A year following its surprise notice instituting tougher tax rules on increasingly popular equity split-dollar life insurance arrangements, the Internal Revenue Service has issued new interim guidance that revise its 2001 notice. Stiffer taxes on these arrangements are still likely once final rules are issued, but the interim rules provide added time for users of these arrangements to huddle with their financial planners to plan ways to minimize the impact.

In early 2001, the IRS issued Notice 2001-10, aimed squarely at equity split-dollar arrangements. These arrangements are especially popular with companies and their executives, and with small-business owners for either buy-sell agreements or to provide cash to pay estate taxes. There are many variations of split dollar, but in a typical arrangement under the old rules, the employee might pay a portion of the premium for a whole life policy equivalent to the premiums for a similarly valued term life policy (determined by the IRS's Table P.S. 58). If the employee pays less than the P.S. 58 table amount, the employee is taxed on the difference.

The employer pays the remaining portion of the premium, but this portion is eventually repaid out of the cash value at the insured's termination, retirement or death. Any remaining cash value goes to the employee (and the death benefits, of course, go to the beneficiary). In short, the executive or business owner receives an interest-free loan from the company, garners potentially substantial investment gains and buys life insurance at a reduced cost.

The 2001 notice hit users hard when it announced that the tax-deferred cash-value gains would be taxed when the policy is "rolled out," which is the point when policy repays the employer's premium payments, versus waiting until the employee's death. The result would be huge tax bills for some employees, including for arrangements already in existence, without the death benefits available to pay for it.

The new notice (2002-08) softens the blow. First, it's important to understand that policy ownership becomes a crucial factor. With the endorsement method, the employer owns the policy along with all equity in the policy, though ownership of such policies can be transferred later to the employee. If the policy is transferred to the employee under the proposed rules, the cash value in excess of the employee's contributions is taxed to the employee.

Under the far more common collateral assignment method, the employee or business owner owns the policy. If the insured is expected to repay the company, then the money provided by the employer is considered a series of loans and the employee owes taxes on the imputed interest. In cases where the employee is not obligated to pay back the premium loans, the loans are treated as compensation to the employee.

A real break falls for arrangements made before January 28, 2002. By either terminating the arrangement and paying back the employer or converting the arrangement to an interest-free loan before January 1, 2004, all policy equity accrued before January 1, 2004 escapes taxation. Policies terminated after the January 1 date will face taxation on the equity at the rollout date. The January 1, 2004 date should give parties time to consult with their financial advisors to see whether it's worth revamping their split-dollar arrangement.

The 2001 and 2002 notices also replaced the outdated P.S. 58 table with a 2001 table. The table more accurately reflects longer life expectancies and has the effect of shrinking the premium payment.

The new rules also allow split-dollar plans created before January 28, 2002, the option of using the old P.S. 58 rates or the new 2001 rates. Plans created on January 28 or after will use the new 2001 table until final regulations are published or an insurer's "generally available" and "regularly sold" term rates.

As complex as split-dollar arrangements are, and with some questions remaining unanswered until final regulations are published, business owners and employers will want to consult closely with their financial advisors. For one thing, until final regulations are published, taxpayers can rely on either older Notice 2002-10 or the newer notice.

This article was produced by the Consumer Affairs Dept. of The Financial Planning Association and provided to you courtesy of Nigel B. Taylor, CFP, Santa Monica, California. If you have any questions or concerns regarding this, or any other financial topic and are a resident of Southern California, please call me at 1-800-444-2237 (California residents only please), or click on the "MORE INFO" button to arrange for a free initial consultation in the comfort of your home or office.