CBTM Aug issue 7/31/03 9:52 AM Page 31 C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting By James E. Salles The early summer saw a fair amount of regula- then logically any increases in the employee’s with- tory and administrative guidance emerge on tax drawal rights, at least to the extent that they reflect accounting issues. (More may be on the way; we employer contributions, should be currently taxable under the “economic benefit” doctrine. 8 On the have Benefits Tax Counsel’s word that the proposed regulations under section 457 1 will be finalized other hand, if the employee is the owner, employer- “soon.” 2 ) In this month’s column: paid premiums are loans, meaning potential imput- ed interest income to the employee. 9 The policy’s • More proposed regulations on “split-dollar” life tax “ownership” should also determine, for exam- insurance fill in some of the gaps in the regula ple, whether distributions are treated as passing tions package released last summer 3 ; through the hands of the employer or as made • Further steps toward “spread periods” for directly to the employee. However, taxpayers fre- cumulative adjustments upon changes in meth- quently relied on Revenue Ruling 64-328 to avoid ods of accounting 4 ; recognizing income on the policy’s initial purchase, • The IRS concedes that some utilities’ special without accounting for other aspects of the transac- charges for fuel or conservation programs will tion consistently with its assumption that the be treated like loans. 5 “employer” owned the policy. The IRS began to address these issues in Notice 2001-10, 10 later superseded by Notice 2002-8. 11 The More “Split-Dollar” Proposed Notices basically allowed taxpayers to choose which Regulations model to follow, so long as they did so consistently. In early May, the IRS issued proposed regula- Among other things, under the “employer-owned” tions filling in some of the gaps in last summer’s model, employees must pay tax on increases in cash regulation package dealing with “split-dollar” surrender value resulting from employer contribu- insurance arrangements. 6 The term “split-dollar” tions. (As discussed below, the taxation of increases refers to an arrangement under which two parties resulting from investment gains has been unsettled.) split rights under a life insurance policy. (For sim- On the other hand, if the employee is to be treated plicity’s sake I shall refer to the party whose life is as the owner, the parties must make a reasonable insured, and is typically entitled to the residual effort to apply the imputed interest rules. death benefit, as the “employee” and the other party as the “employer,” although these arrange- The 2002 Proposed Regulations ments are also encountered outside the employ- The Notices were intended as stop-gap rules ment setting.) The tax treatment of such arrange- while new regulations were under consideration. ments has given rise to considerable confusion over The new regulations will only be effective for the years. The basic question is whether the arrangements entered into (or “materially modi- employer or the employee should be treated as the fied”) after their publication, 12 so taxpayers can rely policy owner, and the degree to which policy for- on the Notices for arrangements in the meantime. malities (or the parties’ choice) should affect the Proposed regulations appeared in July, 2002. 13 Prop. answer. Revenue Ruling 64-328 7 allowed the employer to Regs. § 1.61-22 covers “economic benefits” provid- ed by the policy owner to a non-owner, and Prop. be treated as the policy owner, while the employee Regs. § 1.7872-15 “split-dollar” loans from the non- either paid for term coverage or was taxed upon its owner to the owner, corresponding roughly to the value. As arrangements became more sophisticated, “employer-owner” and “employee-owner” models. however, distortions inherent in this treatment The regulations define a “’split-dollar’ arrange- became apparent. If the employer owns the policy, ment” broadly to include any arrangement between a policy owner and a non-owner under which one of the parties is entitled to recover premiums paid Jim Salles is a member of Caplin & Drysdale in Washington, D.C. A U G U S T 2 0 0 3 31
CBTM Aug issue 7/31/03 9:52 AM Page 32 C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y from the policy proceeds. 14 They will thus reach, for received by the non-owner will be excludable if the example, a “plain vanilla” secured loan, even one non-owner either paid for the coverage or took its that does not date from inception of the policy. The value into account as an economic benefit. Finally, if new rules also apply regardless of the parties’ ownership of the policy is transferred, its value is motive for entering into the “split-dollar” arrange- taken into account at that time, with appropriate provision to avoid double-counting. 21 ment, although arrangements between service provider and recipient, corporation and shareholder, and donor and donee get special treatment in some The “Inside Buildup” Problem regards. 15 The regulations will apply to the first two The treatment of increases in cash surrender categories even if the parties’ arrangement does not value that are attributable to investment return, as meet the general definition, if the service recipient or opposed to additional premiums, has been a trou- corporation pays the premiums and the service blesome issue, partly because it has been hard to provider or shareholder gets the death benefit. 16 find the right analogy. Beneficiaries are taxed on the The threshold issue remains identifying the poli- “economic benefit” when amounts are first set apart cy owner. The regulations generally do away with for them in a trust or escrow account, but they are the Notices’ elective treatment. In the compensation not normally currently taxed on later increases in and gift contexts, the donor or service recipient is the value of their interests resulting from invest- automatically treated as the owner if the other ment gains. In such situations, however, the invest- party’s rights are limited to current life insurance ment gains will normally be currently taxable either protection. Otherwise, ownership is generally deter- to the employer/settlor or to the trust itself. mined under the policy documents. 17 Once the poli- Moreover, in the case of “employee trusts,” cy owner or owners have been identified, different Congress has expressly provided for taxation both “inside” and “outside” the trust. 22 That is, not only aspects of the arrangement can be classified accord- ing to whether the payment (or benefit) flows from does the trust pay tax on its own income, but those the owner or a non-owner. beneficiaries that are “highly compensated employ- The first question concerning a payment by a ees” are taxed annually on increases in the value of their interests. 23 non-owner is whether it represents a “split-dollar” loan under Prop. Regs. § 1.7872-15. Payments to (or By contrast, in the past, increases in split-dollar for benefit of) the policy owner by a non-owner will policies’ cash values typically have not been report- generally be treated as “split-dollar” loans if they ed by anybody. In part, of course, this reflects the are loans under general tax principles or else are exemption for “inside buildup” in a life insurance reasonably expected to be repaid. 18 However, these policy. However, that exemption protects policy rules do not apply in the compensation and gift set- owners, not third parties. If investment gains within tings where the donor or the service recipient is an employer-owned policy permit an employee to treated as the policy owner. In other words, the obtain additional policy loans which in practice do service provider will not be treated as making a not have to be paid back, then the employee is loan to the service recipient, nor a donee to the arguably in “constructive receipt” of the additional donor. 19 If the non-owner payment is not a split-dol- cash value. 24 lar loan, the next question is whether it is consider- The IRS addressed the issue under “old” law in ation for an “economic benefit” described in Regs. § a 1996 technical advice involving a “split-dollar” 1.61-22. If so, the non-owner will generally be enti- arrangement between a corporation and a life insur- ance trust for benefit of one of its executives. 25 The tled to net the payment in computing income from the benefit. Otherwise, general tax principles apply corporation was entitled only to be repaid for the in characterizing the payment. 20 premiums that it had advanced. The trust had all In the other direction, any right that the non- the “incidents of ownership” and was entitled to all owner has under, or to a benefit of, the insurance the other benefits under the policy. Nonetheless, the policy is an “economic benefit.” Policy distributions National Office, stuck with Revenue Ruling 64-328’s and other payments to the non-owner (including “employer-as-owner” model, had to frame the issue policy loans that are not expected to be repaid) are as measuring the economic benefits conveyed by treated as if made to the owner and then transferred the “owner” (the corporation) on the “non-owner” by the owner to the actual recipient. Death benefits (the trust). One of these benefits was the increases 32 A U G U S T 2 0 0 3
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