Clinton Administration Leaves: Split-Dollar Devastation
Important message - I must interrupt my series (well, last month was the first and there will be at least one more) of articles concerning a questionable insurance policy proposed to a family business owner. I will return to the regularly scheduled broadcast next month.
This interruption concerns just one in a series of audacious actions taken by the Clinton administration in the waning hours of his presidency. These actions ranged from outrageous pardons of convicted criminals, to unilateral bans on development of federal lands, to removing the "W" keys from computers throughout _ashington.
The media says that previous administrations took significant actions in their twilight days. I have heard no elaboration on that statement and I don't recall any actions generating this level of furor in my 30+ years of at least semi-awareness of politics. Surely there were some. But, to my knowledge, previous administrations' actions paled in significance compared to Bill's parting shots.
So, what's the transgression? The IRS dealt a staggering blow to split-dollar life insurance arrangements in Notice 2001-10. This unexpected nuclear blast was all the more shocking given the IRS' silence since its 1996 BB shot across the insurance industry's split-dollar bow (reported in my May 1996 Professional Insights column).
Split-dollar is a financing arrangement, not a form of insurance. The story starts with a primer on types of insurance policies.
The premium payment for "term" insurance covers the risk that you will die during the upcoming year. Assuming you are not old, the risk of dying in the next year is small. So, the term premium is small. (I keep expanding out my definition of "old," but for this purpose over 70 will do.)
As you get older, the chances of dying in the next year increase. So, term insurance premiums increase each year. When you get really old, the premium gets really big. The premium for a 100-year old person is darn close to the face amount of the policy. In other types of insurance (e.g., whole, variable, universal, etc.), you are expected to pay much bigger premiums than the term insurance cost. Why? The excess premium is set aside and invested within the policy. The investment earnings grow without income tax, thanks to long-standing law. Those funds and internal earnings then are used in your golden years to offset the rapidly increasing term insurance costs.
In a split-dollar arrangement, the employer (aka, your family's business) agrees to pay the portion of the premium in excess of the term insurance cost. In return, the employer receives the right to a reimbursement of those amounts from the insurance proceeds or from amounts received if the policy is cancelled.
The net effect is that the employer pays the lion's share of the premiums each year (until you are old) and is entitled only to reimbursement without interest when the policy "matures" (the politically correct term for the death of the insured) or is cancelled. The benefit of the interest-free use of the employer's money for life can be huge. If the employer pays the entire premium, the insured is deemed to have taxable compensation income equal to the modest term insurance premium.
Most people jazz up the arrangement by having a trust own the policy. That avoids estate tax on the insurance proceeds. Because the employer pays most of the premiums, the split-dollar arrangement limits the annual taxable gifts by the insured to just the small amounts needed to fund the term cost. The generation skipping tax (GST) consequences of the premium gifts are similarly reduced.
Under the Notice, the employee-insured will have a choice of being subject to income tax on either: (a) imputed interest on the employer-paid premiums under the interest-free loan rules, or (b) the build-up in cash value attributable to earnings within the policy in excess of amounts that must be used to the employer. If the policy is owned by a trust, these income amounts also will be treated as gifts to the trust with associated gift and GST consequences.
Next, the Notice dramatically increases the term insurance component in split-dollar arrangements. Keep in mind that the higher the term component, the greater the insured's gift to the trust or the greater the imputed income and gift if the employer pays that portion.
Previously, you could choose between term rates published back in 1958 ("PS 58" table) or lower term rates quoted by insurance companies based upon today=s longer life expectancies. IRS thinks that the insurance companies were abusing the system by quoting artificially low rates for this purpose. So, the Notice eliminates the choice and creates new Table 2001. Not surprisingly, the new Table's rates are higher than those quoted by insurance companies, albeit lower than the PS 58 rates, thereby reducing the amount that the employer can pay into the split-dollar arrangement.
There are numerous uncertainties concerning the effective dates of the Notice's various provisions, as well as its application to joint-and-survivor and private split-dollar arrangements. As you might expect, the insurance industry has launched a massive lobbying effort to get the Notice withdrawn, or at least toned down.
At this point, the best course of action is to talk with your tax advisor and, probably, sit tight pending further developments. Aggressive individuals contemplating new split-dollar arrangements might want to rush them to completion in hopes of a grandfather provision once the situation is resolved. However, careful consideration should be given to exit strategies in the event such a new arrangement is not ultimately grandfathered.
George _.'s administration is actively reviewing the Clinton administration's actions over the final months of its reign. I suspect that we will see some relief from the potential devastation wrought upon the huge number of people caught off-guard by just this one bombshell.