ($1,500,000 minus the sum of $180,000 payable to R and $60,000 of aggregate
          policy cash value that E actually includes in gross income on E’s year 1, year 2, and
          year 3 federal income tax returns). Thus, E includes in gross income for year 3 the
          sum of $40,000 of policy cash value and the cost of $1,260,000 of current life
          insurance protection.

Example 2

          Facts. The facts are the same as in Example 1 except that E cannot directly or
          indirectly access any portion of the policy cash value, but the terms of the equity
          split-dollar life insurance arrangement or applicable state law provide that the
          policy cash value in excess of the amount payable to R upon termination of the
          arrangement or E’s death is inaccessible to R’s general creditors.

          Analysis. Under the terms of the equity split-dollar life insurance arrangement or
          applicable state law, the portion of the policy cash value exceeding the amount
          payable to R is inaccessible to R’s general creditors. Thus E has current access to
          such portion of the policy cash value for each year that the arrangement is in
          effect. In addition, because R pays all of the premiums on the life insurance
          contract, R provides to E all of the economic benefits that E receives under the
          arrangement. Therefore E includes in gross income the value of all economic
          benefits provided to E under the arrangement.

          Results for years 1, 2 and 3. The results for this example are the same as the results
          in Example 1.

Endorsement arrangements are very common. However, under normal circumstances,
employers typically do not provide employees with access to the policy’s cash value.
Therefore, if the employee cannot tap the equity, and the equity will be available to the
owner and the owner’s creditors, then the employee will only be taxed on the current term
insurance protection and not the “phantom income” measured by the income in the excess
of cash surrender value over premiums advanced.

It goes without saying that if other lifetime benefits are provided, they will be taxable. This
rule applies to the policy owner dividend, the proceeds of “specified” policy loans, a
withdrawal on the proceeds and a partial surrender.

A death benefit payment due to the non-owner’s death is normally not subject to income
tax, assuming the non-owner paid tax on the value of assessed life insurance protection over
the years.




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If an insurance contract is transferred to a non-owner, taxation occurs at the point of
transfer and is measured by the value of the cash surrender value (plus other rights under the
contract other than life insurance protection) less amounts paid by the non-owner (plus any
unrecovered economic benefits previously taken into account for which the non-owner
recovers tax basis).


Proposed Regulations: Taxation Under the Loan Regime – Basics
For collateral assignment arrangements, a loan regime applies. A common approach
involves an employer (non-owner) who advances premiums to an employee (owner), who
owns the policy whose cash value is used as collateral for the premiums advanced. The
employee agrees to repay the employer at termination, retirement or death.

For the last 40 years, such arrangements were considered to be non-taxable interest free
loans from the employer to the employee. Now there is no “free lunch.”

Section 7872 (the provision that taxes loans at “below market” interest rates) applies to split-
dollar arrangements subject to the loan regime, if the loan does not call for interest at the
appropriate AFR rate. If the loan does provide for a sufficient interest rate, it is still subject
to the general rules for debt instruments, including the rules for OID, but will not be subject
to substantive provisions of Section 7872. However, certain provisions of Section 7872 will
apply if the lender waives, cancels or forgives interest on a loan. In that set of
circumstances, Section 7872 provides that the transfers between the lender and the borrower
will be “deemed” to have taken place.

Any loan that is a “below market loan” is treated as a loan at the AFR rate. The amount by
which the AFR rate exceeds the stated rate (or zero if no rate) is deemed to have been
transferred from the lender to the borrower and then paid back to the lender as interest
income. In the typical situation, an employer would end up with a compensation deduction
to offset the deemed interest income, while the employee would only be left with the
compensation income.

If another party is involved (such as an ILIT), two successive loans are deemed to have been
made (e.g., employer to employee and then employee to ILIT).

The loan regime has the benefit of increased tax basis in the policy when compared to the
economic benefit regime. In the loan regime, 100% of the premium has already been taxed
to the owner, who is using previously taxed money to purchase the life insurance policy, thus
constituting basis (investment in the contract) for tax purposes. In the economic benefit
regime, the non-owner (employee or ILIT) does not receive tax basis for either the
economic benefit reported as income or amounts actually paid towards policy premiums!

Proposed Regulations – Split-Dollar Demand Loans

Demand loans are payable in full upon demand of the lender, or within a reasonable time
thereafter. They are tested for sufficient interest (compared to the AFR) on an annual basis
based on the so called “blended” AFR, in order to determine if the loan is a below market
loan (in which case forgone interest is computed). The forgone interest equals the excess of
the blended AFR less the actual interest rate multiplied by the loan.



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For example, assume employer R and an ILIT set up by employee E enter into a split-dollar
arrangement. R pays a $50,000 premium, payable on demand without interest. As a below
market split-dollar loan between R and the ILIT, R is deemed to transfer cash to E and E is
deemed to transfer cash to the ILIT. Thus, two below market demand loans result in a
compensation loan between R and E and a gift loan between E and ILIT. Assuming the
blended annual rate for the year is 4%, the deemed interest (and compensation income to E
and gift to the ILIT) is $2,000 ($50,000 x 4%).

Demand loan transfers are deemed to occur but once per year. Thus, the calculations are
relatively easy, when compared to term loans. The downside, of course, is that interest rates
can be very volatile, and the “cost” of the loan at the outset is uncertain.

Proposed Regulations Split-Dollar Term Loans

A split-dollar term loan is any loan that is not a demand loan, according to the helpful
regulations. Each annual premium is treated as a separate loan.

A term loan is tested for sufficient interest at the time the loan is made, in order to
determine if it is a below market loan. A loan does not provide for sufficient interest if the
amount loaned exceeds the “imputed loan amount” (the present value of all payments due
on the loan, determined as of the date the loan is made, and using the appropriate AFR
(short-term, mid-term, or long-term) and compounding period. The amount of the imputed
transfer is the excess of the amount loaned over the “imputed loan amount.” A split-dollar
term loan will be treated as having OID equal to the amount of the imputed transfer.

If a loan does not have a stated maturity date, the term is presumed to be seven years.

Certain special rules apply to term loans that are gift split-dollar loans, or conditioned on
future performance of services or are payable on death (term based on life expectancy) or are
subject to certain borrower or lender options. The special rules allow for gift loans and
employment related term loans to be treated like a demand loan. Thus, income can be
reported on an annual basis, instead of an accelerated basis (a term loan is tested once at
inception).

For gift tax purposes, a below market gift split-dollar loan is treated as a term loan and the
donor must report as a gift in the year the loan is made the difference between the face
amount of the loan and the imputed loan amount.

The advantage of a term loan is the ability to “lock-in” a rate and determine the cost of the
loan over its term. The downsides, however, are generally higher interest rates and the
acceleration of the entire benefit to the first year of the loan. In a term loan, the entire loan
amount is treated as having been transferred by the lender to the borrower in a single year
even though the lender must report income each year over the term of the loan. Each year’s
premium will be a separate loan and because interest fluctuates, the cost of the total
“program” cannot be predicted. Because of the acceleration issue, a term loan arrangement
should be structured to avoid the below market loan rules.




                                            13 of 20
Proposed Regulations – Split-Dollar Loans: Waived, Cancelled or Forgiven Interest

If interest is waived, cancelled or forgiven by the lending party, the interest will be deemed to
have been paid by the borrower to the lender, then treated as transferred back to the
borrower (as income based on the party’s relationship). This will result in taxation of
interest that is accrued to the lender but unpaid.

Proposed Regulations - Transfer Tax Implications

The “owner” of life insurance for split-dollar purposes is not relevant for gift tax purposes.
Normal gift tax rules are applied. Moreover, whether the death proceeds are considered part
of a decedents’ gross estate will be determined under the normal estate tax rules. Policy
proceeds will be included in the decedent’s taxable estate if the death benefit was made
payable to the decedent’s estate or the decedent held any incidents of ownership with respect
to the policy (e.g., the ability to change the beneficiary, or the ability to borrow from cash
surrender value).

Summary of Proposed Regulations

The broad definition and other aspects of the new rules make it clear that all parties to a
split-dollar arrangement must value and account for a shift in wealth and when the wealth is
shifted, a direct or indirect party to the arrangement will be taxable!


The Safe Harbor – What Needs to be Done Before January 1, 2004?
Important Factors

For pre-January 28, 2002 split dollar arrangements, decisions must be made before the end
of 2003. Unfortunately, rules of thumb do not exist, since each fact pattern is unique. The
following factors will influence the course of action to take:

         •    Age of the insured
         •    Health of the insured
         •    Type of insurance policy (whole life, universal life, variable life, etc.)
         •    Age of the policy
         •    Equity (cash surrender value) in the policy
         •    Annual premiums and due dates
         •    Cumulative premiums paid to date
         •    Comparison of the equity in the policy with the original policy illustration
         •    Projected number of years to “vanish” the premium
         •    Tax posture of the employer
         •    Tax posture of the employee
         •    Purpose of the split dollar plan (death benefit, supplemental retirement, or
              both)




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         •   Specific contractual language in the written split dollar agreement
         •   Date the plan commenced
         •   For public company employees, is the insured as insider for purposes of the
             Sarbanes-Oxley prohibition on employer loans?
         •   For plans designed for life insurance protection only – how long is coverage
             expected to last – the whole life of the insured? And how much coverage is
             desired?
         •   For plans designed to provide supplemental retirement income – When are
             payments expected to begin, how much are they expected to be and how long
             are they expected to last?
         •   When is the employer expected to recover its “Advances” – at retirement or at
             a later death of the insured?
         •   Is an irrevocable life insurance trust (ILIT) a part of the plan?

What Should be Done – Endorsement Arrangements
Most endorsement arrangements involve a funding arrangement for a non-qualified deferred
compensation plan, such as a SERP – a supplemental executive retirement plan. Employers
use cash value life insurance to provide an executive’s beneficiaries with an income tax free
pre-retirement death benefit, as opposed to a taxable pre-retirement death benefit from a
SERP.

For endorsement arrangements used in tandem with a SERP that will be terminated at
retirement, nothing may need to be done before December 31, 2003. Pre-1/28/02 plans can
continue to use the insurer’s term insurance rates after 2003.

However, if an endorsement plan is intended to remain in place after retirement for the life
of the executive, action may be necessary. Each year the insured ages, the value of the
economic benefit (the life insurance protection) increases. Post-retirement, the tax cost
increases dramatically. The problem is exacerbated if the interest in the policy was assigned
to an irrevocable life insurance trust. In addition to recognizing income on the value of the
economic benefit, such value is also considered a transfer to the trust for gift tax purposes.

Possible solutions to avoid this problem might include a distribution of the policy to the
executive, especially if the policy equity is large enough so that premiums have vanished and
no future outlays are required. Distribution of the policy avoids the lifetime imputation of
income.

Another solution might be to make a gift to an ILIT (treated as a grantor trust) and have the
trustee of the ILIT purchase the policy from the employer. To help accomplish this, the
employer may be able to exchange the existing policy for a new policy with a lower premium
(e.g. a term “blend”) and possibly a reduced cash value.

In sum, the pencils and calculators must be employed to determine the exit strategy and
most favorable alternatives when post retirement death benefits are part of the design of an
endorsement arrangement.



                                           15 of 20
Collateral Assignment Plans – Variations
A common collateral assignment arrangement involves an insured executive who owns a
policy that is funded by an employer. The policy is “collaterally assigned” to the employer to
provide security for the repayment of the premiums. The usual design is to fund the policy
with a premium that is “illustrated” (but not guaranteed) to provide a cash value at
retirement (rollout) large enough to not only repay the employer but to also allow for a
stream of income to the executive for a term of years (or lifetime) without any additional
premiums post-rollout. This design calls for the policy to fund the rollout.

Another variation involves a bonus. Under this scenario, the employer intends to bonus the
repayment balance to the employee, or to forgive the repayment amount at retirement. In
either case, the amount is taxable income to the executive. A source of funding the tax on
this income is the policy’s cash value. This design calls for a lower annual premium than a
design that calls for the policy to have cash value sufficient to repay the entire employer
advance.

Another variation is a plan that continues after retirement. At retirement, the plan calls for
the executive to tap the policy equity through loans or withdrawals as a source of additional
income. Some advisors assumed that the executive would not have any taxable economic
benefits after retirement, but the recent IRS notices discount that notion.

Collateral Assignment Arrangements – The Problem

Pre-January 28, 2002 arrangements qualifying for the safe harbor will not result in taxation of
the policy’s equity so long as the plan remains in force and the parties continue to report the
economic benefit. Thus, if the plan is maintained until death and no distributions are made
and the policy equity is not tapped during the insured’s lifetime, the equity will not be taxed.
Therefore, if that is the plan, perhaps no action need be taken.

The problem with this approach is the escalating (term insurance increases with age) cost of
being taxed on the annual economic benefit as income. Moreover, the employer may not
want to wait until death for payback of its advances. And, split dollar plans were not
generally designed to remain in place until death. Instead a “rollout”, at a time when the
policy has equity, is called for. A rollout allows the insured to avoid the expensive term rates
as they age post-retirement. A rollout after year 15 avoids the tax trap of Section 7702,
which causes taxation in cases of a change in benefits or other terms under the policy.

What Should Be Done – Collateral Assignment Arrangements

Plans that are rolled out (terminated) prior to 1/1/04, or are recast as a Section 7872 loan
arrangement on that date should allow the equity to forever escape taxation. Moreover,
since the equity avoids recognition as taxable income, it follows that the equity should not be
considered a taxable transfer in gift tax or generation skipping tax (GST) situations (e.g. ILIT
arrangements).

If the plan is not recast as a loan or terminated prior to 1/1/04, the Service will attempt to
tax such equity at some point down the road – most likely at termination of the plan.




                                            16 of 20
Therefore mature plans with sufficient equity should terminate the plan prior to 1/1/04 and
use the cash surrender value upon rollout to repay the employer.

But, many split dollar policies did not work out as well as planned, especially with the stock
market losses over the past three years. Most often, cash values will not be sufficient to pay
back the amount due the employer. Or, a rollout (cash withdrawal) prior to the sixteenth
year of the plan could result in taxable income pursuant to Section 7702.

If Section 7702 taxation or insufficient policy equity prevents a quick rollout, then what can
be done? There are several possible courses of action.

         •   If the policy permits it, premiums might be increased and accelerated in order
             to allow for a rollout by 1/1/04.
         •   If a rollout is not possible by 1/1/04, request a policy illustration that estimates
             how many more years/premiums are necessary to effect such a rollout, and
             calculate the future costs of a “loan recast” structure.
         •   If a loan recast is too expensive or the insured is covered by Sarbanes-Oxley,
             perhaps the policy can be transferred back to the employer and an
             endorsement structure can be used going forward (recognizing the costs of
             imputed income on the economic benefits for the insured’s lifetime).
         •   Or, after the policy is transferred back to the employer, a death benefit only
             plan could be utilized, in lieu of a split dollar approach – with the
             understanding that a death benefit payment would be taxed as ordinary income
             to the insured’s beneficiary.
         •   Perhaps a pre-1/1/04 termination is possible through a combination of cash
             value withdrawals, bonus, or loan forgiveness (presumably taxable as if a
             bonus). Future premiums might be paid under a “bonus” plan, and the policy
             might be restructured to allow for lower premiums and benefits (or the policy
             might be exchanged tax free for a different kind of policy – such as a single
             premium MEC (modified endowment contract)).
         •   Another alternative might be to pass up the safe harbor and conclude that
             policy equity in a split dollar arrangement is not taxable, and prepare for a
             future dispute with the IRS. This approach is not recommended.
Gift Tax Implications – Collateral Assignment Arrangements

         •   For collateral assignment arrangements involving irrevocable life insurance
             trusts (ILITs), transfer (gift) tax and income tax must be considered.
         •   If policy values are insufficient to effect a rollout before 1/1/04, consider a
             combination of an outright gift to the ILIT, use of cash value, a bonus and
             loan forgiveness – recognizing that the bonus and forgiveness will be income
             to the insured and a gift to the trust.
         •   Or recast the arrangement as a loan as of 1/1/04, with termination as soon as
             possible thereafter, in order to avoid taxation of the equity.
         •   If premiums are still needed to fund the death benefit, consider techniques to
             make tax efficient gifts to the trust such as:


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         •   A short-term grantor retained annuity trust (GRAT) holding appreciating
             property with the ILIT as a remainderman.
         •   Fund the trust with discountable units of a “pass through” entity such as a
             family limited partnership, LLC or S Corp.
         •   Other strategies that employ leveraged gifts.

Questions
Deciding on an optimal action plan in light of the changes in taxation of split-dollar
arrangements is not easy. Please contact your NP attorney if you have any questions on this
complex topic. We would be pleased to help you sort through your options and develop a
tax efficient course of action.




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                                                                                                                              ALBANY, NY
                                                                                                                              Omni Plaza

Nixon Peabody LLP Private Clients Group                                                                                   30 South Pearl Street
                                                                                                                           Albany, NY 12207
                                                                                                                            (518) 427-2650
Please feel free to call or e-mail (emailname@nixonpeabody.com) any of the private clients team members listed below.     Fax: (518) 427-2666

                                                                                                                             BOSTON, MA
                                                                                                                           101 Federal Street
PARTNERS                                          E-MAIL NAME                                   PHONE                      Boston, MA 02110
Deborah L. Anderson, Esq.                         danderson                                     617-345-1206                (617) 345-1000
                                                                                                                          Fax: (617) 345-1300
Walter Angoff, Esq.                               wangoff                                       617-345-1233
Katherine L. Babson, Jr., Esq.                    kbabson                                       617-345-6008                 BUFFALO, NY
John H. Clymer, Esq.                              jclymer                                       617-345-6072             1600 Main Place Tower
                                                                                                                           Buffalo, NY 14202
Thomas M. Farace, Esq., CPA                       tfarace                                       585-263-1440
                                                                                                                            (716) 853-8100
John T. Fitzgerald, Jr., Esq.                     jfitzgerald                                   585-263-1357              Fax: (716) 853-8109
John L. Garrett, Esq.                             jgarrett                                      585-263-1271
                                                                                                                           LONG ISLAND, NY
Kathryn A. Johnson, Esq.                          kjohnson                                      415-984-8448
                                                                                                                          990 Stewart Avenue
Deborah S. Kay, Esq.                              dkay                                          617-345-6128             Garden City, NY 11530
Evelyn V. Moreno, Esq.                            emoreno                                       617-345-6157                (516) 832-7500
                                                                                                                          Fax: (516) 832-7555
Patrice B. Morrison, Esq.                         pmorrison                                     585-263-1657
Jon L. Schumacher, Esq.                           jschumacher                                   585-263-1263               MANCHESTER, NH
Christina Gallagher Nelson, Esq.                  cgallaghernelson                              415-984-8270                 889 Elm Street
                                                                                                                         Manchester, NH 03101
G. Joseph Votava, Jr., Esq., CPA/PFS, CFP         jvotava                                       585-263-1450
                                                                                                                            (603) 628-4000
John D. Witmeyer, Esq.                            jwitmeyer                                     585-263-1276              Fax: (603) 628-4040

                                                                                                                            NEW YORK, NY
COUNSEL                                                                                                                   437 Madison Avenue
William F. Broll, Esq.                            wbroll                                        415-984-8347              New York, NY 10022
Cynthia A. Brown, Esq.                            cbrown                                        617-345-1332                (212) 940-3000
                                                                                                                          Fax: (212) 940-3111
Ronald Garmey, Esq.                               rgarmey                                       617-345-6113
Elliot W. Gumaer, Jr., Esq.                       egumaer                                       585-263-1268             NORTHERN VIRGINIA
David F. Hayes, Esq.                              dhayes                                        617-345-1224             8180 Greensboro Drive
                                                                                                                               Suite 800,
Melvin Pierce, Esq.                               mpierce                                       617-345-1225              McLean, VA 22102
David R. Pokross, Esq.                            dpokross                                      617-345-1214                (703) 790-9110
                                                                                                                          Fax: (701) 883-0370

ASSOCIATES                                                                                                               ORANGE COUNTY, CA
Neil L. Cohen, Esq.                               ncohen                                        617-345-1248                2040 Main Street
Sarah T. Connolly, Esq.                           sconnolly                                     617-345-6075                     Suite 850
                                                                                                                            Irvine, CA 92614
Cressida A. Dixon, Esq.                           cdixon                                        585-263-1075                 (949) 475-6900
Carlton W. King, Esq.                             cking                                         617-345-6133              Fax: (949) 475-6910
Nicole M. Marro, Esq.                             nmarro                                        585-263-1396
                                                                                                                           PHILADELPHIA, PA
Alison S. Piasecki, Esq.                          apiasecki                                     617-345-6172             200 Penn Center Plaza
Christine A. Sackett, Esq.                        csackett                                      585-263-1273                    Suite 200
Patrick J. Simpson, Esq.                          psimpson                                      585-263-1023             Philadelphia, PA 19102
                                                                                                                             (215) 854-4086
Jason P. Torres, Esq.                             jtorres                                       585-263-1165              Fax: (215) 569-0216

                                                                                                                            PROVIDENCE, RI
PARALEGALS
                                                                                                                           One Citizens Plaza
Karen S. Baumgartner                              kbaumgartner                                  585-263-1622              Providence, RI 02903
Cheryl L. Carroll                                 ccarroll                                      617-345-1154                 (401) 454-1000
                                                                                                                          Fax: (401) 454-1030
Elaine M. Dixon                                   edixon                                        585-263-1588
Kathleen E. Flynn                                 kflynn                                        212-940-3760                ROCHESTER, NY
Yvonne E. Franks                                  yfranks                                       617-345-6110                  Clinton Square
                                                                                                                            P.O. Box 31051
Eileen T. Hansberry                               ehansberry                                    617-345-6120
                                                                                                                        Rochester, NY 14603-1051
Judy K. Hicks                                     jhicks                                        415-984-8405                 (585) 263-1000
Donna J. Jackson                                  djackson                                      585-263-1093              Fax: (585) 263-1600
Deborah J. Wilcox Mabry                           dmabry                                        585-263-1350
                                                                                                                         SAN FRANCISCO, CA
Mary-Benham Nygren                                mnygren                                       617-345-6165            Two Embarcadero Center
Kimberly A. Rabideau                              krabideau                                     585-263-1697            San Francisco, CA 94111
                                                                                                                            (415) 984-8200
Susan T. Ruef-Statt                               sruef-statt                                   585-263-1103
                                                                                                                          Fax: (415) 984-8300
Gail L. Simonds                                   gsimonds                                      617-345-6190
                                                                                                                          WASHINGTON, D.C.
                                                                                                                                Suite 900
                                                                                                                          401 9th Street, N.W.
                                                                                                                         Washington, D.C. 20004
                                                                                                                            (202) 585-8000
                                                                                                                          Fax: (202) 585-8080




                                                                     19 of 20
TECHNICAL SPECIALISTS
Richard T. Bentley, CPA     rbentley                 585-263-1643
Mary E. Bott, CPA           mbott                    585-263-1259
Christopher Caldwell, EA    ccaldwell                617-345-6058
Deborah L. Cole, CPA        dcole                    585-263-1496
Stephen G. Green, CFP       sgreen                   585-263-1669
Richard Hadayia, EA         rhadayia                 617-345-6119
Yelena Kuznetsova, CPA      ykuznetsova              585-263-1351
Scott Lefebre, CPA          slefebre                 585-263-1647
Dimitrios Manou, CPA        dmanou                   585-263-1288
Kevin T. McQuaid, EA        kmcquaid                 617-345-6151
Masha Rabkin, CPA           mrabkin                  585-263-1117
Michelle F. Schrader, CPA   mschrader                585-263-1342
Frederick F. Soares, EA     fsoares                  617-345-6191
Donald J. Statt, Jr., CPA   dstatt                   585-263-1184
Alyson L. Stevenson, CPA    astevenson               585-263-1262
Michael A. Tullio, CPA      mtullio                  585-263-1090
Xian Wong                   xwong                    585-263-1665




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