Within the past year, significant changes have been made with respect to the income taxation of the equity built up in insurance policies subject to a split dollar agreement. This article explains very generally the changes in the split dollar area under the new regulations. Some options with beneficial tax consequences may not be available after December 31 of this year.  Anyone with an existing split dollar arrangement should have it reviewed as soon as possible. 

The new regulations change the tax consequences of certain arrangements where insurance policy premiums are funded by someone other than the policy’s owner, with the premiums refunded to the payor at the termination of the split dollar agreement. This situation is similar to an interest-free loan. Increases in the cash surrender value of the insurance policy have not been subject to income tax, and no interest has been due on the loan of premiums.

Under new regulations passed last month, any new equity split dollar arrangement must either (i) be treated as a loan, with interest imposed at the lowest appropriate rate, or (ii) result in an income tax imposed on the equity built up in the insurance policy annually (with the equity being the amount by which the policy’s value exceeds the premiums paid).  This makes the use of a split dollar arrangement as a source of funding the policy significantly less attractive.

Anyone with an existing split dollar plan in place must consider the effect of the new regulations on the plan. Depending on the form of the agreement and factors related to the insurance policy (such as the equity in the policy and future premiums), it may make sense to either convert the split dollar arrangement to a loan with interest or to terminate the split dollar plan and repay the payor of the policy for premiums paid as required under the split dollar plan. If a plan is not modified, the equity in the split dollar arrangement will be subject to income taxes if the plan ends before the insured’s death (such as at the surrender of the policy). The income tax consequences of a conversion or termination of an existing plan  could, in many circumstances, be substantially worse if these actions are taken after January 1, 2004. Generally, if a plan is converted or terminated prior to December 31, no income taxes will be recognized. Alternatively, a change in the structure of an equity split dollar arrangement to a loan with interest or a termination of a plan after January 1 will result in income recognized on the owner’s equity in the policy.

Evaluating the best approach to deal with the impact of the new regulations is complex. Parties to a split dollar arrangement should contact their tax professional before year-end for a review and analysis.