Life Insurance Rules, They're a-Changin'

Split-dollar life insurance has longbeen an attractive financial planningtool for physicians. But therules relating to such plans arechanging beginning in 2004, imposingsignificant taxes on transactions that are anormal part of split-dollar planning. As aresult, it is imperative that existing split-dollararrangements be reviewed beforethe end of 2003 to see if they need to beunwound before the new rules and theirrelated heavy tax burdens take effect.

Split-Dollar Summary

Split-dollar insurance is a plan inwhich 2 parties (ie, in the employmentcontext, the employer and the employee)split the premiums, cash values, ownership,death benefits, and dividends of aregular life insurance policy. Generally,the employer purchases life insurance onan employee, pays the premiums on thepolicy, and retains an ownership interestin a portion of the death benefits or cashvalue of the policy to the extent of thepremiums that are paid. The employerpays premiums for several years, allowsthe policy to increase in value for a fewmore years, and then reclaims its premiumpayments. The policy's remainingcash value and insurance benefits thenbelong to the employee.

These arrangements have drawninterest in the past because of their tax- andcost-effective means of providinginsurance coverage and their ability tocreate deferred compensation for theemployee. At the time the premiums arepaid, the employee owes a small amountof tax on the "cost" of the insurance benefitbeing provided by the employer. Afterthe employer takes back out the amountof the premiums paid and assuming thecash value is adequate to support theinsurance policy into the future, theemployee has a great benefit.

If the policy continues as is, theemployee's beneficiaries receive an incometax–free (and, if properly structured, estate tax–free) death benefit. Theemployee also has the option to draw onthe policy's cash value to provide incomein retirement, which effectively makes thepolicy a deferred-compensation arrangementwithout many of the complicationsof a deferred-compensation program.

Winds of Change

After many years of not paying anyattention to split-dollar arrangements, inJanuary 2001 the IRS announced that itwould impose higher taxes on the valueof the insurance benefit that employerswere providing in split-dollar plans. Moreominously, the IRS proposed to tax theexisting cash value of the contract to theemployee when the company entered intothe transaction to reclaim the premiumson the policy it had paid.

The insurance industry lobbied heavilyin opposition to these changes and,according to an IRS announcement inearly 2002 withdrawing its previous2001 ruling, was successful in deferringthe application of the new rules to givecurrent split-dollar users time to assesstheir alternatives and make any necessarychanges. But unless changed again, newrules with dire tax consequences in relationto the current tax treatment of split-dollarlife insurance plans are on theirway at the end of this year.

Summary of New Rules

According to the rules that arepresently scheduled to take effect after2003, if the employer is listed as the"owner" of the split-dollar insurance policy,the amount of income tax theemployee will pay on the value of theinsurance coverage provided by theemployer will not change dramaticallyfrom current levels of taxation. However,if the company transfers the policy (eg,when the company enters into the transactionto recover its premiums paid andtransfers coverage to the employee), theemployee will have to pay tax on the policy'sentire remaining cash value.

If the employee is listed as the ownerof the contract, the new rules will significantly increase the amount of tax theemployee needs to pay currently on thevalue of the insurance benefit provided.Although the employer's withdrawal ofthe premiums paid will not trigger a taxin this case, the much higher currentincome tax bite may serve to substantiallyundermine the tax benefit of this lifeinsurance plan.

Immediate Plan Review

Existing plans can still be unwound in2003 under the current rules. If you areutilizing such a plan, promptly assess howit will work under the new rules, determineif any changes are necessary, andimplement them before the end of thisyear. Though you could get anotherreprieve if the IRS again delays the proposedchanges, you may be running a significantfinancial risk counting on that. Ifyou have substantial benefits accrued inan existing split-dollar plan, you reallycan't afford to run the risk. Seek outknowledgeable, objective assistance onassessing the impact of the new rules onyour plan and your options for minimizingtax liability under these rules.

And help spread the word. There hasbeen very little written on this subject,despite the fact that it affects many physicians,business owners, and key employees.In fact, many financial advisors arenot even aware of the issue.

Thomas W. Batterman is theimmediate past president of theAssociation of Independent TrustCompanies, a national organizationof more than 100 chartered,well-capitalized, and insured memberswho manage their clients' financial assetsduring life and after death. For more information,visit www.aitco.net.