In This Issue

• Split Dollar Agreements After IRS Notice 2002-8
• Should You Create a Private Foundation?

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Split Dollar Agreements After IRS Notice 2002-8

By Edward C. Hertenstein

On January 3, 2002, Treasury and IRS released Notice 2002-8, 2002-4 I.R.B. 398, announcing the intent to publish proposed regulations providing comprehensive guidance regarding the Federal tax treatment of split-dollar life insurance arrangements. The following is a brief summary of the Notice.

We believe the Notice is extremely favorable to existing split-dollar arrangements (those entered into prior to January 28, 2002), but it is important to plan properly to achieve maximum results.

We also believe, on a going-forward basis for new split dollar arrangements, that the Notice is generally clearer and somewhat more favorable than pronouncements by Treasury and IRS in 1996 and 2001. However, "interest-free" loan economics and "lowest term income cost" are limited to arrangements entered into before January 28, 2002. The Notice does not mention "family" or "reverse" split dollar.

1. Background

   IRS Notice 2001-10, issued in January 2001, consistent with TAM 9604001, provided "interim guidance" to "equity split-dollar" arrangements seeking to discard as inapplicable the traditional theories of Rev. Ruls. 64-328 and 66-110. Notice 2001-10 offered taxpayers a choice pending public comments and the publication of further guidance of treating equity split-dollar arrangements either (1) as loans, taxable under § 7872, or (2) as transfers of property (cash value build-up) under § 83.

   If the arrangement were treated as a "below market" loan under § 7872, the employee/borrower would have income computed at the stated rate (likely zero) or the applicable Federal rate ("AFR") and would be deemed to make a corresponding payment to the employer/lender in the same amount.

   If not treated as a loan, the parties would be required to account under §§ 61 and 83 for all the "economic benefits" of the arrangement. For equity split dollar, the employee would have compensation income under § 83 to the extent the employee had a "substantially vested" interest in the cash value, reduced by any consideration paid. However, the 2001 Notice stated that pending further guidance, the employer will not be treated as having made a transfer of the cash value simply because the cash alue exceeds the premiums paid. The 2001 Notice provided that "[i]f future guidance provides that such earnings increments are to be treated as transfers of property for purposes of section 83, it will apply prospectively."

2. Notice 2002-8

   Notice 2002-8 (the "Notice") does the following:

   1. revokes the 2001 Notice and (by implication but not expressly) TAM 9604001;

   2. announces an intention to publish proposed regulations providing comprehensive guidance regarding the Federal tax treatment of split dollar;

   3. outlines rules expected to be included in the forthcoming proposed regulations;

   4. provides guidance regarding the valuation of current life insurance protection; and

   5. provides an effective date and safe harbor rules with respect to existing arrangements.

   The proposed regulations are expected to tax parties to a split-dollar arrangement under one of two "mutually exclusive" regimes. The first regime is the "endorsement" method governed by § 83 as a transfer upon termination or rollout by the employer to the benefited party. The Notice is clear that there will be no current taxation to an employee of a portion of the cash value "solely because" of an increase in "equity" of the benefited party. The value of life insurance protection and other benefits would be taxed under § 61. We note that this first regime (endorsement method) should not be used by a controlling shareholder to keep policy proceeds out of his or her estate —by an irrevocable insurance trust —because such ownership (and estate taxation) would be imputed to the shareholder from the corporation.

   The second regime is the "collateral assignment" method under which the premiums are treated as a series of loans by the employer to the employee, governed by §§ 1271 through 1275 (relating to original issue discount [or OID] rules) and § 7872 (described under A, above).

   As to the taxable value of insurance protection, Rev. Rul. 55-747 (the P.S. 58 rates) remains revoked. (However, see the grandfather provisions, below, relating to existing arrangements.)

   Further, the Notice states that, except for new rules for valuing life insurance protection, "no inference" should be drawn from it "regarding the appropriate Federal income, employment and gift-tax treatment of split-dollar life insurance agreements entered into before the date of publication of final regulations."

3. Grandfather Provisions

   For existing split dollar arrangements (entered into before January 28, 2002):

   Two major advantages: First, taxpayers may continue to use P.S. 58 rates or the insured's lower published premium rates to measure the value of the term protection. The Table 2001 rates may be used as well. The Notice does not state whether it has any applicability to "family" or to "reverse" split dollar.

   Second, IRS will not assert that there is a taxable transfer of property (equity cash value) upon termination (i.e., "rollout") of the arrangement if the arrangement is terminated prior to January 1, 2004. If so terminated, IRS will not assert that there is any gain recognition under § 83. Presumably, for a taxpayer who does not terminate an arrangement prior to 2004, the IRS and the taxpayer are free to assert that the arrangement is, or is not, covered by Rev. Rul. 64-328, or either of the Notices (back to a "world of uncertainty"). Thus, all taxpayers covered by equity split dollar will want to consider carefully the pre-2004 termination option to "lock-in" equity with the certainty of no § 83 taxation.

   For split-dollar arrangements entered into after January 27, 2002 and before the date of final regulations:

   Taxpayers may use the Table 2001 rates (first published in Notice 2001-10) or, more importantly, the insured's lower published rates available to all standard risks. However, for periods after December 31, 2003, IRS will not consider the rates to be available to all standard risks unless (1) the insurer generally makes the availability of such rates known to persons who apply for term coverage, and (2) the insurer regularly sells term insurance at such rates through the insurer's normal distribution channels.

   IRS will not treat an arrangement as having been terminated (and thus will not impute a transfer of the contract from the sponsor to the benefited party) if the benefited party continues to report the receipt of the "economic benefit." So long as the employer is still owed any amount, the split dollar arrangement will continue to be in effect.

   The parties may treat the premium payments by the sponsor as loans (beginning at inception), and IRS will not challenge "reasonable efforts" to comply with §§ 1271 through 1275 (OID rules) and § 7872 (below market loan rules).

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Should You Create a Private Foundation?

By Erika L. Haupt

You have always made charitable contributions, but you want to take a more active role in the allocation of your funds. You also like the idea of involving your family in your philanthropic endeavors so your descendants will learn the importance of giving back to the community and helping others. You have decided to dedicate a substantial sum for charitable endeavors and plan to add to that fund in future years. Will a private foundation accomplish your goals?

The primary advantage of a private foundation is control. You and your family may serve as members and directors of the foundation. You may elect outside directors but retain removal rights within the family. Your directors or officers control asset investments. Most importantly, foundation beneficiaries and the timing of distributions are decisions made by you and your family.

For many, a private foundation is the perfect charitable-giving vehicle. However, there are drawbacks that may outweigh the benefit of total control in some cases.

1. Annual Taxes

   Private foundations must pay an annual tax equal to 2% of net investment income (dividends, interest, rent, royalties and capital gain). The tax may be decreased to 1% if annual distributions exceed 5% of the value of foundation assets.

2. Limits on Deductions for Contributions of Appreciated Property

   The charitable deduction for gifts to a private foundation is limited to the donor's basis unless the property is publicly-traded stock for which market quotations are readily available. If restricted stock is contributed to a private foundation, the donor's deduction is limited to the donor's adjusted cost basis or the donor must restrict personal trading activities so the foundation may sell the stock within applicable volume limitations under securities law restrictions.

3. Deduction Limits Based on Adjusted Gross Income

   Contributions to a private foundation are deductible only to the extent of 30% of adjusted gross income ("AGI") if the property contributed is cash or a gift for which the deduction is limited to the donor's basis. On the other hand, if the donor gives appreciated property for which the donor takes a deduction based on the fair market value of the property (unrestricted, publicly-traded stock), the deduction is limited to 20% of AGI. Unused deductions may be carried forward for 5 years.

4. Self-Dealing

   A private foundation may not engage in self-dealing transactions. Self-dealing transactions including the following between the foundation and a disqualified person: sales or exchanges of property, leases, loans, providing goods and services, compensation for services and transfer or use of assets. A disqualified person generally is a foundation contributor (2% or more), a relative of a contributor or a foundation director.

5. Jeopardy Investments

   Foundation directors who make jeopardy investments are subject to an excise tax. Activities that may be considered jeopardy investments include margin investments, futures contracts, oil and gas investments, puts, calls, straddles, warrants or short sales.

6. IRS Approval of Scholarships and Grants

   Scholarship and grant programs created and administered by the foundation require IRS pre-approval. However, foundations may make contributions to public charities to create scholarship or grant programs without IRS approval.

7. Minimum Distributions

   Private foundations must distribute annually an amount equal to 5% of its assets (using an averaging calculation). Failure to meet the annual distribution requirement results in a 15% tax.

8. Other Penalties

   Private foundations are subject to a number of rules and restrictions. In addition to the taxes for failure to distribute income or 5% of the value of assets each year, penalties may be imposed on lobbying expenses, unrelated business taxable income and excess business holdings. Penalties and excise taxes are also imposed on self-dealing activities and jeopardy investments.

9. Annual Returns

   Private foundations must file annual information forms with the IRS (Form 990) and the Ohio Attorney General.

A private foundation is an ideal charitable giving vehicle if the goals are to retain absolute control over activities of the organization, investments and appointment of members, directors and officers. In some cases, the disadvantages listed above may make other charitable giving options more appealing. For example, a donor may choose to create a donor-advised fund with a public charity. Although the donor does not have the right to direct the investment of fund assets, the donor may make suggestions as to fund distributions and may appoint successor fund advisors. While the charity has the ultimate decision as to distributions, it is not likely to go against the reasonable requests of the advisor for fear of losing future contributions. The charitable deduction for property contributed to a donor-advised fund is limited to 50% of AGI for cash and 30% of AGI for appreciated securities. The donor has no filing requirements and is not subject to excise or other taxes relating to the fund assets.

A supporting organization may also be created in conjunction with a public charity. Although a donor-advised fund may have minimum contribution requirements of several thousand dollars, the minimum contribution to a supporting organization is usually more substantial. A supporting organization also differs from a donor-advised fund in that it is a separate entity controlled by a public charity. The charity must have the ability to appoint a majority of the board of directors, but the donor, the donor's family and the donor's friends may also serve on the board (and the donor may have input as to the directors appointed by the charity).

There are a number of giving options for philanthropic families. A private foundation may be the right choice, but it is important to understand all aspects of foundation requirements and explore other charitable-giving opportunities so you may select the option that best fits your needs and meets your expectations.

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