Loan Regime Split-Dollar: When Premium Payments Are Loans

When the Loan Regime May Not Fit

Some situations make the structure awkward or unavailable.

• The employer owns the policy. The owner and non-owner roles are then reversed, and the economic benefit framework of Treas. Reg. § 1.61-22 is generally where the analysis begins.
• Administration is unwelcome. The arrangement requires tracking each advance, interest accrual and the applicable federal rate for as long as it lasts.
• Values may fall short. If cash value does not cover the balance at termination, the borrower may face a shortfall to pay from other assets, depending on the loan terms.
• Heirs need the full death benefit. Repayment to the lender reduces what the beneficiary receives.
• Employment may end early. Separation can trigger repayment under the agreement, and under Treas. Reg. § 1.61-22(b)(6) a repayment obligation that is waived, cancelled or forgiven is taken into account by the parties, for example as compensation between an employer and an employee.
• Deduction assumptions. Section 264(a)(1) provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy." A lender secured by the death benefit may be affected by that rule.

Tax Treatment Under the Loan Regime

Section 7872 supplies the core rules once a split-dollar loan is below-market. Forgone interest, defined in section 7872(e)(2) as the excess of interest at the applicable federal rate over any interest actually payable, is treated as moving from lender to borrower and back as interest. Notice 2002-8 described the employment case this way: section 7872 "deems an interest payment by the employee to the employer, which is funded by deemed additional compensation paid by the employer to the employee." In that setting the lender reports interest income and the borrower reports compensation income of the same amount. In a corporation-shareholder loan, the character of the deemed transfer follows that relationship, per Treas. Reg. § 1.7872-15(a)(1). The $10,000 de minimis exceptions of section 7872(c)(2) and (3) do not apply to split-dollar loans, under § 1.7872-15(a)(3).

If the loan provides for sufficient interest under § 1.7872-15(e), no forgone interest is imputed, but § 1.7872-15(c) still bars the borrower's deduction of that interest.

Premiums come next. Before any deduction is considered, section 264(a)(1) bars a deduction for premiums when the taxpayer is "directly or indirectly a beneficiary under the policy."

On the death benefit, section 101(a)(1) generally excludes from gross income amounts "paid by reason of the death of the insured." Section 101(a)(2) limits the exclusion after a transfer for valuable consideration, subject to its listed exceptions. For an employer-owned contract, section 101(j) caps the exclusion at premiums and other amounts paid unless a section 101(j)(2) exception applies and the written notice and consent requirements were met before issuance; neither alone lifts the cap. Whether the lender is an indirect beneficiary under section 264(a)(1), whether section 101(j) reaches the contract and whether a policy transfer triggers section 101(a)(2) all need individual review of the contracts involved by the insurers and a qualified tax professional. Fuller treatment appears under business life insurance tax treatment.

Potential Advantages of the Loan Regime

Each of these is a feature of the structure, not a result any particular arrangement will produce.

• The executive or trust owns the policy and, under typical terms, keeps the cash value above the outstanding loan.
• Premiums are characterized as loans rather than current compensation; any imputed income instead follows section 7872 when the loan is below-market.
• The employer has a contractual right to recover its advances from the death benefit or cash value.
• After repayment, the remaining death benefit goes to the owner's beneficiary, and section 101(a)(1) generally excludes death proceeds from gross income, subject to sections 101(a)(2) and 101(j).
• The arrangement is taxed under the loan rules rather than through annual economic benefit inclusions under Treas. Reg. § 1.61-22.

Important Considerations

Documentation carries much of the weight. The written split-dollar agreement typically states ownership, premium obligations, loan terms, repayment mechanics and the security interest.

The nonrecourse rule is specific. Under Treas. Reg. § 1.7872-15(d)(2)(i), an otherwise noncontingent payment on a nonrecourse loan "is not a contingent payment" if the parties "represent in writing that a reasonable person would expect that all payments under the loan will be made." Until the IRS prescribes otherwise, "Both the borrower and the lender must sign the representation not later than the last day (including extensions) for filing the Federal income tax return of the borrower or lender, whichever is earlier," for the year of the first split-dollar loan, and it must include the names, addresses and taxpayer identification numbers of the borrower, lender and any indirect participants. Without it, payments may be treated as contingent payments under the regulation.

Other points recur:

• Rate tracking. Section 7872(f)(2) states the applicable federal rate in general terms, but a split-dollar loan follows the regulation: a split-dollar demand loan is tested each calendar year against "the blended annual rate for the year," which the Internal Revenue Service publishes in the Internal Revenue Bulletin in July of each year (§ 1.7872-15(e)(3)(ii)), and a split-dollar term loan is tested on the day it is made against the applicable federal rate "appropriate for the loan's term" (§ 1.7872-15(e)(4)(ii)).
• Separate advances. T.D. 9092 explains that treating separate extensions of credit as separate loans "most accurately accounts for the benefits provided."
• Policy performance. T.D. 9092 notes that in early years, surrender and load charges "may significantly reduce the policy's cash surrender value," leaving the lender under-collateralized.
• Termination. If the arrangement ends during life, the agreement typically makes the balance due, which may mean repayment from other assets or a policy surrender.
• Interest cost. The bar on the borrower's interest deduction under § 1.7872-15(c) applies for as long as the loan is outstanding.

Insurer forms, charges and timing vary and are confirmed with the insurers involved.

Tax and Legal Coordination

Coordination is built into the structure rather than added at the end. The loan regime joins federal income tax law under section 7872, life insurance contract terms, and the employment or corporate relationship between the parties, so tax, legal and insurance professionals typically each have a part.

The written agreement is a legal document whose terms drive the analysis under Treas. Reg. § 1.7872-15, and it needs to match the policy's actual ownership and beneficiary designations. Where a business owns a contract, is a beneficiary and the insured is its employee, section 101(j) defines an "employer-owned life insurance contract," and the exclusion cap lifts only when a section 101(j)(2) exception applies and the notice and consent of section 101(j)(4) were completed "before the issuance of the contract." Whether the lender's security interest makes it an indirect beneficiary under section 264(a)(1) turns on the specific facts. Employment tax, estate tax and gift tax treatment also depend on the facts. Related reading includes how each split-dollar regime is taxed.

Alternatives to the Loan Regime

Several other structures address the same business problem.

• Economic benefit split-dollar. Under Treas. Reg. § 1.61-22, the benefited party includes the value of economic benefits provided under the arrangement, rather than the payments being treated as loans.
• Executive bonus arrangement. The employer pays the premium as added compensation, which section 162(a)(1) addresses as "a reasonable allowance for salaries or other compensation for personal services actually rendered," and the employee owns the policy and includes the bonus in income. "Executive bonus plan" and "section 162 plan" are industry shorthand for this arrangement. Section 162(a) is a deduction rule; it does not create a qualified retirement plan, and neither term is defined in the Internal Revenue Code or the Treasury regulations.
• Restricted executive bonus arrangement (REBA). A bonus variation in which an agreement restricts the employee's access to the policy; also an industry label, not a Code term.
• Nonqualified deferred compensation funded with life insurance. A separate structure with its own federal rules.

The choice turns on the parties' objectives, the intended ownership and the tax treatment each side can accept.

Example (Hypothetical): How a Loan Regime Arrangement Is Taxed

This example is hypothetical. Its assumptions:

• A C corporation lends $20,000 a year in premiums to an executive-employee who owns the policy.
• The loan is a demand loan bearing no interest.
• The rate used to test the loan for sufficient interest (the blended annual rate under § 1.7872-15(e)(3)(ii)) is assumed to be 4% for every year. This is an invented round number, not a published rate for any year.
• The loan is nonrecourse, secured only by the death benefit and cash value, and the § 1.7872-15(d)(2) representation is signed.
• Compounding and intra-year timing are ignored for simplicity.

Year 1.

1. Outstanding balance: $20,000.
2. Forgone interest: $20,000 × 4% = $800.
3. The corporation is treated as paying the executive $800 of compensation.
4. The executive is treated as paying $800 of interest back.
5. The executive includes $800 as compensation; the corporation reports $800 of interest income; the executive may not deduct the $800, per § 1.7872-15(c).

After five years.

1. Principal: 5 × $20,000 = $100,000.
2. At termination or death, $100,000 is owed to the corporation, repayable only from the policy's death benefit and cash value.

Actual results depend on the rate each year, the loan terms, policy performance and other facts. The figures illustrate mechanics only and are not a coverage or tax recommendation.