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Employer-Sponsored Split Dollar
Notice 2002-8 from the IRS provides (and the proposed split dollar regulations confirm) that no income tax will be due by the covered executive on his/her share of cash values at the rollout of an equity split dollar arrangement provided: 1) the 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 a plan in which all employer advances (including prior advances) are funded by loans guided by the OID rules of IRC Sections 1271-1275 and the below-market rules of IRC Section 7872. There are tens of thousands of equity split dollar plans currently in effect that were issued prior to January 28, 2002. If not converted to loan plans, equity split dollar plans may be continued as split dollar plans after January 1, 2004; however, at any subsequent rollout (which, unless death occurs, is inevitable due to soaring economic benefit costs), the covered executive will be taxed at ordinary income rates under IRC Section 83 on his/her share of the policy cash value in excess of cost basis. The drop-dead date for conversions (January 1, 2004) provides a once-in-a-generation marketing opportunity that the majority of producers are either deliberately ignoring or are largely overlooking because they are so caught up in mourning about "what's happened to equity split dollar". Part of the reason is pure lethargy, i.e., I have a year to get to it. Part of it is lack of knowledge, i.e., I know there is a problem, but I don't know what to do about it. For several months, we have been recommending that you discuss this issue with those who own equity split dollar plans and, most particularly, with the legal and tax advisors in your community who know where these plans exist -- yours and those of your competitors. Consider writing the following letter and two-page addendum to every such adviser you can find. (InsMark has wide distribution, and imagine your dismay after reading it if your competitors write the letter first to advisers you know.)
Structural Differences: A trust-owned equity split dollar plan can be cast directly between the employer and the trust. The Section 7872 equity plan needs the following steps to work properly: Step 1: The employer annually loans the executive the funds equal to policy premium and typically offsets the loan interest charges with a gross-up bonus. Step 2: The executive, in turn, extends loans to the trust using the loan proceeds received from the employer. Step 3: The loan documents executed between the trust and the executive are assigned by the executive to the employer as security for the loans made in Step 1. Step 4: Using the after tax bonuses received from the employer, the executive and/or spouse gift funds to the trust for its loan interest payments and immediately receive non-taxable loan interest from the trust. (See below for a "Note Regarding Step 4".) Step 5: The executive pays the loan interest due the employer using the loan interest received from the trust in Step 4. Note Regarding Step 4: The trust referred to in Step 4 is a so-called "intentionally defective" grantor trust, the grantor of which is the executive or the executive's spouse. Due to grantor trust rules, there is no income tax due by the grantor on any loan interest received from the trust, i.e., the parties are a single income tax entity. (IRC Section 671 and 675, IRS Reg. 1.671-2(c) and Rev. Rul. 85-13.) Thus, when gifts to the trust provide it with the cash flow for loan interest, the gifts are returned at once as non-taxable loan interest thereby producing a cash flow neutral transaction insofar as gifts and loan interest are concerned. It would be less complicated if a defective grantor trust with the above features could be arranged directly between the employer and the trust, but our legal and tax advisors tell us this cannot be done. (If you have advisors who believe differently, please let us know.) Some of you may be inclined to throw up your hands at this point and say that this transaction is too complex. Please examine the differences between Tables 3 and 4 on Page 4 again. If this doesn't convince you of the extraordinary power of using Section 7872 equity plans, nothing will. The estate planning uses of equity split dollar created a gigantic market throughout the past 40 years -- but it's over! These are the new rules -- learn them or give up the market. InsMark can help with administration, too. The InsMark Section 7872 Administration System is scheduled for release in the first quarter of 2003. It is a web-based administration system for handling all aspects of these plans, including the one with the extra steps involving trusts. Illustrations: The illustrations for the equity split dollar plan are on Pages 10 through, and the Section 7872 equity plan appears on Pages 23 through 37 (click here to view or print both illustrations in PDF format). Using the same policy values, we assumed the equity split dollar plan (issue age 43) is converted at age 45 to a Section 7872 equity plan (what we call a Leveraged Benefit Plan). Therefore, in the accompanying 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 using the "Scheduled loan" selection under the System's "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 29), 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 SystemÔ . In the InsMark Source Data Storage File, we copied and pasted values from an age 43 proposal from years 3 through 40 into an age 45 illustration that runs for 38 years. 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 them to do so. For linking details, 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 net policy values reflected in Table 2 on Page 3 and Table 4 on Page 4 are illustrated after deducting the Section 7872 loans. Other Issues: The IRS clearly indicated in IRS Notice 2002-8 that Section 7872 loan plans (referred to in the Notice as "Regime 2" plans) are acceptable and will be governed under the below-market rules of IRC Section 7872 and the Original Issue Discount ("OID") rules of IRC Sections 1271-1275. Illustrations from the InsMark Section 7872 Illustration System are designed to charge loan interest at least equal to the long-term Applicable Federal Rate ("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 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 report reflect the January 2003 long-term AFR of 4.90%. 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:
Renegotiating is a powerful strategy, and an analysis of the historic AFR is instructive. Table 5 High/Low AFR Rates (1992- 2001)
If, for example, a policy with five scheduled premiums had been purchased in 1993, and the loan for each premium had been made at the highest rate that occurred during each of the five years, the average loan interest rate on the composite of all five loans would end up at 7.62%, as shown in Table 6. Table 6
However, if each loan had been subsequently renegotiated at the lowest rate available over the years in the Table, a far different result would have been produced, as shown in Table 7. Table 7
This example (which may not be representative of interest rates over all durations) reduces the long-range loan interest rate on a regular basis. By the tenth year (2002), it would have been permanently reduced from 7.30% to 4.60%, a 40% reduction -- significant indeed for a series of loans scheduled to stay in force over many years. Any future dips in the AFR below 4.60% could lower it further, and future spikes would not affect it. We allow users of the InsMark Section 7872 Illustration System to reflect 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. The strategy illustrated in Table 7 should be kept in mind when deciding on an illustrative loan interest rate for a Section 7872 equity plan. A final thought on loan interest renegotiations: Many homeowners have refinanced their home mortgage interest rates downward over the last several years -- in some cases, more than once. There have been dozens of opportunities to do so as rates fell; however, the decision to act was controlled to a great extent by 1) the hassle and 2) the costs associated with refinancing, e.g., appraisal fees, points, etc. Imagine if there had been no hassle and no costs -- just a simple form to sign. Under these circumstances, imagine how many times the refinancing would have taken place. Renegotiating the loan interest rates on the loans that support a Section 7872 equity plan is just that simple. How do clients keep track of the rates? If your client elects to have his/her plan administered by the web-based InsMark Section 7872 Administration System, a monthly e-mail is sent outlining each month's new rate and whether any in-force loans are at higher rates. In Case You Were Wondering: Table 8 shows the effect of the Section 7872 equity plan discussed in this report at different non-renegotiated AFRs. (4.90% is the AFR reflected in the Tables 2 and 4.) Table 8
Illustrated cash values are not guaranteed and may be higher or lower than illustrated. Since the introduction of the rules regarding loans governed by Section 7872, the AFR for long-term loans has exceeded 10% only three times (April 1985 -- 10.37%; May 1985 -- 10.36%; and January 1986 -- 10.13%). Even at interest rates well above current rate levels, you can see from Table 8 that a Section 7872 equity plan offers irresistible results to covered executives compared to keeping an equity split dollar plan in effect. How many corporate owners would be willing to run the relatively minor risk associated with Column 2 in Table 8 in order to have the potential to build the cash value account and family death benefit shown in Columns 3 and 4? We think that a great many would! Timing of Rollouts for Section 7872 Equity Plans: The Section 7872 equity plan in this report is illustrated to remain in force past retirement and is assumed to cover sole or majority shareholders of closely-held corporations (although it could be rolled out earlier -- probably via a policy loan used to repay the loan to the employer). Plans provided to key executive non-shareholders will likely be undone earlier, e.g., rolled out at retirement. Specimen Documents: Licensees for the InsMark Section 7872 Illustration System are furnished with a several specimen documents used to establish the loan transactions. New Plans: Don't overlook the use of Section 7872 equity plans for new cases. Due to the new rules affecting split dollar, traditional equity split dollar sales have understandably fallen off a cliff. The need for equity-type split benefit plans has not gone away, just the traditional funding mechanism. Those who jump on the new loan approach will supercharge their practice. Licensing: The InsMark Section 7872 Illustration System is available for licensing now. Please call an InsMark Account Executive at 1-888-InsMark (467-6275) (or click here) for details. Insurance companies and other institutional firms interested in multiple unit or site licensing should contact David A. Grant, Senior Vice President, Sales, at 1-925-543-0500. Workbooks: Licensees for the InsMark Illustration System can review all reports and related menu inputs for the accompanying equity split dollar plan illustrations by selecting the Workbook named MA146.!II from this website. Licensees for the InsMark Section 7872 Illustration System can review all reports and related menu inputs for the accompanying Section 7872 equity plan (Leveraged Benefit Plan) illustrations by selecting the Workbook named MA146.!LB from this website. To go to the Workbook download page on our website, click on Producer's Center; then on Workbook Download (one of the icons at the top of the page). After you download the Workbook files, you can import them into their respective Systems by clicking on Client Workbook / Import Workbook on the main menu bar. To download now, click here. Important Notice: In all cases, the approval of a client's legal and tax counsel must be secured before implementing a Section 7872 equity plan. P.S. Now is the time to write the letter to legal and tax advisers shown on Pages 2, 3, and 4. Your competition will be well ahead of you if you wait until next fall! We have over 1,000 of our licensees writing this letter -- some of them undoubtedly to advisers in your backyard. [Rev.3-10-03] |
