Eleven years ago, the IRS adopted new regulations governing the taxation of split-dollar life insurance arrangements (SDAs) entered into after September 17, 2003. SDAs entered into before that date—unless materially modified after that date—are grandfathered, governed by prior administration rulings and cases. If plan administrators don't maintain the plans as prescribed in the regulations, or materially modify the plan, they risk having the equity in the policy (the cash surrender value in excess of principal) recognized and taxed.
Several key developments demand that plan administrators periodically reevaluate the plan to ensure that they remain compliant. Gain in the policy would be taxable at ordinary rates if the SDA is terminated while the insured is still living. Prior to the new regulations, a typical SDA might have been structured as follows:
In 2003, the IRS revised its position on equity SDA. The IRS concluded the increases in the cash surrender value in excess of the employer's contributions under an equity arrangement represented a taxable benefit to the employee in addition to the value of the insurance protection received.
Plans entered into before September 17, 2003, would not have equity taxed as long as the employer and employee continued to treat the SDA as they had in the past and the plan was not materially modified. If the plan continues until the death of the insured, built-up gain will not be taxed upon payment of the proceeds.
Faced with the possibility of growing equity, many plan administrators and their advisors opted to terminate equity split-dollar plans. Some, however, chose to continue to maintain these plans.
Three key external conditions make it critical to reexamine the wisdom of continuing grandfathered equity split dollar plans:
In light of this reality, grandfathered equity split-dollar plans must be periodically reviewed with appropriate tax and legal counsel. In some cases, it may be the best course of action to consider terminating the arrangement—even if it results in the current income taxation of accumulated equity.
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