Conversion of an Equity Split Dollar Plan
to a Leveraged Benefit Plan

One of the surprisingly "good news" parts of IRS Notice 2002-8 is its treatment of certain in-force Equity Split Dollar Plans. The Notice provides that no income tax will be due by the executive on his/her share of cash values at the rollout of such plans provided: 1) the split dollar arrangement was entered into prior to January 28, 2002, and 2) prior to January 1, 2004, either the rollout occurs or the plan is converted to one funded by Section 7872 loans. This means that split dollar arrangements that have been in force for some years that can handle a rollout prior to January 1, 2004, should be rolled out by that date.

The "bad news" involves in-force split dollar arrangements that cannot support a rollout by January 1, 2004. If they are kept in force as split dollar plans past that date, upon rollout (which, due to soaring economic benefit costs, is inevitable -- unless death occurs), the executive will be taxed on his/her share of the policy cash value in excess of his/her cost basis. To emphasize the point, the following Table reflects an Equity Split Dollar Plan issued two years ago that is kept in force as split dollar past January 1, 2004. The underlying policy has a $2,500,000 level face amount with five $100,000 premiums (issue age 43). The employer is assumed to offset the employee's income tax on the plan's economic benefits with a gross-up bonus.

Equity Split Dollar Plan Issued at Age 43 on April 1, 2000

*If the arrangement is rolled out.

Note: Since the issue age is 43, not 45, the figures in the Table above are slightly different from those of the split dollar arrangement reflected in The Leveraged Benefit Plan Compared to Equity Split Dollar (Parts 1 and 2) ( click to view).

Using the InsMark Section 7872 Illustration System, let's convert this two-year old split dollar arrangement to a Leveraged Benefit Plan. The Table illustrates the results of such a conversion.

Equity Split Dollar Plan Issued at Age 43 on April 1, 2000

Converted to a Leveraged Benefit Plan on April 1, 2002

*If the arrangement is rolled out.

Compare the numbers in Columns 1 and 6 of both Tables (all the other numbers are the same). If this comparison doesn't convince you of the extraordinary power of using the Section 7872 principles inherent in the Leveraged Benefit Plan, nothing will!

There are thousands of in-force Equity Split Dollar Plans -- some of which may well be yours. All but the most seasoned ones must be converted to Section 7872 funding. Are you going to do it, or are you going to allow your competition to do it? (Your competitors may use 1035 exchanges.)

Illustrations: You may review the illustrations for the Equity Split Dollar Plan by clicking here, and the Leveraged Benefit Plan by clicking here. Using the same policy values, we assumed the Equity Split Dollar Plan (issue age 43) is converted to a Leveraged Benefit Plan at age 45. Therefore, in the illustrations, the first year values shown for the Leveraged Benefit Plan are the third year values of the policy.

You can reflect the employer's current receivable (premium advances) from an in-force Equity Split Dollar Plan being converted to a loan in the Leveraged Benefit Plan under the "Premium and Loan Interest Details" tab. The system then automatically recognizes this amount as part of the initial loan that funds the Leveraged Benefit Plan. To see how we handle this, on the Summary of Costs and Benefits (Page 5 of the Leveraged Benefit Plan illustrations), note the initial figure in Column 2 as well as the upper left footnote at the bottom of the page.

We prepared the data for this case using the stand-alone capacity of a SuperLink version of the InsMark Section 7872 Illustration System. In the InsMark Source Storage File, we copied and pasted values from the age 43 proposal from years 3 through 40 into an age 45 illustration from years 1 through 38. While this procedure is effective for showing the principle of a split dollar conversion, in a real situation, you should use actual re-proposal data.

To integrate the results of re-proposal data electronically with InsMark, we need to be linked to your carrier's re-proposal system. (Don't assume we are because we are linked to your carrier's proposal system.)

Until you are electronically linked to re-proposal data, you can accomplish the needed data entry through the year-by-year data entry feature of the stand-alone system. While a tedious procedure, if the purpose is to save your in-force split dollar business (or capture a competitor's), it is worthwhile.

If your carrier's re-proposal system is not linked to InsMark, we suggest you encourage your carrier to do so. For details on this link, contact David A. Grant, InsMark's Senior Vice President of Sales at 1-888-InsMark (467-6275).

Note: One difference between the Summary pages of the two sets of attached illustrations may be confusing unless we bring it to your attention. The executive's share of policy values in the Equity Split Dollar Plan is shown net of the employer's interest in the plan. With the Leveraged Benefit Plan, we show the executive's gross policy values that collateralize the loans associated with the plan -- a change of format we deliberately made in the designs for the Leveraged Benefit Plan; however, to make the comparison easier for you, the executive's net values after deducting the loans are reflected in Columns 4 and 5 in the Converted Plan Table above.

Other Issues: The IRS clearly indicated in IRS Notice 2002-8 that "Regime 2" plans (those characterized by loans) are acceptable and will be governed under the below-market rules of IRC Section 7872 and, where applicable, the Original Issue Discount ("OID") rules of IRC Sections 1271-1275.

The InsMark Section 7872 Illustration System is designed to charge a loan interest rate at least equal to the Section 7872 long-term loan interest rate (often referred to as the "Applicable Federal Rate" or "AFR"). By doing so, two major advantages occur: 1) no further loan interest is deemed to occur between the parties and 2) the OID rules become superfluous. A further advantage of charging at least the AFR is that the plan can easily be constructed to reflect a variety of bonus techniques that offset the executive's loan interest payments.

For illustrative purposes, the Leveraged Benefit Plan illustrations shown in this article reflect the April 2002 AFR of 5.62%. In reality, the loan interest rate for each new loan will likely be different, and each future loan must bear its own AFR that is in effect during the month each new loan is executed. There are four ways to deal with an unknown future AFR:

1. If a bonus is paid to the executive to offset the loan interest, accept the risk: This may increase or decrease the amount of the bonus; however, the loan interest paid to the employer by the executive should provide a full or partial offset, as the case may be.
2. Accrue the additional loan interest: If the loan interest rate increases, the executive could be allowed to accrue the additional loan interest. Alternatively, the executive could withdraw funds from the policy to make up the difference in the loan interest due.
3. Renegotiate the loans: Wait until a time when the AFR dips and recast the series of promissory notes into a new note at the reduced rate.
4. Consolidate all loans at the inception of the plan: In this case, the loaned funds in excess of those needed to pay the policy's initial premium should be reserved by the executive to pay the remaining stream of premiums as they fall due. In this case, the employer may wish to consider requiring some form of custodianship for the reserved funds to be certain they are used for the intended purpose.

The AFR rate for April 2002 may seem low at 5.62% to count on for future years, and an analysis of historic Applicable Federal Rates is instructive.

Applicable Federal Rates

This strategy should be kept in mind when deciding on an illustrative loan interest rate for new Leveraged Benefit Plans.

Note: We allow users to input loan interest rates equal to or greater than the current AFR in order to provide a comfort zone in the initial illustration for those clients concerned that the AFR might spike over the premium paying years.

In all cases, the approval of a client's legal and tax counsel must be secured before implementing a Leveraged Benefit Plan.

Many wealthy clients do not own a business and therefore cannot take advantage of the Leveraged Benefit Plan. In the next article of this series, we will begin the discussion of the Private Leveraged Benefit Plan, a superb wealth preservation arrangement cast between parents and an irrevocable trust formed on behalf of children.

P.S.: Never use a modified endowment contract ("MEC") with a Section 7872 Plan. When a MEC is assigned as collateral security for a loan, taxable income to the executive is produced to the extent of any gain in the contract.

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