Split-Dollar Life Insurance

Quillon Foods pays the annual premium on a policy its vice president personally owns, and files a restrictive endorsement barring her from taking loans or surrendering the contract before a stated date. The tax effect of that endorsement is:

1. A.It defers the executive's income until the restriction lapses, because she cannot reach the values in the meantime.This borrows deferral from arrangements where the benefit is genuinely at risk of forfeiture. Here the policy is hers and the premium has been paid on her behalf, so it is compensation in the year paid.
2. B.It makes the premium nondeductible to Quillon Foods, because the employer retains an interest in the policy.An endorsement limiting the owner's access is not a beneficial interest in the contract. The employer has no right to proceeds or to repayment, so the payment remains deductible compensation.
3. C.None; the premium remains currently deductible to the employer and currently taxable to the executive as compensation.The restrictive endorsement is a contractual limit on the policyowner's rights, not a tax feature. The bonus is compensation when paid, deductible by the employer if reasonable and includable by the executive that year.
4. D.It converts the arrangement into split dollar, because the employer now controls access to the cash value.The hallmark of split dollar is the employer's right to recover its premium outlay from cash value or death proceeds. A restrictive endorsement gives no such recovery right.

Why: A restrictive endorsement is the golden handcuffs sometimes added to a Section 162 executive bonus arrangement. It limits the executive's access to policy values without giving the employer any right to be repaid, so the tax analysis is unchanged: the premium is additional compensation, currently deductible by the employer as reasonable compensation and currently taxable to the executive. What distinguishes split dollar is the employer's right to recover its outlay, which a bonus arrangement does not create.

Under a loan-regime split-dollar plan, Ashgrove Mills has advanced 260,000 dollars of premiums to a non-owner executive. When the plan terminates, Ashgrove forgives the entire balance instead of collecting it. The consequence is:

1. A.Nothing is taxable, because forgiving a policy loan is a transaction inside the contract rather than a payment of income.These advances are loans from the employer, not policy loans from the insurer, and forgiving a genuine debt gives the borrower an economic benefit the tax law recognizes.
2. B.Ashgrove simply recovers the 260,000 dollars from the death benefit later, so the forgiveness has no current effect.That is what would have happened had the arrangement continued. Once the employer releases its right to repayment, there is nothing left to recover from the proceeds.
3. C.The 260,000 dollars is compensation income to the executive in the year of forgiveness and deductible by Ashgrove as reasonable compensation.Cancelling an employee's debt transfers value in the employment relationship, so the forgiven balance is wages to the executive and a compensation deduction for the employer.
4. D.The forgiveness is a transfer for value that makes the eventual death benefit taxable to the executive's beneficiary.No policy interest changes hands. The executive already owns the contract, and releasing the employer's collateral claim is not a transfer of an interest in the policy.

Why: In the loan regime, each premium advance is a loan the executive is expected to repay, which is why the arrangement produces only imputed interest while it runs. Cancelling that obligation hands the executive an economic benefit measured by the balance forgiven, and because the relationship is employment, the forgiven amount is compensation: taxable to the executive and deductible by the employer as reasonable compensation. Nothing about the forgiveness turns it into a policy transaction or a transfer for value.

Kestrel Machining and its president Odalys use a LOAN-REGIME split-dollar arrangement: Odalys owns the 3,000,000-dollar policy, and each year Kestrel lends her the 46,000-dollar premium, secured by a collateral assignment. Which statement describes the tax mechanics?

1. A.Neither party has an annual tax consequence; all tax is deferred until the collateral assignment is releasedBelow-market loans are tested annually. Deferring everything to the release date is exactly what the split-dollar regulations were written to stop.
2. B.Each advance is a loan, and if it carries less than the applicable federal rate the foregone interest is imputed as compensation to Odalys and interest paid back to Kestrel, while the policy values remain hersCorrect. Below-market loan rules drive the annual tax consequence under the loan regime.
3. C.Kestrel deducts 46,000 dollars as compensation each year and Odalys reports 46,000 dollars of incomeThat describes a Section 162 executive bonus arrangement, where the employer makes an outright compensatory payment rather than a secured loan.
4. D.Odalys is taxed each year on the term cost of the death benefit protection she receivesThat is the ECONOMIC BENEFIT regime, which applies when the employer owns the policy and endorses part of the death benefit to the employee.

Why: Under the loan regime, each premium advance is treated as a genuine loan from employer to employee. If the arrangement does not charge at least the applicable federal rate, the foregone interest is imputed: treated as additional compensation to Odalys, which she then is treated as paying back to Kestrel as interest. She owns the policy, so the cash value and the death benefit belong to her subject to the collateral assignment. The clue is that Odalys owns the contract and the employer's advances are secured by an assignment.

Under an ECONOMIC BENEFIT split-dollar arrangement, Calder Industries pays the premium on a policy insuring its vice president, retains an interest equal to the premiums it has paid, and the executive's family trust holds the balance of the death benefit. Each year the executive must:

1. A.Report as taxable income the value of the current life insurance protection provided on the portion payable to the family trust, measured by a published rate tableCorrect. The economic benefit is the annual cost of the protection the executive's designee enjoys, valued under the applicable table.
2. B.Report nothing, because the employer owns an interest in the policy and the executive has no vested right to cash valueThe current protection on the trust's share is itself a measurable benefit and is taxable annually.
3. C.Report the entire premium Calder pays as additional taxable compensation for the yearThe employer retains an interest in the policy, so the executive receives only the protection element, not the whole premium.
4. D.Report the increase in the policy's cash value for the year as ordinary incomeUnder the economic benefit regime the employer's interest covers the cash value. The taxable item is the protection, not the inside build-up.

Why: In an economic benefit split-dollar arrangement, the employer's payment buys the executive something of value: current life insurance protection on the portion of the death benefit payable to the executive's designee. The value of that protection, measured by a published government rate table, is reported as taxable compensation to the executive each year. The executive is not taxed on the whole premium, only on the measured value of the coverage received. The clue is that the employer keeps an interest equal to premiums paid while the family trust holds the rest.