Notice 2002-8: IRS Overhauls Split Dollar

In 2002, the IRS issued Notice 2002-8 which changed the way split dollar life insurance plans are taxed. It addressed issues related to the employee’s interest in the policy cash value and the standards for determining insurance company term rates. The IRS also introduced two alternative theoretical approaches for taxation of split dollar plans. These new rules apply to employment-related split dollar plans and are expected to apply to other types of split dollar plans as well. Split dollar life insurance is a type of employee benefit where the employer pays for life insurance for the employee. The value of this benefit is included in the employee’s income for tax purposes. This applies to all types of split dollar plans, regardless of how they are set up. If the employer provides a benefit to someone else on behalf of the employee, that value is also considered part of the employee’s income. Simply put, split dollar plans with an “equity” component were not specifically addressed in previous rulings. However, the IRS later ruled that the employee’s “equity” in the plan would be considered taxable income under a certain tax code. This means that the employee would need to pay taxes on the value of their increasing interest in the plan. Additionally, the IRS ruled that the employee would also need to report these increases as gifts for gift tax purposes. In 2001, the IRS issued Notice 2001-10, which provided guidance on split dollar life insurance plans. In 2002, they revoked this notice and issued Notice 2002-8, which continued the same general guidance. The IRS also announced plans to issue comprehensive regulations in the future. These regulations will apply to new split dollar arrangements, while the notice provides guidance for existing arrangements. The proposed regulations will require split dollar life insurance to be taxed under one of two different ways. If the employer owns the policy, the traditional regime will apply, and the employee will have to pay taxes on the value of the insurance and any other benefits they receive. However, the employer will not be treated as making a transfer of property to the employee solely because the cash value of the policy exceeds the portion payable to the employer. This means that the employee will not have to pay taxes on the increasing value of the policy until the plan is terminated. If the employee dies before the plan is terminated, the beneficiary should not have to pay taxes on the policy’s value as death proceeds. The notice doesn’t talk about how much the employee needs to contribute. It used to say that the employee could reduce the amount of money they need to claim on their taxes by how much they paid for the cash value interest. But in my opinion, the employee should also be able to reduce the amount by the money they made from their contribution. Otherwise, they would have to pay taxes on the cash value of the policy, which isn’t fair according to tax laws.

The notice also doesn’t talk about how the employer is affected when the cash value interest is given to the employee. Normally, the employer can deduct the amount of money the employee has to claim on their taxes. But there are rules that say the employer might have to pay taxes too if the policy has made a profit.

If the employee is named as the owner of the policy and has to pay the employer back, it’s treated like a series of loans. The employee won’t have to pay taxes on the life insurance or other policy benefits, unless it’s under the usual rules for owning life insurance. In simple terms, the IRS has rules for loans that have low or no interest. If an employer gives an employee a low-interest or interest-free loan, the IRS treats the difference between the low interest and the regular interest rate as extra income for the employee. The employer can deduct this extra income, but the employee has to pay taxes on it. These rules also apply to loans that are like gifts, and they can affect certain life insurance plans. Term loans, where the extra income is calculated all at once when the loan is made, should be avoided. In a split dollar plan, premium advances to the employee should be treated like a loan. If the arrangement ends when the employee leaves their job or if either party asks for it to end, then it’s a “demand loan.” But if the plan continues until the employee dies, it could be seen as a “term loan.” This could complicate things and lead to double taxation for the employee. To avoid this, the employer and employee can agree to pay interest on the loan, which would make the tax treatment simpler. The rule of assigning the tax regime based on policy ownership can be problematic in certain situations. For example, in split dollar plans for controlling shareholder employees, the simple rule may not work well and cause issues with taxes. The IRS is allowing parties to choose either the “traditional” regime or the “loan” regime for their split dollar arrangement, regardless of who owns the policy, for existing and new arrangements entered into before the date of publication of final regulations. However, it’s not clear how this choice is to be made. The rules for arrangements with life insurance are the same whether they were set up before or after the final regulations were published. However, if the arrangement was set up before the final regulations, it won’t be considered ended as long as both parties keep treating the life insurance as a benefit. There’s also an option to treat the arrangement as a loan, which might be better for avoiding taxes. It’s important to compare both options before making a decision. If you had an “equity” split dollar arrangement before January 28, 2002, you might be able to save on taxes when the arrangement ends before January 1, 2004. The IRS also allows you to change the arrangement from a “traditional” one to a “loan” one without paying taxes, if you do it before January 1, 2004. The notice doesn’t say exactly what counts as an “arrangement,” so it could include any kind of agreement or understanding between the people involved. If you’re thinking about changing your arrangement after January 28, 2002, be careful because it could affect your tax benefits. The notice also says that you can use either government rates or the insurance company’s rates to measure how much your life insurance is worth for tax purposes. The government has replaced some old rules for measuring the value of life insurance protection with new ones. These new rules apply to split dollar arrangements, retirement plans, and annuity contracts. If the insurance covers more than one person, adjustments need to be made to the rates. You can still use the old rates for arrangements made before January 28, 2002, but there are new requirements for using the insurer’s rates for arrangements made after that date. Overall, the IRS has provided helpful guidance and cleared up a lot of confusion about these plans.

Source: https://www.floridabar.org/the-florida-bar-journal/notice-2002-8-irs-overhauls-split-dollar/