Split Dollar Endorsement Method
A split-dollar arrangement is a method of purchasing life insurance in which the premium payments and policy benefits are divided in some predetermined way, usually between a business and an employee-but sometimes between two individuals. In a business setting, split dollar is an executive benefit, with the employee being the insured. The premium payments and proceeds are split between the employer and the employee. Split-dollar is a method of buying life insurance, not a reason for buying it. A need for life insurance should always exist before a split-dollar arrangement is implemented. In a business setting, it may be the employer's need to provide a valuable fringe benefit to retain a key employee, or to attract a key employee into the business. For the employee, the split-dollar arrangement provides life insurance protection for survivors at a lower net cost than personally purchased policies. Policy ownership in split-dollar arrangements can be structured in different ways. Two of the most popular are the endorsement method and the collateral assignment method. Here we focus only on the former. The method chosen would have important tax consequences under proposed regulations issued by the Treasury Department. Under the endorsement method, the employer usually owns the policy and a special endorsement to the policy spells out the employee's rights. Typically, this endorsement gives the employee the right to name a personal beneficiary for the employee's share of the death proceeds as prescribed in the split-dollar agreement between the parties. Premiums and death proceeds can be split in a variety of ways, as spelled out in the agreement between the parties. Under the original or "classic" split-dollar arrangement, which is rarely used nowadays, the employer's share of the premiums equals the annual increase in the cash surrender value of the policy. The employee pays the balance of the premium. If the employee dies while the classic arrangement is in effect, the employer receives that portion of the death benefit equal to the aggregate amount of premiums it has paid, or the cash value, depending on the terms of the arrangement. If the employer's recovery is limited to total premiums paid, the net cost to the employer is the loss of the use of the premium dollars while the arrangement is in effect. The level contribution method was designed to ease the employee's burden of having to bear more of the premium cost during the early years under the classic split-dollar arrangement, when the annual cash value increases (and thus the employer's share of the premium) are lower. Each year the employee pays a level amount equal to the guaranteed cash value of the policy at the employee's retirement (or earlier cutoff), divided by the number of years until the employee's retirement (or earlier cutoff). Thus, if the cash value of the policy will be $40,000 when the employee retires in 20 years, the employee would pay a level premium of $2,000 per year. In an employer-pay-all arrangement, the employer advances the entire premium. The sharing of the death benefit under this arrangement can be designed so that the employer recovers its entire investment (net premiums paid) or perhaps the cash value of the policy at the time of the employee's death. The balance of the proceeds in both instances is paid to the employee's beneficiary. Under the so-called "reportable economic benefit equals zero" method, the employee pays the amount of the premium each year that exactly equals the reportable economic benefit that the employee would otherwise have to include in gross income. The employer pays the balance of the premium. This arrangement was designed to offset the taxable income that would otherwise result to the employee. The employer sometimes bonuses to the employee an amount sufficient to pay the employee's share of the premium. The bonus is deductible by the employer as compensation paid, which essentially makes this part of the premium deductible. An obvious disadvantage of the traditional forms of split-dollar is that the death benefit payable to the employee's beneficiary declines each year as the employer's total premium payments or the cash value of the policy increases. For an employee whose need for insurance protection will remain constant for a number of years, the progressive decrease in such protection represents a serious flaw in the purpose of the arrangement. To cure this flaw, the so-called "fifth dividend option" was made available on many participating life insurance products (i.e., policies which may pay dividends, although dividends are not guaranteed). Under this option, policy dividends purchase one-year term insurance each year to make up for the decline in the death benefit under the basic policy. Some companies use a "paid-up additions" or term life insurance rider to accomplish the same goal. The increasing death benefit option on universal life and variable universal life can accomplish the same purpose. The taxation of split-dollar arrangements currently is in a state of flux. The IRS issued Notice 2001-10 in January 2001 to provide interim guidance while it reconsidered the tax rules applicable to split dollar. The rules had been largely unchanged since 1964. In January 2002, the IRS issued Notice 2002-8, which revoked the Notice 2001-10. The new Notice provided some new interim rules and safe harbor protections for existing arrangements, and indicated that proposed regulations on split dollar would be forthcoming. These proposed regulations were issued in July 2002, but they will not apply to split-dollar arrangements until they are made final (perhaps with important changes). The proposed regulations provide for two alternative tax regimes governing the taxation of split-dollar life insurance arrangements. Which regime applies hinges generally, with some exceptions, on whether the particular arrangement was set up under the endorsement method or the collateral assignment method. The "economic benefit regime" generally would apply to the conventional endorsement method arrangement in which the employer owns the policy and the employee's rights are spelled out in an endorsement to that policy. Under the economic benefit regime, the owner of the life insurance policy is deemed to provide an economic benefit to the other party to the arrangement. Under the proposed regulations, the economic benefit regime would apply if: - The arrangement is entered into by an employer and employee in connection with the employee's performance of services for the employer, and the employee is not the policy owner, or
- The arrangement takes the form of a gift from one party to another (unrelated to employment), and the donee is not the policyowner.
The regulations will apply to new split-dollar arrangements when the regulations are issued in final form. The method of valuing the taxable economic benefit in an arrangement taxed under the economic benefit regime has been left open for now, and should be clarified in the final regulations. Until the regulations are finalized, the IRS has provided a set of interim rules in Notice 2002-8 to govern split-dollar life insurance arrangements in the meantime. These interim rules contain several safe harbors and grandfathering provisions for existing split-dollar arrangements. | 
