IRS Refining Rules on Split-Dollar Setups

One of the most sophisticated tools used to supplement employee compensation, make charitable donations and minimize taxes is being scrutinized by the Internal Revenue Service.

On Jan. 29, the IRS published an official notice outlining its concerns regarding the popular loophole. The agency is expected to issue “clarifications” on both business and private split-dollar tax plans within the next six months. Most likely, certified tax and estate planners say, the agency will enhance its ability to collect more revenue and cut down on taxpayers’ ability to give away estates to benefit charities and heirs.

Changes will only affect people who are still in the workforce and involved in split-dollar plans, not retirees who have benefited from them in the past.

Bill Ackerman, a certified estate planner, has operated Tax Concepts Inc. in Fayetteville for the last nine years. He serves several hundred clients in Northwest Arkansas and handles split-dollar plans regularly.

Ackerman said he doesn’t believe the IRS will kill the split-dollar concept altogether.

“I do not think it’s going to be legislated out of the marketplace,” Ackerman said. “But planners will have to be more mindful of how these things are set up and make sure it’s correctly done.

“The important thing will be the timing of rollouts to minimize taxation.”

Business split-dollar plans allow companies to provide additional benefits to employees in the form of life insurance or a combination of that and future compensation. Private versions are used to make charitable donations and preserve estates for heirs.

Both versions are extremely complicated and generally putting them to efficient use requires the aid of a certified planner. In the simplest of terms, a business split-dollar plan is a way to give key executives added benefits or compensation.

If a company takes out a life insurance policy on an executive, in a number of years the policy will reach a break-even point — when the policy’s value becomes equal to the amount the employer has paid in through premiums.

The value accrued thereafter is taxable to the insured when the policy is distributed or cashed in. But rollout can be done at the break-even point before there’s a gain, so the insured simply receives the paid policy and no taxation. The policy can then be kept and future gains are tax deferred.

Employers could also maintain the policy until a forced retirement age is reached. Either way, the employer still recovers its basis.

A charitable split-dollar plan could, for instance, include an individual giving a large sum or piece of property to a non-profit organization. In return, the organization buys a life insurance policy of similar value for an heir or heirs of the gift giver.

That way the person donating the asset receives tax benefits, the charity gets a sizable donation for a minimal cost and the heirs get a much higher percent of the asset or assets they would have inherited. The only taxable event comes when the policy is cashed in or “rolled out,” and the IRS’ “PS 58” rates are applied.

The rates could be as low as 20 cents on the dollar for the value of the benefit.

Ackerman said the popularity of this kind of plan is really what has stimulated the IRS’ interest in firming up its interpretation of the rule.

“Split dollar is a limited use thing, but a very dynamic tool in the right situation,” Ackerman said. “It’s a wonderful vehicle to provide a tax benefit on a tax favorable basis. It will be interesting to see the new interpretation.”