For estate planning using life insurance, and especially for large premium cases, split dollar offers an attractive method for funding the premiums with favorable gifting consequences. Before 2003, the rules for split dollar were a collection of revenue rulings and private letter rulings. But, beginning with Notice 2001-10 and concluding with published Treasury Regulations Sections 1.61-22 and 1.7872-15 and Revenue Ruling 2003-105, the Treasury and the Internal Revenue Service changed the landscape for split-dollar arrangements. The regulations ended “equity” split-dollar arrangements as of Sept. 17, 2003 (that is, those that allowed for the supposed tax-free transfer of cash value from the premium-payor to the policy owner); added loan split-dollar arrangements; and potentially ended the use of the insurance company's “published” term rates for arrangements entered into after Sept. 17, 2003 and for arrangements “materially modified” after that date. Because “equity” split-dollar arrangements were no longer viable and the new regulations were long and complicated, many estate-planning practitioners gave up on using split-dollar arrangements to fund insurance premiums while reducing or ending the gift tax on the premiums paid for the policy.

But, split-dollar arrangements are still very much alive and especially useful where large premiums are involved. The new regulations provide a clear road map as to the structure. Here's what you should do to use split dollar successfully and creatively in a private setting; that is, one in which the arrangement is between an individual and either an irrevocable life insurance trust (ILIT) or another individual.

Terminology Clarified

The terminology in the regulations is one chief cause of confusion. The regulations use “endorsement split dollar” to refer to the old split-dollar type arrangement that measures economic benefit by using the value of one-year term insurance under Treas. Regs. Section 1.61-22. The “owner” is the party who is paying the premium and the “non-owner” is the party receiving the benefit. The regulations use “collateral assignment split dollar” to refer to loan arrangements under Treas. Regs. Section 1.7872-15 in which the “owner” is the party that receives the loan and pays for the policy and the “non-owner” is the party making the loan to fund the purchase of the insurance.

Those terms mislead us because a collateral assignment arrangement can use economic benefit to measure its value. In a properly structured arrangement, the party that controls all the elements is deemed to be the “owner” for Internal Revenue Code Section 2042 purposes, even though that party is not the premium-payer. To make life simple, we'll use the term “economic benefit split-dollar arrangements” to refer to those arrangements that are measured using one-year term rates and the term “loan split-dollar arrangements” to refer to those arrangements that are funded by loans. These immediately identify the structure and tax consequences.

Estate-planning Benefits

In the estate-planning arena, split-dollar funding of life insurance can reduce or eliminate the value of the gift in funding life insurance premiums. That reduction or elimination applies to annual exclusion gifts, lifetime exemption gifts, and generation-skipping transfers (GSTs). When used in a properly structured ILIT, split-dollar funding can be made into a dynasty trust with minimal consequences; it can also be used as a surrogate for other estate-planning techniques (for example, grantor retained annuity trusts (GRATS) or sales to grantor trusts) and may produce better results than those techniques under certain circumstances.1 For example, say a husband (age 49) and wife (age 45) decide to fund a second-to-die life insurance policy using an economic benefit split-dollar arrangement. The insureds pay the premiums on a policy with an $8 million death benefit. The annual premium is $55,000, guaranteed payable for 20 years. Using Table 2001 (that is, the IRS table of rates used to measure the value of the insurance protection), the gift value of the premiums subject to the gift tax is $24 in the first year!

If the husband and wife used a loan split-dollar arrangement to fund the same policy, they will make a single loan to the trust for $2 million. The loan will be used to pay the first premium, with the balance invested for the payment of future premiums and loan interest at the applicable federal rate (AFR). If the investment produces a return equal to or greater than the premiums and interest payments, when the premium payments are finished, the trust can repay the loan from the investment. Because a loan was used, interest was paid at the appropriate rate and the loan was eventually repaid, there are no gifts.

Economic Benefit Regime

Treas. Regs. Section 1.61-22(b)(1) defines economic benefit split-dollar arrangements as:

“any arrangement between an owner and non-owner of a life insurance policy that satisfies the following criteria —

  1. Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including payment by means of a loan to the other party that is secured by the life contract;

  2. At least one of the parties to the arrangement paying premiums under paragraph (b)(1)(i) of this section is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and

  3. The arrangement is not part of a group-term life insurance plan described in section 79 unless the group-term life insurance plan provides permanent benefits to employees (as defined in §1.79-0).”

Regardless of what it is called (for example, “private financing”), if it looks like a duck and quacks like a duck — it's a split-dollar arrangement and you need to follow the regulations.

Treas. Regs. Section 1.61-22 also addresses the taxation of equity in economic benefit split-dollar arrangements. The section applies to all arrangements entered into after Sept. 17, 2003 and any existing arrangement that is “materially modified” after that date. “Equity” refers to any part of the cash value (not including surrender charges) that is available to the non-premium paying party during life. That equity will be taxed at the time it accrues for income tax and transfer tax purposes (if that is also applicable).

The regulations define material modification by what it doesn't include. For example, it doesn't include minor administrative changes and changes made to comply with IRC Section 409(A). One of the things specifically not included as not being a material modification is an IRC Section 1035 exchange from an old policy into a new one (so, by inference, this type of exchange is a material modification).

What Rates Apply?

The value of the gift of the insurance premium payments is based on the economic benefit to the person receiving the benefit. In Notice 2001-10, the IRS created Table 2001, which set new rates to measure the value of the insurance protection (that is, the economic benefit). The IRS had been unhappy with the way the insurance companies defined their “published” term rates available for sale. The rates used were unrealistically low and few, if any, policies were actually sold. While Notice 2002-8 revoked Notice 2001-10, it republished the Table 2001 rates so that they were (and are) still in effect. These new rates set out in Table 2001 apply to all new arrangements entered into after Jan. 28, 2002. The regulations say that the taxable term table can be changed at any time. The regulations allowed the continuation of the “published” rates for older arrangements (that is, arrangements entered into on or before Jan. 28, 2002 and not modified on or after that date). If the IRS changes the new rates, we hope that the taxpayers with existing arrangements will have the choice of which rates to use — that is, if the new rates are higher, taxpayers can continue to use the old rates and if the new rates are lower, they can switch to the new rates.

Although Rev. Rul. 2003-15 revoked Rev. Ruls. 64-328, 66-110, 78-420 and 79-50 (those rulings were the basis for all previous split-dollar arrangements), that ruling specifically does not revoke Notice 2002-8, Sec. III, para. 3, which states:

“For arrangements entered into on or before Jan. 28, 2002 by continuing to determine the value of current life insurance protection by using the insurer's lower published premium rates that are available to all standard risks for initial issue one-year term insurance.”

The notice also says:

“For arrangements entered into after Jan. 28, 2002 the IRS will not consider an insurer's published premium rates to be available to all standard risks who apply for term insurance unless (i) the insurer generally makes the availability of such rates known to persons who apply for term insurance coverage from the insurer, and (ii) the insurer regularly sells term insurance at such rates to individuals who apply for term insurance coverage through the insurer's normal distribution channels.” (Emphasis added.)

We are not aware of many carriers today that have a term product that they feel meets this more restrictive definition; in some cases, the carrier won't take a position on whether its rates qualify (since it is a legal decision). In the absence of qualifying term rates, the taxpayer must use Table 2001 to measure the economic benefit.

As you see, the economic benefit split-dollar arrangement is alive and well, as long as the taxpayer follows the rules. Note that the premiums paid by the “owner” are advances, not loans. The owner is only entitled to receive back the greater of premiums advanced or the cash surrender value. There is no interest component; that is an important distinction when compared to loan arrangements.

Loan Regime

Treas. Regs. Section 1.7872-15 created a new kind of split dollar funded by loans rather than advances. Treas. Regs. Section 1.7872-15(a)(2)(i) describes a loan as:

“General rule. A payment made pursuant to a split-dollar life insurance arrangement is treated as a loan for Federal tax purposes, and the owner and non-owner are treated, respectively, as the borrower and the lender, if —

  1. The payment is made either directly or indirectly by the non-owner to the owner (including a premium payment made by the non-owner directly or indirectly to the insurance company with respect to the policy held by the owner);

  2. The payment is a loan under general principles of Federal tax law or, if it is not a loan under general principles of Federal tax law (for example, because of the nonrecourse nature of the obligation otherwise), a reasonable person nevertheless would expect the payment to be repaid in full to the non-owner (whether with or without interest); and

  3. The repayment is to be made from, or is secured by, the policy's death benefit proceeds, the policy's cash surrender value, or both.”

Even if the arrangement would not be taxed as a loan under general principles of federal tax law, it will be considered a loan if “a reasonable person nevertheless would expect the payment to be repaid in full to the non-owner (whether with or without interest).” Treas. Regs. Section 1.7872-15(d) gives a road map that, if followed, assures loan treatment for the transaction. The payment of interest calculated on a demand, a so-called hybrid or a term loan, is sufficient to avoid the application of IRC Section 7872 (that imputes interest on below market loans) if it equals the appropriate AFR. The borrower can accrue, rather than pay, interest on the loan at the AFR to avoid application of IRC Section 7872. A loan arrangement between private parties (that is, an individual and an ILIT or other individual) is often referred to as private premium finance (as opposed to a loan from a third-party lender).

Finally, for life insurance not to be included in the insured's estate under IRC Section 2042, the loan agreement and collateral assignment have to be carefully drafted to avoid inadvertently giving the insured any incident of ownership in the policy used in the loan split-dollar arrangement. A loan can be made to a trust that owns life insurance if the loan is used directly or indirectly to pay for the life insurance, the life insurance is used as collateral for the loan and the appropriate representation is made with the original loan, with copies of the original representation filed if any further loans are made. In other words, this is a loan that will be respected for tax purposes, even though there is no seed money or collateral other than a life insurance policy. Further, even if the policy has no cash value, this is considered a loan if it is secured by the death benefit of the policy.2

Exit Strategies

A split-dollar arrangement will eventually fail without an exit strategy3 designed to repay the obligation to the premium payor because:

  • The taxable term cost grows every year

    So, what started out as low cost increases over time making the rates at older ages disadvantageous. For example, $1 million of at-risk death benefit for a 65-year-old is $13,510; for a 70-year-old, $20,620; for a 75-year-old, $33,050; and for an 80-year-old, $54,560. If the policy is second-to-die and one of the insureds dies, the taxable term cost is the single life rate under Table 2001. In our previous example of a 49-year-old and 45-year-old with $8 million of death benefits and a premium of $55,000, if one dies and the survivor is 70-years-old, the taxable term rate is $164,960 for that year.

  • If annual loans are made, each loan is made at a new rate

    Additionally, if a loan is renewed at the end of its term, it renews at the rate then in effect. If interest accrues the interest due later on is quite substantial and may wipe out the death benefit when the loan and the interest are repaid.

Effective exit strategies for both economic benefit and loan arrangements create a fund to repay the obligation during the insured(s)' lifetime(s) and pay future premiums thereafter, if any are due.

The following are possible strategies:

  • Use annual exclusion gifts. This is useful if the premium is greater than the available gifting (that's the reason you use split dollar) but any funding will help, especially if it can be invested successfully. Note that making gifts to pay the interest will, under an unusual provision of the regulations, result in the transaction being subject to IRC Section 7872, even if interest is being paid at the AFR.4

  • For loan arrangements, consider (for an additional premium cost) a policy with an increasing death benefit that mirrors the increasing liability. Many companies have a return of premium rider that can be increased each year by a fixed percent. Model the policy to see if there are restrictions on the amount and/or duration of the additional death benefit.

  • Use a GRAT with the ILIT as remainder beneficiary, which can provide funds if the GRAT is successful. Note that, because of the estate tax inclusion period rules, this strategy is not useful for GSTs; as an alternative, consider an installment sale to the ILIT if the trust has generation-skipping implications.

  • Make a large initial loan (with interest accrued at the AFR) to cover all future premiums. If the money is invested and earns more than the interest and premiums due there will be enough in this side fund to repay the loan at the death of the insured without touching the insurance death benefit. This works best if the loan is to an ILIT that is a grantor trust from the lender's point of view, so that taxes do not reduce the trust's return and the interest accruing to the lender isn't taxed.

  • If an economic benefit arrangement is used, switch to a loan arrangement when the economic benefit is greater than the interest that will be paid on the loan. All the premiums previously advanced and any cash value above that amount will be the initial amount of the loan in the year of conversion.

And remember: It is critical that you model the arrangement and exit strategy to see the consequences, including the variability of the interest rate. What comes trippingly off the tongue may look very different when shown on paper.

Endnotes

  1. See Richard L. Harris, “Split-Dollar Loan to a Grantor Irrevocable Life Insurance Trust,” Estate Planning, December 2009, for a discussion of using split-dollar loans in place of grantor retained annuity trusts or sales to intentionally defective grantor trusts.
  2. See Treasury Regulations Section 1.7872-15(a)(2)(i)(C). For a more detailed discussion of the loan rules, see also ibid.
  3. See Lawrence Brody and Michael Weinberg, “The Side Fund Split-Dollar Solution,” Estate Planning, January, February 2006.
  4. Treas. Regs. Section 1.7872-15(a)(4).

Lawrence Brody, far left, is a partner at the St. Louis law firm of Bryan Cave LLP. Richard L. Harris is the managing member of BPN Montaigne LLC in Clifton, N.J.