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ACLI Comments on Split-Dollar Regs

JUL. 8, 2003

ACLI Comments on Split-Dollar Regs

DATED JUL. 8, 2003
DOCUMENT ATTRIBUTES
  • Authors
    Lewis, Laurie D.
  • Institutional Authors
    American Council of Life Insurers
  • Cross-Reference
    For a summary of the July 9, 2002 regulations (REG-164754-01), see

    Tax Notes, July 15, 2002, p. 361; for the full text, see Doc

    2002-16108 (24 original pages) [PDF], 2002 TNT 135-10 Database 'Tax Notes Today 2002', View '(Number', or

    H&D, July 5, 2002, p. 175. For a summary of the May 9, 2003

    regulations, see Tax Notes, May 12, 2003, p. 809; for the full

    text, see Doc 2003-11568 (21 original pages) [PDF]; 2003 TNT

    90-8 Database 'Tax Notes Today 2003', View '(Number'; or H&D, May 9, 2003, p. 1685.
  • Code Sections
  • Subject Area/Tax Topics
  • Industry Groups
    Insurance
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2003-15887 (17 original pages)
  • Tax Analysts Electronic Citation
    2003 TNT 134-73

 

July 8, 2003

 

 

CC:PA:RU (REG-164754-01)

 

Internal Revenue Service

 

Courier's Desk

 

1111 Constitution Avenue, N.W.

 

Washington, D.C. 20224

 

 

RE: Split Dollar Life Insurance Arrangements

RIN1545-BA44

Dear Sir/Madam:

On behalf of the member companies of the American Council of Life Insurers, we are submitting comments on the proposed regulations relating to the valuation of the economic benefits under certain equity split dollar life insurance arrangements ("2003 proposed regulations"), released May 8, 2003. This issue was reserved in the proposed split dollar regulations issued on July 3, 2002 ("2002 proposed regulations"). The American Council of Life Insurers is the primary association representing the life insurance industry. The 383 member companies of the ACLI account for 70% of the life insurance premiums in the United States among legal reserve life insurance companies. In addition, their assets represent 73% of all United States life and health insurance companies. Many of our member companies issue life insurance contracts that are used in connection with split dollar life insurance arrangements.

As an initial matter, we note that the preamble to the regulations states that the 2003 proposed regulations address only those comments received on the valuation of economic benefits under an equity split dollar arrangement governed by the economic benefit regime and that comments received on other issues regarding the 2002 proposed regulations will be addressed when both sets of proposed regulations are finalized. We interpret these statements to mean that the comments made by the ACLI on the 2002 proposed regulations are still being actively considered. We strongly urge the Internal Revenue Service ("Service") and the Treasury Department ("Treasury") to adopt the alternative proposal and the other changes previously recommended by the ACLI1. Accordingly, this comment letter focuses on the conceptual concerns that we have with the 2003 proposed regulations. We have also prepared a comprehensive outline of the taxation of split dollar arrangements under the ACLI alternative proposal and are prepared to discuss this more detailed methodology with you at your convenience.

While we appreciate the time and effort that the Service and the Treasury have made in drafting the proposed regulations and agree that regulations are needed, after review and analysis, we believe that these proposed regulations are unnecessarily rigid and are contrary to established tax rules and tax policy. Many of the issues raised in our comments arise because of the novel position advanced in the 2002 regulations that a life insurance policy may not be owned by more than one taxpayer unless the ownership interests are pro rata.2 In sum, our concerns with the proposed regulations are:

 

1. The various rules proposed in proposed regulation section 1.61-22 fail to take into account the economic benefit principles codified in Internal Revenue Code ("Code") section 83, which expressly cover transfers of beneficial ownership interests in property in connection with performance of services, e.g.,

 

a. Split-dollar arrangements involve the sharing and transfer of beneficial ownership interests in property, that is, life insurance policies with a cash surrender value. The cash surrender value is expressly defined to be "property" under long-standing regulation section 1.83- 3(e).

b. Proposed regulation section 1.61-22 fails to recognize the regulatory preemption rule reflected in regulation section 1.61- 2(d)(6). This final regulation under Code section 61 expressly recognizes that the subsequently enacted statutory provisions of Code section 83 (and the regulations interpreting them) preempt any inconsistent regulations and rules under Code section 61, where these Code section 83 rules apply to any "property transferred, premiums paid and contributions made in connection with performance of services after June 30, 1969."

 

2. The "valuation" rules in proposed regulation section 1.61- 22(d)(3)(ii), and principally the definition of "access" therein, are inconsistent with the language of Code section 83 rules. Under section 83, taxation arises upon a transfer of property when the taxpayer's interest in the property is vested. To the extent that "current access" constitutes a transfer of property, the Code section 83 rules apply. In addition, once the taxpayer has become the owner of the transferred property, he or she is its owner for all purposes of income taxation. The proposed regulations fail to recognize this fundamental principle of section 83. For example:

 

a. A basic principle of Code section 83 is that, once beneficial ownership in a property interest is transferred to (and substantially vested in) the employee, any appreciation and other economic benefits allocable to such property interest are not taxed further to the employee as compensation income, because the transferee is thereafter treated as the tax "owner" of such property for all federal income tax purposes. See, e.g., Rev. Proc. 83-38, 1983-1 C.B. 773, Sec. 2.03. For example, when an employee is taxed on a transfer of a share of stock under Code section 83, further unrealized appreciation in that stock is not taxable until there is an actual sale or other disposition.

b. Code section 83 contemplates a transfer of a beneficial ownership interest in property by various means and does not limit a transfer to a formal transfer of title as does proposed regulation section 1.61-22(g). e. f.

 

3. The definition of "current access" in proposed regulation section 1.61- 22(d)(3)(ii) is unnecessarily broad and ambiguous in that it purports to impose tax on policy cash value increases in situations where the employee has no right to access the cash value:

 

a. Taxable "current access" is triggered by any state law limitation on the rights of the employer's creditors to reach the policy cash value, even though the employee has no greater right to access the policy cash value than an unsecured general creditor of the employer and the policy cash value is subject to the claims of the employer's creditors.

b. The definition of "current access" is so ambiguous that the parties to the split dollar arrangement can never be assured that they will not inadvertently be treated as having "current access" to the policy cash value.

* * *

 

 

Our comments will address the following issues:

I. Policy Issues.

 

A. Treatment of "Current Access" under section 83 as a Transfer of Beneficial Ownership.

B. Adoption of the section 83 Economic Benefit Regime.

C. Elimination of Mutually Exclusive Regimes.

 

II. Technical Issues.

 

A. Clarification of Economic Benefit and Current Access under section 61.

B. Valuation of Policy Cash Value.

C. Valuation of Life Insurance Protection.

 

III. Effective Date.

 

* * *

 

 

I. Policy Issues.

 

A. Treatment of "Current Access" under Code section 83 as a Transfer of Beneficial Ownership.

 

We recognize that the 2003 proposed regulations adopt a concept of "current access" that is similar to that proposed in the ACLI letter of January 6, 2003. We agree that the concept of current access is generally an appropriate trigger for a taxable event. However, we disagree strongly that "current access" results in a "taxable interest in policy cash value" under Code section 61, as provided by the preamble to the 2003 proposed regulations. Instead, we remain convinced that the Code generally requires that the taxation of a grant of "current access" be determined under the economic benefit regime of Code section 83 for the following reasons:

 

1. "Current access" to the policy cash surrender value will generally constitute a "transfer" of a beneficial ownership interest in the cash surrender value under regulation section 1.83-3, instead of a "taxable interest in policy cash value" under section 61.

2. Code section 83 and regulation section 1.83-3 do not limit a transfer of a beneficial ownership interest to a formal change of ownership title or the issuance of a new policy, as do the proposed regulations, but contemplate that such a transfer can occur in many different ways, based on substance (i.e., beneficial ownership), not form.

3. Code section 83 rules preempt any inconsistent section 61 rules when there is a transfer of a beneficial ownership interest in property that is subject to such section 83 rules. Regulation section 1.61-2(d)(6).

 

Code section 83 provides that the property transferred in connection with the performance of services is taxable in the first year that the rights of the person having beneficial ownership are transferable or not subject to a substantial risk of forfeiture. This section is a codification of the economic benefit rules as they apply to such transfers of property and is more specific than section 61.

Regulation sections 1.83-1(a)(1) and 1.83-3(a)(1) and Rev. Proc. 83-38, Sec. 2.02 and 2.03, provide that (1) the transferee of property is treated as the tax owner of such property for all tax purposes when beneficial ownership therein is transferred and becomes substantially vested, and (2) until such property becomes substantially vested, the transferor shall be treated as the tax owner of such property and any income from such property received by the employee or the right to the use of such property shall constitute additional compensation income and shall be included in the gross income of the employee for the taxable year in which such income is received or such use is made available. Regulation section 1.83-3(e) provides that in the case of a transfer of a life insurance policy, only the cash surrender value of the policy is considered property.3

Regulation section 1.83-3(a)(1) states that a transfer of property occurs when a person acquires a beneficial ownership interest in the property. Sections 1.83-3(a)(2)-(6) of the regulations indicate that a transfer occurs where the transferee incurs the risk that the value of the property at the time of the transfer will decline substantially, where there is no requirement that the property be returned upon the happening of an event that is certain to occur, such as termination of employment, or where the consideration to be paid to the transferee upon surrendering the property approaches the fair market value of the property.

Regulation section 1.83-3(b) provides that property is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture. Regulation section 1.83-3(c) states that substantial risk of forfeiture exists where rights in the property that are transferred are conditioned directly or indirectly on the performance of substantial services or the occurrence of a condition related to the purpose of the transfer and the possibility of forfeiture is substantial if the condition is not satisfied. Regulation section 1.83-3(d) states that a property is transferable if property can be sold, assigned or pledged.

Regulation section 1.83-3(c)(4), Example (4) illustrates how an employee's interest in stock of the employer becomes substantially vested to the extent of 10% per year, causing the employee to be treated as the tax owner of that increasing portion of the stock each year, and thereby entitling the employee to the basis, gain and loss allocable to that increasing portion of the stock (while the employer continues to be treated as the separate tax owner of the remaining non-vested portion of such stock under regulation section 1.83-1(a)(1)).

Accordingly, existing regulation sections 1.83-1(a)(1), 1.83-3 and 1.61-2(d)(6) require the following tax treatment of a transfer of a beneficial ownership interest in a policy's cash surrender value (that is, when the interest becomes substantially vested):

 

1. Pursuant to regulation section 1.83-3(c)(4), Example (4), and Rev. Proc. 83-38, Sec. 2.02 and 2.03, the transferee of such beneficial ownership interest is treated as the tax owner of that portion of the property for all tax purposes (and is entitled to a cost basis therein), regardless of who is the record owner of all (or any part) of the property and regardless of who is treated as the tax owner of any other portion of the property.

2. Pursuant to regulation section 1.83-3(c)(4), Example (4), and Rev. Proc. 83-38, Sec. 2.03, the transferee's treatment as the tax owner of such vested portion of the property means that this transferee is also treated as the tax owner of any increase (or decrease) in value and other economic benefits properly allocable to such portion of the property, by analogy to the appreciation (or depreciation) and dividends allocable to the stock referred to in Example (4) and Rev. Proc. 83-38. Accordingly, as is best illustrated by the case of a variable life insurance policy (nominally owned by an employer), if an employee is allowed "current access" to 10% of its cash surrender value during a year in such a way that the employee is treated as having a (substantially vested) beneficial ownership interest in such 10% of the policy under regulation section 1.83-3, then the employee will be treated as --

 

a. the tax owner of such 10% of the policy;

b. the tax owner entitled to any basis allocable to the tax cost and other costs of acquiring such 10% beneficial ownership interest;

c. the tax owner entitled to the tax-free increase (or decrease) in such 10% of the fluctuating cash surrender value; and

d. the tax owner entitled to the cost of life protection and any other policy benefits that are allocable to such 10% beneficial ownership interest.

 

3. Furthermore, as is indicated by Example (4), if the employee is also allowed a similar "current access" to an additional 10% of the policy's cash surrender value over each of the next 9 years, then the employee will be treated as the tax owner of such additional 10% beneficial ownership interest in the policy each year, as well as all of the policy benefits and basis allocable to such beneficial ownership interest. As a result, by the end of the tenth year the employee will be treated as the tax owner of the entire policy, regardless of who is the record owner of the policy.

4. In the meantime, if the employee is also entitled to all of the remaining current life insurance protection provided by the policy, then the employee will be subject to tax each year under Code section 61 only on the annual term cost for the portion of such protection allocable to the decreasing portion of the policy for which the employee is not treated as the tax owner for that year (e.g., 80% for year 2 and 70% for year 3), in accordance with regulation section 1.83-1(a)(2) and Rev. Proc. 83-38, Sec. 2.02.

 

Section 1.61-22(d)(3)(ii)(A)(2) of these 2003 proposed regulations provides that the value of the economic benefits provided to a "non-owner" equals the amount of policy cash value in which the non-owner has "current access." A non-owner has "current access" to that portion of the policy cash value that is directly or indirectly accessible by the non-owner, inaccessible to the owner, or inaccessible to the owner's general creditors. Proposed regulation section 1.61-22(d)(3)(ii)(C). "Current access" is further defined in the preamble as follows:

 

For this purpose, "access" is to be construed broadly and includes any direct or indirect right under the arrangement of the non-owner to obtain, use, or realize potential economic value from the policy cash value. Thus, for example, a non- owner has current access to policy cash value if the non-owner can directly or indirectly make a withdrawal from the policy, borrow from the policy, or effect a total or partial surrender of the policy. Similarly, for example, the non-owner has current access if the non-owner can anticipate, assign (either at law or in equity), alienate, pledge, or encumber the policy cash value or if the policy cash value is available to the non-owner's creditors by attachment, garnishment, levy, execution, or other legal or equitable process. Policy cash value is inaccessible to the owner if the owner does not have the full rights to policy cash value normally held by an owner of a life insurance contract. Policy cash value is inaccessible to the owner's general creditors if, under the terms of the split dollar life insurance arrangement or by operation of law or any contractual undertaking, the creditors cannot, for any reason, effectively reach the full policy cash value in the event of the owner's insolvency.

 

We believe that the definition of "current access" in the proposed regulations generally is consistent with the definition of "transfer" in the Code section 83 regulations. That is, providing an employee with "current access" will constitute a transfer of beneficial ownership instead of a "taxable interest in policy cash value." The indicia listed in regulation section 1.83-3(a) that a transfer of property has occurred should be applied to determine whether an employee with "current access" to the policy cash surrender value is considered to have received a transfer of a beneficial ownership interest in such cash surrender value under Code section 83. For instance, the employee bears the risk that the interest conveyed could be lost if the value of the policy declines substantially, e.g., because the policy is a variable policy and the market declines or because the insurer becomes insolvent. Where the cash surrender value is inaccessible to the employer or the employer's creditors, this indicates that the employee has the equivalent of a secured promise to pay from the employer under regulation section 1.83- 3(e), and this creates a "property" interest for the employee. Again, the employee generally bears the risk of loss if this property interest declines in value, indicating that beneficial ownership therein has been transferred to the employee under regulation section 1.83-3(a). There is also no requirement that the life insurance policy be returned upon any particular event, and the employee is entitled to the full market value of its interest in the policy cash value upon a surrender.

Once a beneficial ownership interest in the cash surrender value of a life insurance policy is "transferred," Code section 83 rules preempt any inconsistent section 61 rules. Regulation section 1.61- 2(d)(6) expressly provides that: "Certain property transferred, premiums paid, and contributions made in connection with the performance of services after June 30, 1969 - (i) Exception. Paragraph (d)(1), (2), (4), and (5) of this section and § 1.61-15 [dealing with compensation from services and options] do not apply to the transfer of property (as defined in § 1.83-3(e)) after June 30, 1969 . . . If section 83 applies to a transfer of property, and the property is not subject to a restriction that has a significant effect on the fair market value of such property, then the rules contained in paragraph (d)(1), (2), and (4) of this section and § 1.61-15 shall also apply to such transfer to the extent such rules are not inconsistent with section 83." (Emphasis added)

The Code section 83 rules provide that a transferee of property will be treated as the tax owner when the property transferred becomes substantially vested. Substantial vesting occurs when the property is either transferable or not subject to a substantial risk of forfeiture. "Transferable" is defined as the right to sell, assign or pledge the property. "Substantial risk of forfeiture" arises when the property rights are conditioned upon the performance of substantial services. Both of these conditions are generally satisfied when current access is conveyed.

The Code section 83 rules also provide that a transferee of property that is not substantially vested is taxed under section 61 only on the right to the use of that property. In the case of the cash surrender value of a life insurance policy, the most logical measure of the right to the use of the cash surrender value is the interest that would be imposed under the policy if the cash surrender value were borrowed. This measure of taxable income is entirely different from one that uses the annual increase in the cash surrender value.

Consequently, whenever "current access" constitutes a transfer under Code section 83, one of two tax rules applies:

 

1. when the employee's interest in the transferred property is substantially vested, the value of such property, e.g., the cash surrender value, less any "amount paid" for the property is taxable under section 83, and

2. when the transferred property is not substantially vested, the value of the right to the use of such property is taxable under regulation section 1.83-1(a)(1). In this case, we believe that it is reasonable to measure the value of the use of the cash value by imputing interest on a deemed loan.

 

In either instance, it is inappropriate to define taxable income as the annual increases in the cash surrender value under Code section 61, as is provided for in the 2003 proposed regulations.

The preamble to the 2003 proposed regulations states that "current access" creates a "taxable interest in the policy cash value" consistent with the doctrines of constructive receipt, economic benefit and cash equivalence under Code section 61. We disagree. For the reasons discussed above, the economic benefit rules of section 83 generally treat current access to the cash surrender value as the transfer of a property interest under regulation section 1.83-3 that is subject to very specific rules that control both the timing and amounts of includable compensation income and that are independent of any doctrines of economic benefit, constructive receipt or cash equivalence under code section 61. As a result, the section 61 doctrines are preempted by the more specific economic benefit rules of section 83 when a property interest is transferred subject to section 83. In that case, both the Service and the Treasury are bound by the well- established rules under section 83, which represents the subsequently enacted codification of the economic benefit rules (as they relate to the transfer of a property interest in connection with the performance of services).

Applying the doctrine of constructive receipt and cash equivalence to cash value increases in life insurance policies is inappropriate. First, these doctrines have never before applied to life insurance. It is counterintuitive that cash value increases that are not taxable to the owner of the policy become taxable to a "non- owner" under a split-dollar arrangement because he or she has the rights of the owner. This anomalous outcome is the direct result of the 2002 proposed regulations' characterization of the parties to a split-dollar arrangement as an owner and a non-owner.

Second, the tax policy concerns are aggravated when the policy is variable and losses are not recognized. Conceivably, cash value increases could be taxed in one year, lost the next year and re-taxed the following year due to market fluctuations. This result is impossible to justify, particularly when it is based on an already strained construction of the law.

The preamble to the 2003 proposed regulations also states that current access does not create a transfer because current access does not constitute "actual transfers of ownership of the underlying life insurance contract (or portion thereof) from the owner to the non- owner," as described in proposed regulation section 1.61-22(g). Proposed regulation section 1.61-22(g) refers to a transfer within the meaning of paragraph (c)(3) which in turn requires the non-owner to become the owner within the meaning of paragraph (c)(1). Paragraph (c)(1) defines an owner as "the person named as the policyowner" of the policy or "two or more persons named as policyowner" if "each person has all of the incidents of ownership with respect to an undivided interest" in the policy. In other words, the 2002 proposed regulations require a transfer to be evidenced by a change of ownership title or the issuance of a new policy. There is nothing in Code section 83 that allows such a narrow "form over substance" definition of a transfer. Rather, section 83 bases taxation on a transfer of a beneficial ownership interest, as compared to a change in formal legal title. See, e.g., regulation section 1.83-3(c)(4), Example 4, and Rev. Proc. 83-38, Sec. 2.02 and 2.03.

We also note that "current access" is defined more broadly in the 2003 proposed regulations than in the ACLI proposal or in any other code section or regulation. We are concerned that the definition in the proposed regulation is overly broad and lacks sufficient clarity. These concerns are discussed in detail in Section II.A. of this letter.

B. Internal Revenue Code Section 83 Economic Benefit Regime.

In those cases where the Code section 83 rules apply, we strongly urge that the ACLI alternative proposal, which was included in our comment letter on the 2002 proposed regulations and further elaborated upon in a supplemental submission dated January 6, 2003, be adopted. In brief, our alternative recognizes that:

 

a. Any transfer of a substantially vested beneficial ownership interest in a life insurance policy to an employee in connection with the performance of services is taxable to the employee to the extent that the value of the beneficial ownership interest exceeds the "amount paid" by the employee for such interest;

b. Such a transfer occurs when the employee has the current right to borrow, take withdrawals or transfer the policy. However, the grant of a restricted option does not create a transfer until the option is exercised;4

c. Such a transfer creates a separate beneficial ownership interest in the policy (or "account") that is treated as owned by the employee and creates a cost basis (investment in the contract under Code section 72) and premium obligation in the employee;

d. Because Code section 83 taxes the beneficial ownership interest in a life insurance policy only by reference to its cash surrender value, the ACLI proposal assumes that a transfer of a beneficial ownership interest in the cash surrender value carries with it an allocated (pro-rata) interest in the death benefit and in any other economic benefits of the policy;

e. Code section 83 regulations (e.g., section 1.83-3(c)(4), Example 4) clearly contemplate that a partial interest in property can be transferred and that such a transfer could occur without an actual change of the ownership title of the life insurance policy;

f. Where the employee has current access to all cash value accruals, the percentage of pro rata ownership could change each year as additional accruals reflect a greater percentage of cash surrender value that is treated as (beneficially) owned by the employee.

 

We propose that the ACLI alternative function either (1) as an alternative economic benefit regime under Code section 83 where applicable (e.g., where "current access" constitutes a transfer of beneficial ownership in the cash surrender value) or (2) as a clarification of where and how the economic benefit regime in proposed regulation section 1.61-22 needs to be modified to operate consistently with the applicable Code section 83 rules (to avoid being preempted by them). In the latter case, this would involve at least 3 major changes, i.e., a recognition (1) of where "current access" constitutes a transfer of beneficial ownership of part or all of the cash surrender value; (2) that a transfer is triggered by an event specified in the split dollar agreement, instead of being conditioned on a change of ownership title or the issuance of a new policy; and (3) that the employee's cost basis is increased by the cost of current life insurance protection paid by the employee or included in the employee's gross income, as well as any other amounts includable in his gross income, pursuant to section 72(f) and regulation section 1.83-4(b).

Prior to such a transfer, the employer is treated as the owner of the cash surrender value, and the Code section 61 economic benefit regime applies to tax the cost of life insurance protection to the employee. After the transfer, the employee is treated as the owner of the pro rata portion of the policy transferred. The ACLI proposal can easily be adapted to apply to other split dollar arrangements between donors and donees and between corporations and shareholders, particularly since the transfer tax provisions applicable to donor/donee arrangements are also based on property concepts.

From a tax policy standpoint, the ACLI proposal is consistent with the economic benefit principles upon which the proposed regulations are based, and does not exempt split dollar arrangements from a significant tax when "current access" is conveyed. It simply conforms the manner of economic benefit taxation more closely to the Code section 83 rules and other existing law, and preserves split dollar arrangements as a viable means of providing life insurance to employees, shareholders and donees and sharing their costs appropriately.

From an administrative and audit standpoint, the ACLI proposal is significantly less burdensome than the proposed regulations. In both cases, the split dollar agreement controls which party has "current access" to the cash value. However, under the ACLI proposal, "current access" to the cash surrender value can trigger just one taxable event; whereas the proposed regulations require the employer and the insurer to account and report cash value increases every year and to adjust the cost of current life insurance protection, and the employee's basis, by those increases every year. This continuous reporting obligation is complicated, costly and confusing, and will undoubtedly result in errors that will compound year after year.

C. Elimination of Mutually Exclusive Regimes.

The establishment of mutually exclusive tax regimes for split dollar arrangements by the proposed regulations, based primarily on formal legal title, is artificial and rigid and not consistent with current law. Under the ACLI alternative proposal, such mutually exclusive tax regimes can and should be eliminated. The ACLI proposal can apply to any split dollar arrangement, regardless of which party is the owner of record of the underlying life insurance policy, because the beneficial ownership rights are governed by the split dollar agreement. A transfer can be made by endorsement, assignment or split ownership. The parties to the split dollar arrangement can be required to set forth in the agreement which regime is applicable, and to make the accounting and reporting that must be performed by the employer and the employee consistent with that regime. Only where the split dollar agreement fails to designate the applicable regime properly would it be appropriate for the regulations to provide a presumption of a taxing regime. We suggest that, in the absence of a proper designation in the split dollar agreement, the proper presumption is the rule currently set forth in the proposed regulations, in other words, that equity collateral assignment split dollar arrangements (e.g., where the employee is the designated policyowner) are generally treated as loan arrangements and all other arrangements are subject to an economic benefit regime.

II. Technical Issues.

A. Economic Benefit and Current Access under Code section 61

From a technical standpoint, we have two significant concerns with the definition of "current access" for determining the taxation of economic benefits. First, the definition is overly broad, and second, the definition lacks sufficient clarity.

First, the definition of "current access" appears to be overly broad. The proposed regulations state that a non-owner has "current access" if the policy cash value is "directly or indirectly accessible by the non-owner, inaccessible to the owner or inaccessible to the owner's general creditors." The preamble to the 2003 regulations indicates that the non- owner has "current access" if the policy cash value is "available to the non-owner's creditors by attachment, garnishment, levy, execution or other legal or equitable process" and is "inaccessible" to the owner's creditors "if, under the terms of the split dollar life insurance arrangement or by operation of law or any contractual undertaking, the owner's creditors cannot, for any reason, effectively reach the full cash value in the event of the owner's insolvency." In Example 2 of proposed regulation section 1.61-22(d)(3)(ii)(G), the non-owner is treated as having "current access" to the policy cash value because the split dollar arrangement or state law provides that the policy cash value is "inaccessible" to the creditors of the owner. State law controls in this example, even though the "non- owner" does not have any direct or indirect right to access any portion of the policy cash value, has not contractually restricted the rights of general creditors of the employer, has no greater rights than those of a general creditor, and derives no current benefit from the state law restriction. State law would also control the availability of the policy cash value to the non-owner's creditors even though the non- owner has not contractually enhanced the rights of its creditors and does not have direct or indirect right of access himself.

One reading of the definition of "current access" as described in the preamble and in Example 2 is to potentially tax all non-equity split-dollar arrangements (i.e., those in which the employee receives no interest other than current life insurance protection), as if they were equity split dollar arrangements (i.e., those in which the employee receives an interest in the policy cash value, as well as current life insurance protection, each year) merely because of state creditor laws. For example, an employee in an endorsement split dollar arrangement who is endorsed only the current life insurance protection and has no interest in the policy cash value would be taxed on the cash value increases if the employer's creditors were restricted in any way by state law from reaching the cash value. Similarly, an employee in a collateral assignment split dollar arrangement who assigns all of his rights in the policy cash value to the employer would be taxed on cash value increases or forced into the loan regime if the employee's creditors had any right under state law to reach the cash value. We strongly believe that such results are not equitable or appropriate. To base taxation on the operation of state law alone takes away the ability of the parties to contractually establish their rights and obligations under the split dollar arrangement, and discriminates among employees based on the state in which they contract.

Deferred compensation rulings and recent legislative proposals allow tax deferral if the employee's rights are no greater than those of the employer's general creditors and if the assets financing the employer's obligations are subject to the claims of general creditors. Employees are taxed currently (and the employer is allowed a deduction) under deferred compensation plans only when the plan enhances the rights of the employee or limits the rights of the employer's creditors. In contrast, the 2003 proposed regulations impose a tax (without a corresponding employer deduction) under a split-dollar arrangement even when the employee's rights (and the rights of the employee's creditors) are not enhanced (as compared to an unsecured general creditor) and the employer's creditors have full rights provided by law to reach the policy cash value. To the extent that deferred compensation concepts are applied to split dollar arrangements, they should result in parity of tax treatment. This definition of "current access" does not accomplish that tax policy goal.

We suggest that the definition of "inaccessible to the employer's general creditors" in the preamble be revised to state that "[T]he policy cash value is inaccessible to the owner's general creditors if, under the terms of the split-dollar agreement or any contractual undertaking, the general creditors cannot effectively reach the full cash value of the policy in the event of the employer's insolvency." This rule protects the employer's creditors, is fair to the employee, and is consistent with the rules for deferred compensation.

We further suggest that the definition of "accessible to a non- owner" in the preamble be revised to state that "the non-owner has current access ... if, under the terms of the split dollar agreement, the policy cash value is available to the non-owner's creditors by attachment, garnishment, levy, execution, or other legal or equitable process." This rule protects the employer and the employer's creditors and is fair to the employee.

Second, the definition of "current access" lacks sufficient clarity. The only definition of "current access" in the proposed regulations is found in proposed regulation section 1.61- 22(d)(3)(ii)(C). This section states that a "non-owner" has "current access" to that portion of the policy cash value that is directly or indirectly accessible by the "non-owner," inaccessible to the owner, or inaccessible to the owner's general creditors. Two examples are given in subsection (g) to help illustrate the definitions. In Example 1, the right to borrow or withdraw a portion of the policy cash value is viewed as "current access" to that portion. In Example 2, the fact that the portion of the policy cash value is "inaccessible to the employer's general creditors" pursuant to the terms of the split dollar arrangement or applicable state law is sufficient to treat the employee as having "current access," even though the employee has no direct or indirect access to any portion of the policy cash value. A more complete listing of rights that constitute "current access" is found in the preamble to the 2003 proposed regulations, but even this language is general and uses many undefined terms. For example, there is no explanation of what the term "indirectly" means and whether it restricts the employer's right to borrow from the policy and make an unrelated payment to the employee. In any event, this language will not have the force and effect of a regulation.

Split-dollar arrangements should not become a trap for the unwary. To our knowledge, no one would knowingly enter into a split dollar arrangement if he or she understood that the gain accruing in the life insurance policy might be taxable each year. It is essential, therefore, that the regulations establish clear boundaries around the concept of "current access," so that both parties to the split dollar arrangement can know with certainty that they will fall outside of them. This can be accomplished through safe harbor language that could be included in the split dollar agreement, or by clear examples in the regulations of what does not constitute "current access." What will not work is a general definition of "current access" that can be interpreted to include unexpected non- owner interests. That type of regulation leads to uncertainty and a trap for the unwary or, worse, a trap for the unlucky.

We propose that the regulations provide a safe harbor prohibition of "current access" that can be included in the split dollar agreement. If the employee is prohibited by the split dollar agreement from "current access" to the cash surrender value, as defined in the safe harbor, no taxable event will be triggered with respect to the cash surrender value under the regulations. If the safe harbor language is not used, the parties may still be able to prove that the split dollar agreement is adequate to prevent "current access," but they cannot rely on the safe harbor.

We suggest the following safe harbor language based on the preamble language:

 

The [employer] shall have all ownership rights in the policy provided by law and the policy terms and the [employer's] general creditors shall have all rights provided by law to assert and enforce a claim against the cash surrender value of the policy in the event of the [employer's] insolvency. The [employee] shall not have any current right, directly or indirectly, to make a withdrawal from the policy, borrow from the policy, effect a total or partial surrender of the policy, anticipate, assign (either at law or in equity), alienate, pledge or encumber the policy or exercise any other ownership rights in the policy, and this agreement shall not provide the [employee's] creditors any current right (and shall be interpreted to preclude any such right) to assert a claim against the cash surrender value of the policy by attachment, garnishment, levy, execution or other legal or equitable process.

 

B. Valuation of Policy Cash Value.

The 2003 proposed regulations provide that "policy cash value" is determined without regard to surrender charges or other similar charges or reductions. This definition raises a number of questions. First, we assume that "policy cash value" is equal to the gross cash value that the company calculates. Second, we question why the "policy cash value" is determined without regard to surrender charges. The Code section 83 regulations and Code section 72(m)(3)(C) both look to the cash surrender value, instead of the gross cash value, as the measure of the economic benefit provided by a life insurance policy in both qualified and nonqualified compensatory arrangements. Code section 72(e)(5) also taxes partial and full surrenders from life insurance policies based on the "amount received," which reflects a reduction for surrender charges. It is logical that the same tax should apply on a constructive receipt as would apply on an actual receipt under these sections. We would add that, to the extent the Service is concerned about manipulation of amounts of cash surrender value, the Service can look to its "artifice and device" provision.

The 2003 proposed regulations provide further that "policy cash value" is determined on the last day of the non-owner's taxable year. In addition, solely for purposes of the employment tax and the penalty for failure to pay estimated income taxes, the portion of the "policy cash value" that is treated as provided by the owner to the non-owner during the non-owner's taxable year is treated as provided solely on the last day of that taxable year. The Service and the Treasury have requested comments on whether a different date would be appropriate for employment tax withholding purposes. Our members believe that requiring an actual valuation of the employee's portion of the cash value on December 31 is not feasible given the payroll systems that are currently in place. Most payroll systems perform the actual FICA tax calculation several days or even weeks before the end of the year, so that the proper amount is available for deposit with the Service by the relevant due date.

If actual valuation of the cash value is delayed until December 31, then in the case of many large employers, there will not be any time for the insurer to convey the cash value figures to the employer and for the employer still to calculate, deduct and deposit the employee's portion of the FICA tax in a timely manner. Failing this, the employer would be compelled to pay the FICA tax from its own funds and to try to recover it from the employee later or deposit all of the employment taxes with the Service late and incur a penalty. In addition, December 31 is not the date that many insurance company systems automatically report the cash value of their policies. Most systems are designed to report the cash value on the policy anniversary, and the system changes necessary to report the values on a different date would require considerable expense.

We believe that the more appropriate approach would be for the employer to use the cash value on the policy anniversary. Where the policy anniversary falls after the date on which payroll data for the year is processed, the employer could make a "good faith" estimation of the value of the employee's taxable interest in the cash value on or about the date that the employer processes its last payroll data with respect to the employee's taxable year. This amount would then be trued-up in the next taxable year and reflected in the next year's taxable value.

C. Valuation of Life Insurance Protection.

As we requested in our comments to the 2002 proposed regulations, we request that the use of an "average death benefit" for purposes of valuing the current life insurance protection be replaced with the use of the death benefit on the policy anniversary or December 31 of each year, at the life insurance company's discretion. Our members have systems in place that calculate the death benefit on the policy anniversary or December 31 and convey that information to the policyowner in the annual statement. Requiring an "average death benefit" would require new systems to be designed at significant expense to our member companies, and would confuse the policyowner because it would produce a different value from the one shown on the annual policyowner statement. We believe that the cost and confusion of this approach is not justified when the value of the death benefit cannot be manipulated and when this value is disclosed to the policyowner on the annual policyowner statement.

III. Effective Date.

We believe that it is crucial that the final regulations define "split-dollar arrangement" and clarify which events constitute a "material modification" thereof for effective date purposes. We believe that a split dollar arrangement should refer to the agreement setting forth the rights of the parties. Therefore, any change permitted by the policy, such as the purchase of paid-up additions or increases in the death benefit under a universal life contract, or a Code section 1035 exchange, that is consistent with the split dollar agreement should not constitute a "material modification" that would trigger the application of the final regulations. Many policies are purchased because of their flexibility or are exchanged because of legitimate concerns about performance or insurer solvency. These rights are integral to the design and operation of a long-term arrangement such as a split dollar arrangement. It would be inequitable to penalize the parties to a split-dollar arrangement by subjecting the arrangement to more onerous tax rules just because the underlying policies operate according to their terms, or are exchanged for a more suitable policy, when the resulting changes are consistent with the split dollar agreement.

 

* * *

 

 

Thank you for your consideration of our comments. We look forward to the opportunity to work with the Service and Treasury in resolving the concerns raised herein.
Sincerely yours,

 

 

Laurie D. Lewis

 

cc: Pam Olson

 

Greg Jenner

 

Eric Solomon

 

William Sweetnam

 

Michael T. Doran

 

Helen Hubbard

 

Ann Cammack

 

Mark S. Smith

 

Harlan Weller

 

Michael Novey

 

Cathy Hughes

 

David Silber

 

Rebecca Asta

 

Elizabeth Kaye

 

Lane Damazo

 

FOOTNOTES

 

 

1 See, ACLI letters of October 7, 2002; January 6, 2003; and February 14, 2003.

2 For convenience, this letter discusses split dollar arrangements between an employer and employee, unless otherwise indicated.

3 It was argued in a prior comment letter filed in connection with the 2002 proposed regulations that the 2002 amendment to regulation section 1.83-3(e) is overreaching and should be substantially modified.

4 In our letter of January 6, 2003, we proposed that:

 

1. A taxable transfer of part or all of the cash surrender value occurs when the employee is treated as having a (substantially vested) beneficial ownership interest in such cash surrender value. This is deemed to occur when (i) the employee acquires the right to borrow currently, the right to withdraw currently, or the right to transfer such part (or all) of the cash surrender value of a life insurance policy currently, (ii) the employee bears the risk of loss or gain in such part (or all) of the cash surrender value, or (iii) the employee has the right to exercise currently an option to acquire such part (or all) of the cash surrender value that does not satisfy the definition of a restricted option below.

2. A restricted option to acquire part or all of the cash surrender value does not constitute a transfer of beneficial ownership until exercised. A restricted option is defined as an option that must be exercised at a time or times set forth in the split dollar agreement, with the following limits (1) no more frequently than once a year, with a meaningful option price, (2) within 90 days of severance of employment, disability, hardship, or substantial (more than 50%) reduction in the income of the employee and the employee's spouse, or (3) at any time if the option price is equal to the employer's interest in cash value.

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Lewis, Laurie D.
  • Institutional Authors
    American Council of Life Insurers
  • Cross-Reference
    For a summary of the July 9, 2002 regulations (REG-164754-01), see

    Tax Notes, July 15, 2002, p. 361; for the full text, see Doc

    2002-16108 (24 original pages) [PDF], 2002 TNT 135-10 Database 'Tax Notes Today 2002', View '(Number', or

    H&D, July 5, 2002, p. 175. For a summary of the May 9, 2003

    regulations, see Tax Notes, May 12, 2003, p. 809; for the full

    text, see Doc 2003-11568 (21 original pages) [PDF]; 2003 TNT

    90-8 Database 'Tax Notes Today 2003', View '(Number'; or H&D, May 9, 2003, p. 1685.
  • Code Sections
  • Subject Area/Tax Topics
  • Industry Groups
    Insurance
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2003-15887 (17 original pages)
  • Tax Analysts Electronic Citation
    2003 TNT 134-73
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