Sample Academy Fax Alert

For purposes of valuation, the IRS reviewed the P.S. 58 tables and found them to be clearly out of date and inappropriate, no longer approximating the real cost of term insurance. In the Notice, the IRS indicated this has led some taxpayers to under-report income, especially with regard to "Reverse Split Dollar" arrangements, where the use of the table causes the value of insurance policy benefits allocated to the employer to be overstated.

The IRS has issued Notice 2001-10 that announces the IRS is reviewing:

1. The federal income tax treatment of equity split dollar arrangements ("SDAs") between employers-employees;
2. The federal income tax treatment of private SDAs (i.e. SDAs involving non-employees);
3. Split dollar economic benefits to corporate shareholders; and
4. SDAs involving gifts.The IRS states that Notice 2001-10 is intended to provide the following:
5. Clarification of previous PLRs issued by the IRS;
6. Interim guidance until more permanent guidance is issued; and
7. Notice and request for comments from practitioners.

REVENUE RULING 55-747 REVOKED

For purposes of valuation, the IRS reviewed the P.S. 58 tables and found them to be clearly out of date and inappropriate, no longer approximating the real cost of term insurance. In the Notice, the IRS indicated this has led some taxpayers to under-report income, especially with regard to "Reverse Split Dollar" arrangements, where the use of the table causes the value of insurance policy benefits allocated to the employer to be overstated.

Notice 2001-10 revokes Revenue Ruling 55-747. This means the P.S. 58 tables are no longer the standard for measuring the economic benefit received by an insured for the net amount at risk payable to the insured's beneficiary. Exception: The P.S. 58 rates can be used as in the past for taxable years ending on or before December 31, 2001.

TABLE 2001 AND SUBSTITUTE RATES

The Notice provides a new table, Table 2001, with rates substantially lower than the P.S. 58 rates. The new rates are based upon the IRC § 79 Treasury Regulations.

The IRS also addresses the use of "alternative" or "substitute" term insurance rates (so-called "published term rates" issued by insurance companies). The Service expresses concern that the use of these rates may be abusive, and feels that to "ease administrative burdens, minimize disputes, and provide greater assurance that similarly situated taxpayers are treated the same" a new table should be used for both SDAs and for life insurance in qualified retirement plans.

Even with the new table, substitute rates can still be used. In other words, in valuing the net amount at risk, a taxpayer may still substitute for the table rates the insurer's lower published premium rates available to all individuals who are considered standard risks for initial issue one year term insurance, but only if the following "tests" are met:

1. The insurer must let people who apply for term insurance know about the availability of the lower rates;
2. The insurer must regularly sell such term insurance at the published lower rates under its regular distribution channels; and
3. The insurer cannot more commonly sell term insurance at higher rates to individuals who are considered standard risks.

Notice 2001-10 also makes it clear that this ability to choose substitute rates may not last forever. With respect to term contracts issued after March 1, 2001, the IRS makes no assurance that the substitute method will be available after the later of:
(a) December 31, 2003; or
(b) December 31 of the year the IRS publishes further guidance.

THE IRS ON SDAS

The IRS states that none of the past PLRs directly address equity SDAs. In its opinion it is clear that the employee derives the entire economic benefit in an SDA that goes beyond just life insurance protection. The IRS concludes it is necessary for the covered employee to account for and be taxed on this additional benefit. The taxation of the benefit should follow the contractual positions and actions of the parties.

The IRS' position is now clarified to be that every payment made by an employer in an SDA must be treated as either:

1. A loan;
2. An employer investment; or
3. Currently taxable compensation income to the insured employee.

PICK AND CHOOSE

Pending further guidance to taxpayers, the IRS has issued these general guidelines:

1. The parties to an equity SDA can characterize it as either IRC § 83 income or as a loan (or series of loans) from the employer under IRC § 7872. However, such characterization must be consistent with the realities of the arrangement.
2. Whatever characterization is used, it must have been followed by the parties from the time the SDA took effect.
3. The parties must account for all the economic benefits received by each party in a manner consistent with the characterization of the transaction as income or a loan.

IRC § 7872 LOAN TREATMENT

The employee's annual increase in wealth under an equity SDA (basically, the amount by which the cash value of the policy exceeds the payments made by the employee into the contractual arrangement) may be taxable currently either under IRC § 83 or IRC § 7872, depending on what the intent of the parties was at the time they entered into the SDA (as evidenced by the SDA as well as any other relevant facts and circumstances). The result of the characterization of an SDA as a compensation-based below-market loan is that payments imputed to the "borrower" are treated as currently taxable compensation under IRC § 7872 (which deals with below-market loans). This means:

1. No additional income will be charged to the insured employee for the term insurance protection; and
2. The policy's cash value will not be taxable to the employee under IRC § 83.The employee will have additional reportable income, however, if the employee doesn't pay off the loan according to the SDA schedule. And, the employee can still have additional reportable income, even if he or she meets all the above tests, for distributions actually received under the contract (under IRC § 72).

NON-LOAN TREATMENT

What if the employee can't meet the test or if the parties to the SDA decide the arrangement is something other than a loan or series of loans? If the parties have not consistently treated the arrangement as a loan (or series of loans) from the employer, then the arrangement will be treated as follows:

1. The employer will be considered to have obtained beneficial ownership in the policy through its premium payments (presumably regardless of whether or not the employee or third party, such as a trust, actually and initially applied for the policy); and
2. The employee will have currently reportable compensation income each year under IRC § 61 for the amount of the term insurance coverage (reduced, of course, by premium payments the employee makes);
3. The employee will have currently reportable compensation income under IRC § 61 each year for any dividends (or similar benefits) received directly or in the form of additional policy benefits; and
4. The employee will have currently reportable compensation income each year for any substantially vested interest acquired in the policy's cash value reduced by any consideration paid by the employee for that interest.For more information about how this Notice will affect current and future business, retirement and estate planning transactions, and to receive a copy of the full text of Notice 2001-10, contact our office.