A vital financial-planning tool for high-income individuals--from corporate executives to small-business owners--just got a reprieve. A year ago, the Internal Revenue Service threatened to ratchet up taxes on "split-dollar" life insurance, retroactively hurting existing plans and making it less desirable to set up new ones. But now the IRS has backed down--and tax experts and financial planners are celebrating. "This gives us back the breathing room that the IRS took away last year," says Andrew Liazos of the Boston law firm McDermott, Will & Emery.
In a split-dollar plan, an employer generally buys life insurance on a key employee, with the company retaining a share of ownership in the death benefits or cash value of the policy. In a typical arrangement, the employer might pay premiums for several years, wait a few years longer for the policy to build up its cash value, then reclaim its premium payments. The policy's benefits and remaining cash value would then belong to the employee. Big companies use split-dollar plans to give their executives deferred pay that they can pass along to heirs without estate taxes. The owner of a small business can use a split-dollar plan to set up a fund for estate taxes, to provide cash for children who don't want to inherit the business, or just to ensure that the owner has good life insurance.
For almost 40 years, the IRS paid little attention to split-dollar plans--and few of the plans' benefits were taxed. That all changed in January, 2001, when the IRS said it would impose higher taxes on the value of insurance that employers were providing in split-dollar plans. More ominously, the tax service said it thought an employee should be taxed on the cash value received at "roll-out," when the company reclaims its premiums. With policies worth hundreds of thousands of dollars, employees could get stuck with huge tax tabs.
That sent a shiver through the life-insurance industry, which set out to change the IRS's mind. "It was a very intense dialogue," says David Downey, a Champaign (Ill.) insurance consultant and chairman of an Association for Advanced Life Underwriting task force. On Jan. 3, the talks paid off, as the IRS revoked its 2001 ruling and issued a new notice of how it would treat split-dollar plans.
The notice gives owners of existing plans a big break: They have until the end of 2003 to unwind their arrangements without facing heavy taxes on cash values. Starting in 2004, such plans will face higher levies. But the two-year window "gives everyone time to figure out their best course," says Liazos.
For future split-dollar plans, the IRS says it will draw up two sets of rules that tax benefits according to the ownership of the policy. Roughly speaking, it will work like this:
-- If the company owns the policy--if, for example, the employer is just providing coverage during an executive's working years--the year-to-year tax tab will be less. But if the company ever decides to transfer the policy, the employee will face a stiff tax bill on the policy's cash value.
-- If the executive owns the policy--when it's being used to provide deferred compensation, for example--he or she will pay more tax while the company is paying premiums. But the executive won't be hit when the employer rolls out of the plan and turns over the remaining cash value.
That's a very generalized explanation--and split-dollar deals are almost always custom-designed. "You've got to do the arithmetic for each specific plan," cautions Ethan Kra, chief retirement actuary for benefits consultants William M. Mercer. The IRS is sending you a message: Get together with your financial adviser and crunch some numbers now. By Mike McNamee