IRS Issues New Rules on Employer Provided Life Insurance

For many years, employers have provided life insurance for their employees as a regular part of their benefit package. In addition to this typical term insurance coverage, employers have also used life insurance policies to provide extra financial benefits for employees either through a non-qualified deferred compensation plan or through a shared ownership plan known as Split-Dollar insurance. These special benefit arrangements were the target of new Internal Revenue Service regulations issued on September 11, 2003.

A primary target of the IRS attack was the Split-Dollar insurance program, but the regulations are broad enough to encompass other deferred compensation programs. In a traditional Split-Dollar plan, an employer would provide all premium payments for a permanent life insurance policy. Under a signed agreement with the employee, the employer would agree to be reimbursed only the amount of those premium payments, leaving any remaining value, including all appreciation, to the employee. Since the employer would receive no interest on the premium advances, this amounted to a substantial tax-free benefit to the employee.

In the past, the employee would be taxed only with the value of term insurance coverage (formerly known as the PS 58 cost). The IRS concern, however, was that if the policy was either terminated or transferred to the employee, all of the cash value build-up in excess of the premiums paid was transferred to the employee free of any income tax.

The new IRS regulations indicate that all future Split-Dollar plans will either (1) charge the employee with taxable income equal to the increase in cash surrender value over the premiums paid, or (2) treat the premiums paid by the employer as a loan, and charge the employee with income equal to the imputed interest on all premium payments from the inception of the Split Dollar arrangement.

Many planners feel that the use of formal Split-Dollar arrangements between employers and employees will come to a complete halt. The greater concern, however, is that the IRS, in general, will apply the Split-Dollar regulations to any permanent insurance acquired by an employer on an employee’s life. Some deferred compensation plans, funded with life insurance, could trigger unexpected income tax consequences for employees even if no distributions have been paid. This means that any employer-acquired life insurance, other than typical term insurance benefits, should be immediately reviewed.

The IRS has given limited grandfather protection to Split-Dollar plans entered into prior to the new regulations. In some cases, steps will have to be taken by December 31, 2003, in order to preserve the grandfathered protection. Some plans will have to be terminated before December 31, some plans will have to be modified by that date, and other plans may be fine as is, with the understanding that if those plans are terminated before death, harsh income tax consequences will occur.

We would be pleased to review any business arrangements, including life insurance, to assist our clients in taking any necessary action prior to the December 31, 2003 deadline.