Beginning with Internal Revenue Service Notice 2001-10, followed by Notice 2002-8, Proposed Regulations and Notice 2002-59, the split-dollar life-insurance world changed for good. In particular, as a result of Notice 2002-8, issued on Jan. 3, 2002, existing split-dollar arrangements, with rare exceptions, will not work as they were originally devised.
To gauge the fallout, in January, we conducted a telephone survey of 727 professional advisors (see “The Advisors,” at the bottom of page), asking 22 questions. All the advisors derive most of their average annual revenue from high-net-worth clients, with estates of $5 million or more. The respondents were identified through a Prince & Associates database of advisors with annual incomes of $300,000 or more. The sample represents the top 25 percent of advisors based on income.
First, we had to determine whether these professionals have clients with split-dollar arrangements. It turned out that 68.4 percent of our respondents did. But a surprising 18.7 percent of them did not even know whether their clients have split-dollar plans.
Next, we asked the 497 advisors who knew they had clients with split-dollar arrangements if they had alerted their clients to the new regulations. The vast majority—85.3 percent—had not.
Why not? We found two, interrelated reasons. Only 18.1 percent of these advisors with split-dollar clients said their understanding of current regulations was detailed. Worse, only 13.1 percent said they knew how to fix the problem, not merely by unwinding the plan but also restructuring it so the client can continue to reap benefits.
Not all split-dollar plans are, of course, in jeopardy. Those plans set up after Jan. 28, 2002, still can use the insurance companies’ published one-year term rates (assuming they continue to be published or are not revised). While previously all split-dollar plans were an economic-benefit arrangement, now existing plans also can become loan arrangements governed by Internal Revenue Code Section 7872. If an existing equity split-dollar plan is not terminated or switched to a loan arrangement before either equity accrues to the benefited party or Jan. 1, 2004, and is then later terminated before death, the equity becomes taxable. But if an equity split-dollar plan already has accrued value for the benefited party and that plan is either terminated or converted to a loan plan before Jan. 1, 2004, that accrued value will not be taxed.
The upshot is that anyone who entered into an equity split-dollar plan now will have a different result than the one originally intended.
Contrary to the impression created by some insurance companies and practitioners, there is no single split-dollar rescue plan. But it’s clear advisors had better do something, both to maintain the client’s goodwill and to head off any potential liability. This four-step process is a good start:
Step 1: Assess the situation by examining the:
• client’s current agenda,
• client’s current estate plan,
• client’s financial situation,
• sources for premium dollars,
• client’s current insurability,
• existing policy performance,
• mechanics of the split-dollar arrangement.
Step 2: Analyze the scenario
• Match appropriate preservation methods to the situational assessment results
Step 3: Confirm and implement
• First, advisors and client agree on a strategy
• Then, they identify the steps and timeline
• As soon as possible, the solution is implemented
Step 4: Make the process ongoing
• Monitor the regulatory environment for changes to split-dollar
• Monitor the policy performance
• Monitor the client’s estate planning and financial situations
Sampling of Methods
Various methods can enable clients to maintain, if not augment, the benefits of a split-dollar plan under the new rules. Here are some examples:
• Sell the policy to an entity that aleady is funded, such as a properly structured Family Limited Partnership or an existing trust.
• If the arrangement is non-equity or the crossover point to equity is far in the future, wait to see what develops—but have a rollout strategy in mind, if not actually set up.
• Fund the policy so there will be enough equity to terminate the agreement and continue the insurance without further payments from either party.
• Switch from an economic-benefit arrangement to a loan arrangement at the equity crossover point.
• Fund the policy until it has enough equity to self-fund; then terminate the agreement.
• Exchange the policy for another, more efficient policy using IRC Section 1035.
• Terminate the plan and enter into a transaction that better suits the current situation.
• If there is no taxable gain, an exchange may not be necessary.
• With older clients, an exchange to a single-premium immediate annuity may provide the necessary funding to pay premiums on a new policy.
• Do nothing if the insured has a short life expectancy.
Very often these methods are used in combination with other planning strategies—it all depends on the situation analysis.
But it is vital that advisors understand the new rules and the many ways life insurance still can be used to transfer wealth.
Their clients’ estates are worth at least $5 million.
Private bankers/trust officers 19.4%
Life insurance agents 41.1%
Trusts and estates lawyers 9.8%
727 professional advisors surveyed