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CCH® PENSION AND BENEFITS — 4/25/07

IRS issues guidance on application of Code Sec. 409A to split-dollar life insurance arrangements

In conjunction with recently released regulations under Code Sec. 409A, the IRS has issued guidance on the application of the regulations to split-dollar life insurance arrangements. The guidance addresses the application of Code Sec. 409A to materially modified split-dollar arrangements.

Generally, split-dollar life insurance arrangements that provide for deferred compensation under Reg. §1.409A-1(b) are subject to the requirements of Code Sec. 409A. Code Sec. 409A provides that amounts deferred under a nonqualified deferred compensation plan for all taxable years may be currently includible in gross income, unless certain requirements are met. Split-dollar life insurance arrangements that provide only death benefits to or for the service provider, or which provide a legally binding right to amounts that are included in income in accordance with the exception for short-term deferrals under Reg. §1.409A-1(b)(4) are not considered to provide for deferred compensation, and are excluded from coverage under Code Sec. 409A.

Arrangements that have undergone material modifications may be considered new split-dollar life insurance arrangements for tax purposes. Under Reg. §1.61-22(j)(1)(i), any split dollar life insurance arrangement entered into after September 17, 2003 is potentially subject to tax, because under Reg. §1.6122(j)(2)(i) , an arrangement entered into on or before that date that is materially modified after September 17, 2003 is treated as a new arrangement as of the modification date, for tax purposes. Some changes that are not material modifications are listed in Reg. §1.61-22(j)(2)(ii) , and the IRS has now provided additional information on such material modifications. This latest guidance takes into account comments the IRS has received regarding changes to split-dollar life insurance arrangements made to bring the arrangements into compliance with Code Sec. 409A. Commentators had expressed concerns that these changes could cause the arrangements to be treated as materially modified for purposes of Reg. §1.61-22(j)(2).

The application of Code Sec. 409A is not effective for amounts deferred under a split-dollar life insurance arrangement in taxable years beginning prior to January 1, 2005, unless the arrangement was materially modified after October 3, 2004. Therefore, a split dollar life insurance arrangement entered into after September 17, 2003 and modified after October 3, 2004, is generally subject to tax. Amounts deferred prior to January 1, 2005, are grandfathered from the application of Code Sec. 409A if, prior to that date, the service provider had a legally binding right to be paid the amount, and that right was earned and vested. The IRS adds that Code Sec. 409A is not effective with respect to earnings on Code Sec. 409A grandfathered benefits. Such earnings on grandfathered benefits include an increase in the policy cash value, but do not include any increase in the policy cash value attributable to continued services performed, nor do they include compensation earned, or premium payments or other contributions made on or after January 1, 2005.

Included in the latest guidance is an example of a calculation method for situations where benefits under a split-dollar life insurance arrangement have both grandfathered and non-grandfathered benefit components. Any reasonable method that allocates increases in policy cash value attributable to the grandfather benefit is acceptable. However, the method may not allocate a disproportionate amount of policy costs and expenses to the non-grandfathered component. The IRS also states that grandfathered premiums include both premiums actually paid on or before December 31, 2004 that were earned and vested as of that date, and premiums paid after December 31, 2004 pursuant to a legally binding right that was earned and vested as of that date.

IRS clarifies Code Sec. 409A grandfathered benefits

A split-dollar life insurance arrangement, or a portion thereof, that is not grandfathered under the new regulations of Code Sec. 409A but is subject to the rules of Reg. §1.61-22, and which does not provide for only a short-term deferral excluded from coverage under the new regulations, provides for deferred compensation for tax purposes if the service provider has a legally binding right during its own taxable year to compensation that may be includible in the income of the service provider in a later taxable year.

A split-dollar life insurance arrangement or a portion thereof, that is not grandfathered under the new Code Sec. 409A regulations, but is treated as a split-dollar loan under Reg. §1.7872-15 generally will not be considered a deferral of compensation, unless amounts on the loan are waived, cancelled, or forgiven.

Split-dollar life insurance arrangements that are grandfathered under Reg. §1.61-22 provide for deferred compensation for purposes of Code Sec. 409A if the service provider has a legally binding right during a taxable year to compensation that is payable to or on behalf of the service provider in a later year, such legally binding right does not qualify as a short-term deferral, and it is not treated as provided under a death benefit plan.

Also, the IRS will not treat a modification of a split-dollar life insurance arrangement necessary to bring such arrangement into compliance with Code Sec. 409A or to avoid application of Code Sec. 409A as a material modification of such arrangement. The IRS adds that a modification is considered necessary for compliance only if all of the following requirements are met:

1. the service recipient or provider has determined that Code Sec. 409A is applicable, but the arrangement does not comply with the requirements of Code Sec. 409A;
2. the service recipient or provider has determined that the modification causes the arrangement to comply with Code Sec. 409A or results in Code Sec. 409A no longer being applicable, or that the modification is necessary to cause the arrangement to come into compliance with Code Sec. 409A or to cause Code Sec. 409A to no longer be applicable;
3. the modification consists solely of changes to the applicable definitions or changes to the payment timing requirements, or changes to the conditions under which all or part of the benefit under the arrangement will be forfeited, reasonably intended to conform the arrangement to the requirements of, or to qualify for an exclusion from, Code Sec. 409A;
4. the modification establishes a time and form of payment, or establishes potential times and forms of payment that are consistent with times and forms of payment under which the benefits could have been paid prior to the modification; and
5. the modification does not materially enhance the value of the benefits to the service provider under the arrangement.

The IRS also points pension professionals to IRS Notice 2002-8, which contains previously-issued interim guidance on split-dollar life insurance arrangements entered into prior to September 18, 2003. The notice covers situations in which the value of current life insurance protection is treated as an economic benefit provided by a sponsor to a benefited person under a split-dollar arrangement. The notice also clarifies when the parties to the arrangement may treat premium or other payments by the sponsor as loans.

For more information on this and related topics, consult the CCH Pension Plan Guide.

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