The Final Split-Dollar Regulations: The IRS Offers Up a Complex Array of Rules

The flurry of IRS and Treasury Department activity focusing on split-dollar insurance arrangements came to a close when the Treasury issued final regulations for all such arrangements entered into or after September 17, 2003. Notwithstanding voluminous taxpayer and practitioner comments, these regulations offer few changes from the July 2002 and May 2003 proposed ones on this popular executive benefit. All new and materially modified split-dollar arrangements will follow either the economic benefit or the loan regime (explained below). Rejecting criticism of this rigid system and the suggestion that taxpayers be permitted to elect which regime applies, the Treasury held firm to a bright-line mandatory rule based on policy ownership. Consequently, CPAs will find a handful of complex definitions will determine the treatment of all future private-company split-dollar arrangements. PUBLIC-COMPANY PLANS In its explanation the Treasury Department expressly declined to address the issue of whether the Sarbanes-Oxley Act of 2002 applies to split-dollar arrangements, noting that the interpretation and administration of the act fall within SEC jurisdiction. As a result of the uncertainty CPAs should advise public companies to discontinue payments under split-dollar arrangements for directors and officers until the SEC addresses the issue, if ever. THE FINAL REGULATIONS The final rules apply only to split-dollar arrangements entered into or materially modified after September 17, 2003. Although the regulations don't define material modification, they include a nonexclusive list of safe harbors. For example, changes in the mode of premium payment, policy-loan interest rates or beneficiary choices (provided the beneficiary is not a party to the arrangement) are not material under Treasury regulations section 1.61-22(j)(2). Notably, IRC section 1035 like-kind exchanges did not make the safe harbor list. If the examples are any indication, the only sure bet is to assume any change with economic significance will be a material modification governed by the final regulations. Pre-September 17, 2003, arrangements. IRS notice 2002-8 continues to govern these plans. (Except as provided in the notice, the IRS declared obsolete the rulings practitioners previously relied on--revenue rulings 79-50, 78-420, 66-110 and 64-328). Notice 2002-8 divides pre-September 17 arrangements into two categories: those created before and after January 28, 2002. Pre-January 28 arrangements may continue to use the insurer's lower published premium rates for income and gift tax purposes. Post-January 28, 2002, plans, however, may use these lower rates only if the insurer actually discloses them to policy applicants and regularly sells insurance using these rates--which is not likely to happen. Otherwise, CPAs must determine the income and gift tax consequences for post-January 28, 2002, arrangements using the much higher table 2001 rates (which were published in notice 2001-10). The final regulations did not extend the December 31,2003, sunset provision for the safe harbors under notice 2002-8 for pre-January 28, 2002, arrangements. That means the opportunity to terminate or convert these arrangements to loans without recognizing income expired on December 31, 2003. Subject to the premium rate rules described above, ongoing pre-September 17 arrangements arguably may operate as in the past, without participants recognizing as income the equity buildup within the policy in excess of the amount needed for premium reimbursement (excess policy equity). Notice 2002-8 contains no-inference language that may support such a strategy while the arrangement is in effect. It says, No inference should be drawn from this notice regarding the appropriate federal income, employment and gift tax treatment of split-dollar insurance arrangements entered into before the date of publication of the final regulations. …