Ever since the Internal Revenue Service issued Notice 2001-101 in January of 2001, planners who advise clients on their split-dollar life insurance arrangements have had to deal with a Byzantine set of rules that yield different answers depending on the type of arrangement, when it was implemented, and if amended (also when). With the passage of Internal Revenue Code Section 409A and the issuance of Notice 2007-34,2 planners have to deal with a whole new set of additional complications.
Notice 2007-34, issued April 10, 2007, accompanied publication of the final Section 409A regulations. The notice provides guidance on the application of Section 409A3 to employment-related split-dollar life insurance arrangements. In short, the IRS has concluded that some, but not all, employer-sponsored split-dollar arrangements are deferred compensation arrangements. While the language of Notice 2007-34 leaves room for interpretation, one thing is clear: Employers, both public and private, who have relied on the “no inference” language of Notice 2002-84 to stay the course with their pre-final regulation equity, collateral assignment split-dollar arrangements to their surprise — and dismay — now must revisit that decision. Once again, these employers might conclude that no action is necessary or even advisable. But there is enough at stake here, especially when those split-dollar arrangements involve irrevocable life insurance trusts, to take a close look at this whole new set of issues for compensatory arrangements.
We will suggest an approach for evaluating the impact of Section 409A on the most common types of split-dollar arrangements to which Section 409A applies or might apply. After describing some typical arrangements and the operative guidance for those arrangements pursuant to Notice 2002-8, we will give an overview of the application of Section 409A to each type of arrangement. Then we will focus more critically on the arrangements to which Section 409A does (or might) apply and suggest an approach for determining:
- what the planner should look for in both the underlying documentation and the basic economics for each type of arrangement;
- how to assess the impact of Section 409A;
- how to evaluate various courses of action to deal with the application of Section 409A; and
- how to offer some practical recommendations to the client that don't create a paralysis by analysis.
Planners today are most likely to encounter three types of employer-sponsored split-dollar arrangements: (1) traditional non-equity endorsement arrangements implemented before or after the Sept. 17, 2003 effective date of the final split-dollar regulations;5 (2) collateral assignment equity arrangements that either pre-dated the final split-dollar regulations and were recast as loans or were implemented under the loan regime of the final split-dollar regulations; and (3) collateral assignment equity arrangements that pre-dated the final split-dollar regulations and were not recast as loans pursuant to Notice 2002-8 nor materially modified in any respect after the effective date of those regulations.
The traditional endorsement and loan-based arrangements tend to follow a standard template. However, the design and operation of the third type of arrangement can differ widely in ways that have critical implications for both “pure” split-dollar taxation under Section 83 and Notice 2002-8, and for taxation purposes under Section 409A.
Traditional Non-Equity Endorsement Arrangements — Whether established before or after the final split-dollar regulations, in a traditional, non-equity endorsement arrangement, the employer is the owner, beneficiary and premium payer, but the insured designates a personal beneficiary for a portion of the death benefit in excess of employer reimbursement. The insured has imputed income for the economic benefit of the insurance protection, less any contribution he makes to the arrangement. The economic benefit is measured by the lower of Table 2001 or the insurer's qualifying term rates. This type of plan usually terminates at retirement, but may remain in effect for the lifetime of the insured, who will be taxed on the economic benefit until he dies, less any contribution. The insured has other no rights or interest in the policy; accordingly, this type of plan provides only a death benefit, with no access to or rights in a policy's cash value during the insured's lifetime. Notice 2007-34 makes it clear that Section 409A does not apply to the traditional endorsement plan because it is a “death benefit-only” plan and does not involve deferred compensation.
Loan Regime Arrangements — The second type of arrangement is the collateral assignment equity plan that was either recast as a loan under Notice 2002-8 or (less likely) established from the outset as a loan regime plan under the final split-dollar regulations. Notice 2007-34 provides that Section 409A does not apply to a collateral assignment loan regime plan unless the employer agrees to forgive the loan, waives payments, etc.6
Pre-Final Regulation, Equity Collateral Assignment Arrangements — This type of arrangement is the usual format: a collateral assignment equity plan that was established before Sept. 17, 2003, and not recast as a loan pursuant to the safe harbor of Notice 2002-8. Here, the insured or the insured's irrevocable life insurance trust (ILIT) owns the policy and the employer advances the premiums to the insurer. Upon termination of the arrangement during the insured's lifetime, the employer is repaid the total premiums paid or the lesser of the total premiums it advanced or the policy's cash value. Once repaid, the employer releases the assignment and any cash value greater than the employer's share, the equity, belongs to the insured or the ILIT.
Notice 2002-8 governs taxation of these pre-final regulation collateral assignment plans. In the context of the applicability of Section 409A, the critical aspect of Notice 2002-8 is the taxation of policy equity upon termination of the arrangement. Essentially, for plans established before Jan. 28, 2002, the IRS will find no transfer (of the equity) under Section 83 and therefore will not tax the equity as long as the plan remains in force.
Notice 2002-8 also offered safe harbors for avoiding taxation of the equity upon termination; under those safe harbors, the equity would not be taxed if the plan was either terminated (rolled out) before Jan. 1, 2004, or was recast as a loan under Section 7872 or the applicable provisions of the tax law. Presumably, if the plan were neither terminated nor recast by Jan. 1, 2004, the IRS would attempt to tax the equity upon termination, subject to the “no inference” provision of the notice. Bear in mind that if an ILIT owns the policy, taxable equity is both income to the employee and a gift to ILIT (and, in an appropriate case, a generation-skipping transfer to the ILIT.)
The vexing portion of Notice 2002-8 is language stating that, except for the standards for valuing current life insurance protection, “no inference shall be drawn from Notice 2002-8 regarding the appropriate federal income, employment and gift tax treatment of split-dollar life insurance arrangements entered into prior to the date of the publication of the final regulations.”7 Interpretation of the “no inference” language has been problematic for planners from the day it was published. Some planners maintain that the IRS has essentially grandfathered existing arrangements and won't pursue the equity for income or gift tax purposes on termination of these arrangements. Others believe that the IRS was merely saying that it reserves the right to make its arguments in favor of taxation. In fact, IRS representatives have indicated that their position is that the equity in the arrangement is taxable when the arrangement is terminated, despite the no-inference language. They also have indicated that, under certain circumstances, the equity could be taxable even before termination if the employee accesses that equity, for example, for retirement income.
Interpretation of (and planning with respect to) the no-inference language of Notice 2002-8 is now also problematic for purposes of determining the applicability of Section 409A.
Notice 2007-34, part III.D, addresses pre-final split-dollar regulation arrangements that are “not grandfathered under Section 1.409A-6.” This notice refers to the language in Notice 2002-8, which states that “the IRS will not treat the arrangement as having been terminated for so long as the parties to the arrangement continue to treat and report the value of the protection as an economic benefit provided to the benefited person.” Notice 2007-34 then states that “in such cases, provided that all other requirements of Notice 2002-8 are satisfied, the IRS will not assert that there has been a transfer of property to the benefited person by reason of termination of the arrangement for purposes of Section 409A.”8
Notice 2007-34 does not contain the same no-inference language that was included in Notice 2002-8, which permitted practitioners to take the position that there was no taxation of the equity at the termination of the arrangement by relying on older rulings. As we've noted about the split-dollar notice, the ambiguity is clear. Is the IRS saying in Notice 2007-34 that there is no taxation (of equity) upon termination of the split-dollar arrangement? Or is the IRS merely saying that parallel to Notice 2002-8, for purposes of Section 409A, it won't consider a split-dollar arrangement terminated so long as the employer is charging out the economic benefit and there will be no transfer of property (deferred compensation) until the arrangement is terminated? If the IRS isn't saying the latter, there wasn't much point in publishing the notice.
Application of 409A
With the focus now squarely on the third type of arrangement, the pre-final regulation collateral assignment equity split-dollar plan, let's consider prototypical arrangements with common variations on the theme. We will use the first prototype as a vehicle for offering practical guidance for determining whether Section 409A applies and, if it does, whether the agreement complies with Section 409A. We also will discuss the remedies for curing an arrangement that does not comply with 409A.
First, there is the classic arrangement — between an employer and an executive — that has been in force for some time. Here, the first question: Have premiums been paid since 2004? That's because under Notice 2007-34, any premium payments made before Jan. 1, 2005, and any growth in the cash value of the policy allocable to these premium payments will be grandfathered and Section 409A will not apply to these amounts.
Furthermore, if the employee's right to have the premium payments made by the employer was earned and vested prior to Jan. 1, 2005, then even premium payments paid after Jan. 1, 2005, and earnings on those premiums will be grandfathered under Section 409A. This situation may happen when the employer agrees to pay the premiums for the rest of the employee's life (or more likely, if the policy is a second-to-die insurance policy, agrees to pay the premium after the employee's death during the employee's surviving spouse's lifetime.) Accordingly, only those premium payments made after Jan. 1, 2005, and the growth of the cash surrender value of the policy allocable to those premium payments will be considered deferred compensation under Section 409A. When benefits are both attributable to pre- and post-2005 premiums, the notice allows any reasonable method that allocates increases in cash values to the grandfathered benefit (so long as it doesn't allocate a disproportionate part of policy expenses to the non-grandfathered portion.)
In our hypothetical, premiums have in fact been paid subsequent to 2004. Therefore, we have to look at the agreement and determine if it complies with Section 409A. The agreement will comply if amounts payable under the arrangement cannot be distributed earlier than:
(a) the executive's separation from service;
(b) the date the executive becomes disabled;
(c) the executive's death;
(d) a specified time or pursuant to a fixed schedule specified under the plan at the date the arrangement was entered into that any amount of deferred compensation under the arrangement would be paid;
(e) a change of ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation; or
(f) the occurrence of an unforeseeable emergency.9
All of those terms are defined in the Section 409A final regulations.
Some arrangements would comply with most of these requirements — although, for example, the definition of “change of control” in an agreement may not comply with the Section 409A definition. But most such arrangements give the employee a unilateral ability to terminate the arrangement (directly or indirectly) and thereby obtain the policy cash values. This right appears to violate the provision requiring a fixed date for payment of the deferred compensation.
In our first prototype, the agreement provides that it can be terminated upon only certain delineated events that comport with the requirements of Section 409A. Most notably, neither the employer nor the executive is entitled to unilaterally terminate the arrangement before separation from service or other event sanctioned by Section 409A. But before concluding that the agreement complies with Section 409A, the employer must deal with the requirement of Section 409A that the payment to certain specified executives of public companies must be delayed for six months after termination of the arrangement. This agreement does not contain this provision.
At first blush, even the publicly held employer might demur on the basis that it suspended premiums on plans for senior executives in 2002 because of concerns that those payments would be considered personal loans under Sarbanes-Oxley.10 If that's the case, there would be no premiums paid after 2004, so the entire arrangement would be grandfathered. However, if the employer had been paying premiums on executives who became “specified executives” after 2004, then Section 409A will apply to those executives.
It's not uncommon to find that the employer never documented the split-dollar arrangement. In other words, the policies are in place, maybe even collaterally assigned with the insurer, and the employer has been charging out one-year term costs to the executives. But there is no underlying agreement. Aside from whatever problems this situation creates from a “pure” split-dollar perspective, including the possible Employee Retirement Income Security Act (ERISA) requirement for a written plan document, it seems clear that the absence of any underlying split-dollar agreement means that an executive can at any time accelerate the receipt of equity (that is to say, deferred compensation) by simply repaying the employer. The arrangement would not comply with Section 409A.
If Section 409A applies to the arrangement and the agreement does not comply, the payments made under the arrangement, unless grandfathered, for the current taxable year and for preceding taxable years (starting in January of 2005) would be includable in the service provider's taxable income, increased by 20 percent, plus interest determined at the underpayment rate (plus an additional 1 percent) on any amounts of deferred compensation for prior taxable years that were not reported. To avoid these penalties, the employer might be able to amend a non-complaint agreement. Fortunately, Notice 2007-86 extended the deadline for amendments to the end of 2008. However, the arrangement must be administered during this time period in compliance with Section 409A and the final regulations, even if the documents have not been amended, meaning the agreement no longer contains all of the provisions applicable to the arrangement, making its proper administration difficult.
Planners who have been working with these pre-final regulation collateral assignment plans know that if an arrangement is “materially modified” after Sept. 17, 2003, it will lose its grandfathering status under the economic benefit regime and be governed by the loan regime. Presumably, any equity in the arrangement at the time of the modification would be taxable to the executive, because a conversion to a loan regime arrangement results in the parties to the arrangement no longer continuing to treat and report the value of the protection as an economic benefit provided to the benefited person. Accordingly, the IRS is no longer precluded from asserting that there has been a transfer of property to the benefited person by reason of termination of the arrangement, as provided under Notices 2002-8 and 2007-34.
Because the IRS has not provided any further definition of the term “material modification,” and has announced that it will not rule on the issue,11 planners intent on preserving economic benefit treatment for an arrangement have approached anything that seems like a modification with appropriate caution. Notice 2007-34 recognizes the inherent conflict of providing for (potential) modification of an agreement to comply with Section 409A with the virtually invisible tripwire of a material modification for purposes of the final split-dollar regulations. Notice 2007-34 provides transitional relief from the material modification rule of the final split-dollar regulations, but only if all requirements are met:
- There has to be a reasonable determination that Section 409A applies, the arrangement doesn't comply, and that the modification will cause it to comply or no longer be subject to Section 409A.
- The modification consists of changes to definitions, payment timing or conditions of forfeiture to conform the arrangement to Section 409A or to exclude it from coverage.
- The modification establishes a time and form of payment of the benefit consistent with those applicable before the modification.
- The modification doesn't “materially enhance” the value of the benefits to the employee under the arrangement.12
In our prototypical arrangement, the employer might be comfortable amending the agreement to comply with Section 409A. A change to defer the termination of an arrangement with a specified executive for six months is not likely to fall outside the parameters of either the rules or expectations that the parties had for the arrangement in the first place (except, perhaps literally, the provisions of the third requirement.) But, as we will discuss, planners will encounter other situations in which it will not be possible to comply with Section 409A without creating serious income and gift tax issues for the executive.
Assuming that the employer in our first prototype does amend the agreement (or it complied in the first place), what will be taxable to the executive under Section 409A when the arrangement is terminated? Notice 2007-34 tells us that amounts deferred before 2005 are not subject to Section 409A unless the plan was “materially modified” after Oct. 1, 2004. Amounts are considered deferred before 2005 if there was a legally binding obligation to pay the amounts and the right was vested. And, as we've noted, when benefits are both attributable to pre- and post-2005 premiums, the notice allows any reasonable method that allocates increases in cash values to the grandfathered benefit (so long as it doesn't allocate a disproportionate part of policy expenses to the non-grandfathered portion.) Again, grandfathered amounts include only those attributable to premiums paid before 2005.
But now we have to focus on the interplay of Notice 2002-8's no-inference language, which creates doubt about taxation of the equity at plan termination, and Notice 2007-34, which has no such language and appears to require taxation of the equity as deferred compensation when the plan is terminated. A fair reading of the respective notices could bring a planner to a variety of conclusions, each supportable in its own right. Consider these conclusions, not necessarily in order of compelling logic.
The equity at the termination of a pre-final regulation arrangement is not taxable under Section 83, but is taxable as deferred compensation under Section 409A to the extent it's not grandfathered.
The equity at the termination of a pre-final regulation arrangement is taxable under Section 83, but under Notice 2007-34 only non-grandfathered amounts are subject to the rules of Section 409A. This would be the same situation for a deferred compensation agreement that was partially funded prior to Jan. 1, 2005. When the deferred compensation is paid out, the grandfathered amounts are still taxable but those amounts are not subject to the rules of Section 409A.
The equity at the termination of all pre-final regulation arrangements is taxable in all instances, and in addition, the non-grandfathered amounts also are subject to the penalties of Section 409A if the plan is not properly structured. Planners who take this view believe that the no-inference language in Notice 2002-8 does not prevent taxation of the equity at the termination of the arrangement because older rulings recognized that such equity was a taxable economic benefit provided to the benefited person. Therefore, Notice 2007-34 does not discuss whether the equity is taxable or not, because the IRS' position on that issue was resolved in Notice 2002-8 and the notice is merely defining what portion of the taxable equity is subject to Section 409A.
The equity at the termination of all pre-final regulation arrangements is not taxable under Section 83 due to the no-inference language of Notice 2002-8, but the non-grandfathered amounts must comply with Section 409A to avoid its penalties.
It's unclear which is the correct position for pre-final split-dollar regulation arrangements. In light of this uncertainty, it's possible to continue to take the first position we've described, namely, that only the non-grandfathered equity in an arrangement is taxable at the termination of the arrangement under Section 409A because Notice 2007-34 addresses only the treatment of that equity and then only for purposes of Section 409A. It's therefore possible to continue to rely on the no-inference language of Notice 2002-8 to take the position that, at termination, the equity — in all other pre-final split-dollar regulation arrangements and grandfathered equity in compensatory pre-final split-dollar regulation arrangements — is not taxable.
Based on which position regarding the taxation of equity on termination of an arrangement the planner agrees with, Notice 2007-34 seems to effectively eliminate reliance on Notice 2002-8's no-inference provision for the non-grandfathered portion of the equity in a compensatory split-dollar arrangement.
The second prototype involves a pre-final regulation arrangement that can be terminated by either party at any time. This is the type of arrangement planners typically see between closely held employers and their owners/executives. These arrangements are also common when the policy is owned by an ILIT created by such an executive.
This type of arrangement is clearly not in compliance with Section 409A, because it enables the executive (or the executive's ILIT) to accelerate receipt of the equity in the policy, which the IRS considers deferred compensation. If the employer has advanced premiums after 2004 on this type of arrangement, the agreement will have to be amended for compliance.
Can this type of agreement be amended within the constraints for the amendment imposed by Notice 2007-34? It's not clear, because the necessary amendment is likely to alter the time of payment of the benefit under the agreement in a manner that is not consistent with the original payment timing provision of the agreement, or will materially enhance the value of the benefits under the agreement, or both.
What's more, if a rollout is planned (and funded) for the 15th policy year but now has to be deferred until separation from service, then compliance with Section 409A could involve a significant income tax cost for the insured executive and, if applicable, significant gift tax cost. It also could materially impact the employer's cost of money for the plan.
The third type of arrangement is common among tax-exempt employers who have used collateral assignment split-dollar as a way to provide a form of deferred compensation to executives. In the guise of a “death benefit-only plan,” these arrangements would call for the release of the employer's interest at the employee's death. Although the employer would continue to impute the economic benefit in the income of the retired executive, the employee would access the policy's cash value via (what are supposed to be tax-free) policy loans or withdrawals for retirement income, that is to say, deferred compensation. Many of these pre-final regulation arrangements are still in force. In some cases, no premiums were paid after 2004. In others, not only were premiums paid after 2004, but also premiums are still being paid. In all cases, they rely on the no-inference language of Notice 2002-8, Section 72 or both as authority for the executive's tapping the equity in the policy on a tax-free basis. The IRS has told us that it does not agree with that position.
Notice 2002-8 and Section 72 aside, Notice 2007-34 has to be unwelcome news for these plans. If, as seems clear, the IRS considers the equity in the arrangement to be deferred compensation, then the executive's ability to access that equity before he dies puts the plan out of compliance with Section 409A. While the agreement technically could be amended to comply with that section, the amendment essentially would recast the arrangement as a “real” death benefit plan. These situations are going to be very problematic, economically and politically, for many such employers.
Curiouser and Curiouser
Section 409A adds a new layer of complexity to the already complex tax, economic, accounting and human resource issues associated with many employers' collateral assignment equity split-dollar plans. Perhaps Section 409A will be the proverbial straw that breaks the back of these plans. At the very least, Section 409A is a mandate for planners to reach out to the companies that have implemented these plans, revisit Notice 2002-8, analyze Notice 2007-34, and help these clients find a solution that is as sound technically as it is workable — from a business and compensation perspective.
— The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or Bryan Cave LLP. This article should not be construed as legal, tax, accounting or any other professional advice or service. No one should act upon the information contained herein without appropriate professional advice after a thorough examination of the facts of a particular situation.
- Internal Revenue Service Notice 2001-10, 2001-5 Internal Revenue Bulletin 459.
- Internal Revenue Code Section 409A; I.R.S. Notice 2007-34, 2007-17 I.R.B. 996.
- IRC Section 409A.
- IRS Notice 2002-8, 2002-1 Congressional Bulletin 398.
- Treasury Regulations Section 1.61-22 (2003).
- IRS Notice 2007-34, 2007-17 I.R.B. 996.
- IRS Notice 2002-8, 2002-1 C.B. 398.
- IRS Notice 2007-34, 2007-17 I.R.B. 996.
- IRC Section 409A.
- Sarbanes-Oxley Act, 15 United States Code Section 78m (2002).
- IRS Revenue Procedure 2008-3, 2008-1 I.R.B. 109.
- IRS Notice 2007-34, 2007-17 I.R.B. 996.
Charles L. Ratner, top, is the national director of personal insurance counseling at Ernst & Young LLP in Cleveland.
Lawrence Brody is a partner in the St. Louis office and Mary Ann Mancini is a partner in the Washington office of Bryan Cave LLP