Skip to main content
A Better Partnership

Publications

Jun 2001
05
June 05, 2001

What's New in Executive Compensation?

There has been a noteworthy development in the world of executive compensation involving split dollar life insurance.

Many companies use split dollar life insurance to provide additional insurance benefits for executives and for other corporate planning purposes. The IRS recently issued a Notice which will profoundly affect the most common arrangement in use today: “equity split dollar.”

In split dollar policies generally, the employer pays the premium for a substantial whole life policy on the life of an executive. The executive is able to name the beneficiary of the policy for the face value of the policy less a portion of the proceeds which will return to the employer at the executive’s death. The executive is taxed on the value of that life insurance protection each year —using very low “PS 58” costs—but not on anything else.

Recently, split dollar life insurance arrangements have been structured more aggressively and have prompted an IRS counter-response. In the “old days”, the entire cash surrender value would come back to the employer, leaving the executive’s beneficiaries with the pure insurance portion of the policy. Recently, however, these policies have been structured to provide for return to the employer of only the premiums paid by the employer—usually substantially less than the cash surrender value of the policy. Thus, the executive’s beneficiaries receive part of the cash surrender value—the portion greater than the premiums paid by the employer—plus the entire policy proceeds above the cash surrender value. This led to the term “equity split dollar,” since some of the equity in the policy ends up in the hands of the executive’s beneficiaries.

Two things have happened. First, the old “PS 58” cost is gone. The IRS replaced that outdated measurement of the annual tax impact on the executive with a new “Table 2001 Cost” to value the life insurance coverage provided to the executive each year. This approximates the term insurance value of the pure insurance portion of the policy—that is, the amount above the cash surrender value. This is not bad news, since the Table 2001 Cost is actually more reasonable than the old PS 58 cost.

Second, the IRS has now outlined a more detailed, and more logical, treatment for equity split dollar arrangements. Remember, in an equity split dollar arrangement, the employee’s beneficiaries receive part of the cash surrender value in addition to the pure insurance coverage portion of the policy. That “extra” is the earnings on the premium paid by the employer built up inside the policy.

Since this kind of equity split dollar has been around, everyone has acted like that transfer of funds to the executive’s beneficiaries is no big deal, even though it amounts to a tax-free way to get money to the employee’s beneficiaries at the employee’s death. Well, the IRS finally figured this out, so now we have a few new rules.

The first rule is that the money the employer pays into the policy must now be treated as:

  • A loan to the employee, which can have current tax consequences;

     
  • Current wages to the employee, which of course will have current tax consequences; or

     
  • An investment in the insurance contract by the employer that will be wages later when it is paid to the individual.

In other words, there is no free lunch. If the executive’s beneficiaries will receive any part of the cash surrender value, there will be some tax consequence to the employee or the beneficiaries somewhere along the line.

The second part of this, however, represents part of the “kinder, gentler” IRS. Although there are three ways to handle this kind of situation, the IRS actually lets the employer and the employee choose which of the three ways they want to apply. The IRS says it will honor the agreement of the employer and the executive as long as they are consistent, they account for all of the economic benefit conferred on the employee by the employer and they do not act contrary to the substance of the underlying insurance policy or the overall arrangement.

This IRS position is not the final word, but it is logical and hard to argue with. My guess is that it will stand up. Assuming that, every equity split dollar arrangement should be reviewed sooner rather than later in order to be properly positioned for the final rules in this area when issued by the IRS, which will probably be fairly soon.


* * *

Anthony J. Kolenic, Jr. is a partner in the Grand Rapids office of Warner Norcross & Judd LLP. He focuses his practice in the area of employee benefits law, ERISA and employee stock ownership trusts laws. He may be reached directly at 231.727.2625. Because each business situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.

MiBizWest

NOTICE. Although we would like to hear from you, we cannot represent you until we know that doing so will not create a conflict of interest. Also, we cannot treat unsolicited information as confidential. Accordingly, please do not send us any information about any matter that may involve you until you receive a written statement from us that we represent you.

By clicking the ‘ACCEPT’ button, you agree that we may review any information you transmit to us. You recognize that our review of your information, even if you submitted it in a good faith effort to retain us, and even if you consider it confidential, does not preclude us from representing another client directly adverse to you, even in a matter where that information could and will be used against you.

Please click the ‘ACCEPT’ button if you understand and accept the foregoing statement and wish to proceed.

ACCEPTCANCEL

Text

+ -

Reset