Split-Dollar Exit Strategies: Ending an Arrangement

When It May Not Fit: Situations That Complicate Exit

Some facts make an exit harder or more costly:

• A cash value shortfall. The cash value is below the employer's cumulative premiums, and the employee cannot cover the gap.
• Declining health. The insured's health has declined, so replacement coverage may be costly or unavailable if the policy lapses.
• A silent agreement. The agreement names no exit method, which invites disputes over valuation and the employer's recovery right.
• A large loan balance. Under the loan regime, the employee cannot repay the balance, and forgiveness then becomes the issue.
• A pre-2003 arrangement. The arrangement predates the final regulations and has not been brought under them, so a separate analysis under earlier guidance applies.

Tax Treatment: Federal Income-Tax Rules at Exit

Policy transfer under the economic benefit regime. Section 83 of the Internal Revenue Code governs "property transferred in connection with performance of services." For a transfer of a contract providing life insurance protection, 26 C.F.R. § 1.83-3(e) provides that "the policy cash value and all other rights under such contract ... other than current life insurance protection, are treated as property." Under 26 C.F.R. § 1.61-22(g)(1), when ownership of the contract is transferred to the non-owner, the transferee takes into account the excess of the contract's fair market value over the sum of the amount the transferee pays for it and the cash value and other economic benefits already taken into account (or paid for) under § 1.61-22(d)(2)(ii) and (iii). Section 1.61-22(g)(2) defines that fair market value as "the policy cash value and the value of all other rights under such contract ... other than the value of current life insurance protection." For a transfer made in connection with the performance of services, § 1.61-22(g)(3) provides that paragraph (g)(1) "does not apply until such contract ... is taxable under section 83." For arrangements entered into on or before September 17, 2003 and not materially modified, 26 C.F.R. § 1.83-3(e) treats only the cash surrender value as property.

Valuation. Rev. Proc. 2005-25 provides safe-harbor formulas for the fair market value of a life insurance contract for purposes of sections 79, 83 and 402. One formula, for non-variable contracts, uses an "Average Surrender Factor," and a separate formula applies to variable contracts. Its conditions apply as written.

Employer recovers its interest. Where the employer takes back its interest and the employee receives nothing further, the economic benefits for earlier years are taken into account year by year under 26 C.F.R. § 1.61-22(d), and under § 1.61-22(d)(5)(i) the economic benefits for the year in which the arrangement terminates are valued on the day it terminates. Under 26 C.F.R. § 1.61-22(e)(1), an amount received under the contract, such as a withdrawal or partial surrender, is treated, to the extent provided directly or indirectly to a non-owner, as though it had been paid to the owner and then paid by the owner to the non-owner, as a payment of compensation, a distribution under section 301, a contribution to capital, a gift, or other transfer depending on the relationship between them.

Loan regime. Repaying loan principal is a repayment, not income, and interest follows the rules of 26 C.F.R. § 1.7872-15. If the repayment obligation is waived, cancelled or forgiven, 26 C.F.R. § 1.61-22(b)(6) requires the parties to take the amount into account in accordance with their relationship, for example as compensation in the case of an employee-employer relationship. A policy transferred in satisfaction of a loan raises fact-specific questions.

Deductions. Section 264(a)(1) allows no deduction for "premiums on any life insurance policy ... if the taxpayer is directly or indirectly a beneficiary under the policy." Compensation, by contrast, falls under section 162(a)(1), which allows "a reasonable allowance for salaries or other compensation," subject to reasonableness.

Transfer for value. Under section 101(a)(2), a transfer "for a valuable consideration" can limit the death-benefit exclusion to the consideration paid plus later premiums. Section 101(a)(2)(B) excepts transfers "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer." Whether a transfer of a policy between owners qualifies for an exception needs individual review by the insurers involved and a qualified tax professional.

Potential Advantages: What a Well-Structured Exit Can Accomplish

A structured exit can serve both parties, depending on the agreement's terms and the regime that applies:

• The employee may keep a permanent policy, with its cash value as a contract feature, without having to qualify for new coverage.
• The employer may recover its premium outlay, or a defined portion of it, under a known formula.
• A rollout under the economic benefit regime may turn an employer-sponsored benefit into an individually owned policy, removing the employer going forward.
• Under the loan regime, full repayment of the balance may close the arrangement without raising the question of forgiveness.
• A planned exit may avoid the uncertainty of an unplanned termination caused by death, disability or separation.

None of these outcomes is assured. Each depends on the contracts, the policy's performance and the facts at exit.

Important Considerations: What Can Go Wrong

Valuation drives most of the risk at exit. The policy's fair market value is the starting figure for the employee's income under 26 C.F.R. § 1.61-22(g) and section 83, and the IRS guidance in Rev. Proc. 2005-25 applies only on its own terms.

Other issues often arise:

• Loan growth. Years of below-market loans can build a large balance, which makes forgiveness a larger income event.
• Policy performance. Cash value below projections can leave the employer's recovery interest above the policy's value.
• Insurer procedures. A release or retitling requires the insurer's cooperation. Forms, procedures and timing vary by insurer.
• Pre-2003 arrangements. Earlier guidance may govern these arrangements.
• State rules. Replacement and other insurance rules vary by state.

A rollout may also involve exchanging the existing policy for a new one under the federal rules for policy exchanges. An exchange adds its own conditions and its own interaction with the arrangement's exit.

Tax and Legal Coordination: What Professionals Review at Exit

Professional review at exit usually follows a sequence:

1. Read the agreement. The original split-dollar agreement sets the exit method, the valuation basis and each party's rights.
2. Confirm the regime and the date. The parties determine whether the economic benefit regime or the loan regime applies, and whether the arrangement predates September 18, 2003.
3. Value the policy. The policy is valued under Rev. Proc. 2005-25 or another method.
4. Coordinate with the insurer. The insurer releases the collateral assignment or retitles the policy.
5. Take the income into account. The amounts the employee takes into account are determined under the regime that applies. Any employer deduction turns on section 264(a)(1) and the reasonableness standard of section 162(a)(1).
6. Check transfer for value. If the policy changes hands, the section 101(a)(2) analysis applies.

The site's page on business life insurance ownership explains how ownership drives each of these questions. Structure, ownership and tax treatment are confirmed with qualified tax, legal and insurance professionals.

Alternatives: Other Ways to End or Transition the Arrangement

A rollout is not the only way to end an arrangement.

• Surrender. The owner surrenders the policy and receives the cash surrender value. The arrangement ends, the death benefit ends, and gain on surrender is generally taxable.
• Lapse. The policy ends for non-payment of premiums, and both parties' interests generally end with it.
• Shift to an executive bonus structure. The employer stops split-dollar funding and pays premiums as compensation to the employee, who owns the policy. "Executive bonus plan" and "section 162 plan" are industry shorthand for this arrangement; neither is a qualified retirement plan, section 162(a) is a deduction rule, and neither term is defined in the Code or the regulations. Any deduction rests on section 162(a)(1) reasonableness, and the bonus is taxable to the employee.
• Continuation. The parties keep the arrangement running, and the regime's annual treatment continues.

The site's overview of split-dollar life insurance explains the arrangement itself. The detailed annual rules are on the page on split-dollar taxation.

Example (Hypothetical): Rollout Under the Economic Benefit Regime

This example is hypothetical, and every figure in it is assumed.

Assumptions:

• The employer owns the policy under the endorsement method.
• The economic benefit regime applies.
• The arrangement was entered into after September 17, 2003.
• The policy has been in force for 10 years.
• The employer has paid $200,000 in cumulative premiums.
• The agreement gives the employer the return of its premiums paid at rollout.
• The employee pays that amount from other assets and receives the policy.
• The employee has not taken any policy cash value into account in earlier years, and the employee's rights in the policy are not subject to a substantial risk of forfeiture.

Step 1. The employer's recovery interest. Under the assumed terms, the recovery interest is $200,000. If the agreement instead gave the employer the greater of premiums paid or cash value, the employer's share would absorb the cash value, and the employee would receive no equity.

Step 2. The value of the policy. Assume a fair market value of $320,000 for the policy. This figure is assumed for the example, not calculated.

Step 3. The employee's income. $320,000 value received − $200,000 paid by the employee = $120,000 that the employee takes into account under 26 C.F.R. § 1.61-22(g)(1).

Step 4. The employer's recovery. The employer receives $200,000. Its tax treatment depends on the arrangement's facts.

Actual results depend on the policy, the agreement and the regulations. A qualified tax professional confirms the valuation and the income figure for any real arrangement.