Private Split Dollar, IRS Notice 2001-10,
And Estate Tax "Reform"

The equity variation of Private Split Dollar ("PSD") has been one of the great wealth preservation planning innovations of the last 10 to 15 years, and the InsMark Illustration System contains a terrific module for illustrating it.

Unfortunately, IRS Notice 2001-10 was not kind to equity PSD. While this strategy was not specifically mentioned in IRS Notice 2001-10, the Notice did include this footnote:

"For income or gift purposes outside the compensation context, transfers of beneficial interests in the cash surrender value of life insurance contracts may similarly be treated as transfers of property interest in accordance with general tax principles."

Unless some relief surfaces from another quarter (a change-of-mind by the IRS or a successful court challenge establishing IRC Sec. 72 as the determining statute as to taxation of cash value increases), this probably means the effectiveness of equity PSD is seriously reduced.

For those who are proponents of IRC Sec. 83(b) elections to relieve the sting of income taxation of an executive's cash value increases in employer-sponsored equity split dollar arrangements, 83(b) does not apply to equity PSD as Sec. 83 is a compensation-related statute and neither it nor a Sec. 83(b) election applies to private situations in which an employer is not a participant.

This is why we added the limited collateral assignment version of PSD in the recently released version 9.0 of the InsMark Illustration System. Limited collateral assignment PSD should surge into prominence due to the absence of any gift tax issues associated with IRS Notice 2001-10, and because it provides the flexibility required by the new estate tax law.

Typically, with limited collateral assignment PSD, an irrevocable trust is the Plan Recipient that owns the policy. The trust assigns the policy cash value to the Plan Sponsor (usually the parents); consequently, this strategy eliminates any problems associated with IRS Notice 2001-10 since no cash values are transferred to the trust as a result of the Plan Sponsor's premiums.

In addition, because plan documentation prohibits the Plan Sponsor from canceling the policy and/or borrowing or withdrawing funds from it during the term of the split dollar arrangement, the estate tax free nature of the trust's death benefit share should be preserved.

Is the loss of the effectiveness of equity PSD reversed by the new limited collateral assignment PSD? We believe it is - and then some. You can review both plans in the illustrations that accompany this article by clicking here and here. (Two separate windows will open, one for the Equity Private Split Dollar (EPSD) reports (pages 7-15), and one for the Limited Collateral Assignment Private Split Dollar (LCAPSD) reports (pages 16-24). You can either leave the windows open as you read the article or print the reports out and close the windows.

The underlying policy is the same in both cases - $10,000,000 of increasing death benefit variable survivor life covering Nathan and Greta Baier (ages 65 and 60). The policy has continuous premiums of $100,000.

Gift Reserve Account

Each plan illustrated in this article uses InsMark's unique innovation, the Gift Reserve Account, to average out the gifts to the trust to keep them (as much as possible) within this couple's available annual gift exclusion. The Gift Reserve Account is nothing like the Unearned Premium Account usually associated with reverse split dollar as the Gift Reserve Account represents a reserve of unused cash gifts warehoused to meet the high economic benefits required by the trust in later years.

The Gift Reserve Account works more efficiently with equity PSD since, as shown in Column 8 on Page 24, the limited collateral assignment PSD arrangement develops imputed future interest gifts to the trust which chip away at the unified credit. (If the Plan's values are imported into the PSD selection under the Gift Scheduling tab within InsGiftâ -the Wealthy and WiseÔ System, InsGift will include the imputed gifts in its calculations - as reflected in the Wealth to Heirs graph shown later in this article.)

An interesting way to measure the difference between the two plans is to run them both through InsGift.

Case Study

This analysis involves a wealthy couple, Nathan and Greta Baier, ages 65 and 60. Based on our InsGift analysis, after their retirement income needs have been met, below is a snapshot of their projected estate values along with the expected transfer taxes using the new estate tax rules - including repeal for one year in 2010.

*Full repeal for one year

**Amount of transfer taxes shown in Year 10 is heirs' income tax on pension values.

Let's compare funding an additional $10,000,000 of their estate tax liability with both equity PSD and limited collateral assignment PSD.

The graph below compares the impact of either plan on the Baiers' living Net Worth.

Strategy 1 is the Status Quo, i.e., neither split dollar plan is acquired. Strategy 2 reflects the equity PSD plan illustrated on Pages 7 through 15. Strategy 3 reflects the limited collateral assignment PSD plan illustrated on Pages 16 through 24. Either plan appears to be an affordable solution; however, the limited collateral assignment variation has the least impact on living Net Worth. This is because the policy cash values in Strategy 2 are owned by the Plan Recipient (the trust) and, in Strategy 3, they are assigned to the Plan Sponsor (the parents). The graph below compares the impact of either plan on the amount of Wealth to Heirs.

Again, Strategy 1 is the Status Quo, i.e., neither split dollar plan is acquired. Strategy 2 reflects the equity PSD plan illustrated on Pages 7 through 15. Strategy 3 reflects the limited collateral assignment PSD plan illustrated on Pages 16 through 24. In this case, Strategy 2 has the slight edge but, in our opinion, Strategy 3 is the preferred solution for the following reasons: 1) The impact on living Net Worth is less and 2) There is no danger of additional gifting impact from IRS Notice 2001-10. (Incidentally, the spike in Wealth to Heirs values reflects the one year of full estate tax "repeal".)

Exporting/Importing Private Split Dollar Data: Version 6.0 of InsGift has special importing fields under its Gift Scheduling tab to reflect PSD data calculated in version 9.0 of the InsMark Illustration System - including accounting for the long-range imputed gifts associated with limited collateral assignment PSD discussed in the section above entitled Gift Reserve Account.

To export data to Source Data Storage from the PSD illustration modules in the InsMark Illustration System, click on the following Export icon (after completing all input items and previewing the illustration results for accuracy):

To import the exported PSD data into version 6.0 of InsGift, click on the following icon that is found in the "Private Split Dollar" selection available under the Gift Scheduling tab in InsGift:

Note: The InsMark Illustration System also has an employer-sponsored version of limited collateral assignment split dollar available under the Executive Benefits tab.

Other Gift Valuation Considerations: An issue that may surface with survivor life policies funded via limited collateral assignment PSD involves the increase in economic benefit that occurs after the death of the first-to-die under a second-to-die PSD plan. In order to recognize one-life split dollar economic benefit, this event would require either an increase in gifts to the trust or massive use thereafter of the Plan Sponsor's unified credit. There are several alternate ways to deal with this:

1. Rollout the plan at that point by gifting the Plan Sponsor's policy interests to the trust and thereafter gifting the funds for any remaining premiums that are due. This may use up part of the available unified credit, but it may be a better choice than continuing years of accelerated gifts in order to maintain the split dollar arrangement in force.
2. Rollout the plan by having the Plan Sponsor provide an IRC Sec. 7872 term loan to the trust to provide it with the funds to acquire the Plan Sponsor's policy interests, i.e., the policy cash value, thereby terminating the split dollar arrangement. Here is the procedure: Step 1: The Plan Sponsor (the parents) loans the funds to the trust; Step 2: The Plan Recipient (the trust) then writes a check back to the Plan Sponsor for the same amount and, by so doing, acquires the policy cash values. (The Plan Sponsor has exchanged an assigned interest in the plan's cash values for a promissory note of the same amount.) Thereafter, the Plan Sponsor continues to loan the Plan Recipient the funds for any remaining premiums that are due. The Plan Sponsor gifts an amount equal to the loan interest due by the trust, a sum which when added to any loans for premiums that are due should be significantly less than the gifts required to continue a single-life limited collateral assignment PSD arrangement. Loans to the trust should not require use of the Plan Sponsor's annual gift exclusions or unified credit. The loan interest should be set to the IRC Sec. 7872 rate in effect at the time each loan is made. If the trust is a grantor trust (which it will likely be), the trust's loan interest payments to the Plan Sponsor do not constitute taxable income to the grantor (assuming the Plan Sponsor is the grantor), as a grantor trust and its grantor are assumed to be a single entity for income tax purposes (IRC Sections 671 and 675, IRS Reg. 1.671-2(c), and Rev. Rul. 85-13).

3. Cast the arrangement as an IRC Section 7872 plan from inception. InsMark's Private Leveraged Benefit Plan ("Private LBP") System uses this approach, and InsGift can import plan data from Private LBP. (Private LBP is in full compliance with the Sec. 7872 safe harbor of IRS Notice 2001-10.)

Flexible Estate Planning: Assume our politicians vote to extend repeal permanently in 2010. This means the limited collateral assignment PSD arrangement will no longer be needed - nor will ownership of the policy by the trust be required since the trust itself will no longer be needed - at least as a strategy to offset estate taxes. If the Plan Sponsor would like to reclaim the policy as a personal asset, limited collateral assignment PSD offers this versatility. Consider the following language in the Agreement between the parties contained in the Private Limited Collateral Assignment Split Dollar set of specimen documents in version 11.0 (or higher) of InsMark's Documents On A DiskÒ System or InsMark's Documents On The NetÔ System. (The term "Owner" refers to the trust.)

10. TERMINATION OF AGREEMENT

Unless otherwise agreed to by the Owner and the Sponsor, this Split Dollar Agreement shall terminate upon the occurrence of any one of the following events:

1. Request by either the Owner or the Sponsor upon submission of 30-day advance written notice to the other.
2. The Owner's failure to pay his/her/its agreed-upon share of premium as herein defined.
3. The Owner's failure to apply the Sponsor's premium advances to the Policy premiums as herein defined.
4. The Owner's election, at any time, to receive a release of assignment of the Policy from the Sponsor.

Upon such termination, the Owner shall have a 90-day option to receive from Sponsor a release of assignment of the Policy in consideration of a payment to the Sponsor of an amount equal to the Sponsor's Policy Interests as herein defined. In the event the Owner elects not to exercise said option, the Owner shall transfer the entire policy to the Sponsor in satisfaction of the Owner's obligations to the Sponsor.

The language in Article 10.A allows the Plan Sponsor to request termination - not of the policy, but of the limited collateral assignment PSD arrangement.

The language in Article 10.B effectively does the same thing since the Plan Sponsor could withhold gifts to the trust thus "starving" the trust of funds it needs to pay its premium share. Since the trust presumably has no other funding source, either 10.A or 10.B triggers the option contained in the first sentence of the last paragraph of Article 10:

"Upon such termination, the Owner shall have a 90-day option to receive from Sponsor a release of assignment of the Policy in consideration of a payment to the Sponsor of an amount equal to the Sponsor's Policy Interests as herein defined."

Since all policy cash values are assigned to the Sponsor, the trust would typically have no other funds with which to exercise this option thereby triggering the results dictated in the second sentence of the last paragraph of Article 10:

"In the event the Owner elects not to exercise said option, the Owner shall transfer the entire policy to the Sponsor in satisfaction of the Owner's obligations to the Sponsor."

Overall result? The policy reverts to the Plan Sponsor.

Note: One of the exceptions to the Transfer for Value rules of IRC Sec 101 (income taxation of death benefits in excess of the new policy owner's cost basis) allows a transfer to the insured. If the unwinding of the limited collateral assignment PSD arrangement involves transferring the policy to the Plan Sponsor, and he/she intends to keep the policy in force, be sure the transfer occurs only when the Plan Sponsor and the insured are the same party. (In the rare case where the Plan Sponsor is not the insured, if policy ownership is subsequently re-transferred to the insured, problems associated with Transfer for Value rules should also be avoided on any subsequent death benefits - but watch out for gift tax issues associated with a re-transfer if the re-transferee is not a spouse.)

Illustration Data: We used version 6.0 of InsGift for the graphics and the calculations behind the graphics in this article. Space prevents us from including all the reports generated by InsGift; however, InsGift users can review reports and related menu inputs by downloading the InsGift Workbook named PSD-128.!ig from the Workbook Download section of this website. To review the related menu inputs for the two PSD cases reviewed on Pages 7 through 24, download the InsMark Illustration System Workbook named PSD-128.!wb.

To download the Workbooks now, click here; otherwise, click on Producer's Center on our main webpage, then click on the Workbook Download icon at the top of the next page. After downloading, you can import the appropriate Workbook into its respective System by clicking on Client Workbook/Import Workbook on the Main Toolbar. If you are not licensed for one or both Systems and want more information, contact an InsMark Account Executive at 1-888-InsMark (467-6275).

Note: In all cases, the approval of legal and tax advisers must be secured before any variation of private split dollar is utilized.

Revised: [5/17/02]

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