Material Modifications

What about “Material Modifications” to Grandfathered Split-Dollar Arrangements?

As noted in Question C.3, grandfathered split-dollar arrangements “materially modified” after September 17, 2003 are subject to tax based on the final regulations rather than the provisions of pre-regulation guidance.

Why Does a Material Modification Matter?

There are significant differences between the tax rules applicable under the pre-regulation guidance and those under the final regulations. As illustrated below, the application of the final regulations to a grandfathered split-dollar arrangement due to a material modification may produce substantially different and adverse tax consequences for the parties to the grandfathered agreement.

What Qualifies as a Material Modification?

Unfortunately, the final regulations do not define the term “materially modified.” They only provide a “non-exclusive list of changes” that will not constitute material modifications for purposes of grandfathered split-dollar arrangements, including changes solely:

• In the mode of premium payment (e.g., from monthly to quarterly)
• In the policy beneficiary, unless the beneficiary is a party to the split-dollar arrangement
• In the interest rate payable on a policy loan
• Necessary to preserve the status of the life insurance contract under IRC §7702
• To the ministerial provisions of the policy (e.g., a change in payment address)
• Made under the non-discretionary terms of any agreement (other than the policy) that is a part of the split-dollar arrangement and in effect on or before September 17, 2003
• In the policy owner as a result of a IRC §381(a) transaction (dealing with corporate acquisition of assets in certain liquidations or reorganizations) and in which substantially all the former owner’s assets are transferred to the new policy owner
• To the policy if required by a court or a state insurance commissioner as a result of the insolvency of the carrier that issued the policy
• To the administering insurance carrier as a result of an assumption reinsurance transaction that did not involve the parties to the arrangement.

The final regulations authorize the IRS to provide additional guidance regarding other non-material modifications for purposes of split-dollar arrangements, and, in 2007, the IRS issued Notice 2007-34, which addresses the impact of modifications of split-dollar arrangements necessary to address compliance issues associated with IRC §409A (dealing with nonqualified deferred compensation). Apart from this guidance, the IRS has remained almost silent on this issue.

What are the Tax Consequences of the Loss of Grandfathered Status?

The potential tax consequences due to the loss of grandfathered status for a split-dollar arrangement will vary depending on the structure of the grandfathered arrangement and whether it involves an equity component.

Loss of Certainty in Using Insurer Term Rates to Determine Economic Benefit. Pre-regulation guidance taxes both grandfathered endorsement and collateral assignment split-dollar arrangements based on the annual economic benefit provided (e.g., the annual term cost of the current life insurance protection). As discussed , this benefit is measured the annual term rates under Table 2001 or the Insurer Term Rates published by the issuing insurance carrier, if they are lower than the IRS table rates (which they typically are) and available to all standard risks. Post-regulation split-dollar arrangements subject to the economic benefit regime under the final regulations  are similarly taxed with regard to the annual cost of current life insurance protection provided to the insured.

Split-dollar arrangements entered into after January 28, 2002,62.1 however, including post-regulation arrangements, are subject to stricter limitations on the ability to use the Insurer Term Rates, and carriers generally will not opine as to whether their rates are compliant. The difference between the use of the Table 2001 rates and Insurer Term Rates can be substantial.

Example: A $1 million policy insuring a 65 year old employee is subject to a grandfathered endorsement split-dollar arrangement. Under Table 2001, the cost of insurance for an insured, age 65, is $11,900, while using the Insurer Term Rates, the cost of insurance would be $2,030. A material modification to the agreement could result in an additional taxable economic benefit of up to $9,870 (with further increases each year).

Thus, if a material modification of a grandfathered arrangement results in application of the economic benefit tax regime under the final regulations (e.g., as with modification of a grandfathered endorsement arrangement), the loss of certainty regarding the use of Insurer Term Rates to determine the annual economic benefit could have a significant tax impact. In addition, for contributory arrangements , the insured’s contribution will now be considered taxable income to the business, which will increase the business’ (but not the insured’s) tax basis in the policy.

Current Taxation of Built-Up Equity.For grandfathered equity arrangements, pre-regulation guidance protects the policy equity from current taxation as long as the grandfathered split-dollar arrangement remains in force. The IRS considers the arrangement in force as long as the parties continue to report the annual economic benefit provided to the insured, the business retains some reimbursement right under the arrangement, and the agreement is not materially modified.

A material modification to the grandfathered equity arrangement, however, will subject the arrangement to tax under the final regulations, which may dramatically affect the taxation of any policy equity to the insured, as follows:

• Endorsement Arrangements. A material modification of a grandfathered endorsement arrangement likely will result in taxation under the economic benefit regime of the final regulations, and the IRS may seek to currently tax the economic benefit provided by the insured’s access to the policy’s existing cash value. Where the focus is on death benefit protection, not access to cash value, the parties may want to consider modifications to eliminate the insured’s/ILIT’s access to cash value.
• Collateral Assignment Arrangements. A material modification to a grandfathered equity collateral assignment arrangement likely will subject it to tax under the loan regime of the final regulations.Under a safe harbor in pre-regulation guidance, the parties to the split-dollar arrangement may elect to include all premiums paid by the employer to date as a loan entered into as of the beginning of the year of the modification, and subsequent premium payments by the business will be treated as additional loans. If the loan does not charge adequate interest (such as at the appropriate applicable federal rate (“AFR”) for the date and term of the loan), the foregone interest will taxed to the insured as income (and as a gift to the ILIT, if it holds the policy). See discussion beginning at Question D.35 for the treatment of split-dollar loans. Depending on the age of the policy, this loan amount could be quite large.In addition, if the policy has developed any equity, the IRS may attempt to tax the equity to the insured at the time of the modification, less the insured’s basis in the policy, if any.

Example: X Co. has paid $1 million of premiums on a policy subject to a grandfathered collateral assignment arrangement, which currently has $2.1 million of cash value. A material modification is made to the split-dollar arrangement. E, the insured employee may now have an outstanding loan balance of $1 million bearing interest at the AFR for the duration of the split-dollar arrangement, which interest he must take into income as compensation if not paid or accrued. In addition, E may be subject to income tax on some portion of the $1.1 million of policy equity in the policy. If an ILIT holds the policy, not only will E not have access to the policy’s cash value to pay taxes, a corresponding taxable transfer may have been made to the ILIT for gift and GST tax purposes.

Practical Note: This issue typically also arises upon roll-out of a policy at termination of a split-dollar arrangement. Until definitive guidance is issued, parties to a grandfathered split-dollar arrangement who contemplate a 1035 exchange should weigh the potential benefits of the exchange versus the tax consequences of the loss of grandfathered status.

Does a 1035 Exchange Constitute a Material Modification?

The parties to a grandfathered split-dollar arrangement may wish to exchange the original policy for another in a tax-free exchange under IRC §1035 (a “1035 exchange”). That section generally provides that no gain or loss is recognized on the exchange of one life insurance policy for another insuring the same insured. The ability to make such a tax-free policy exchange provides significant flexibility for policy owners to modify their coverage as needed to adapt to changing circumstances and to take advantage of new product developments.

Unfortunately, the lack of IRS guidance on material modifications creates a significant risk that a 1035 exchange of a policy subject to a grandfathered arrangement will result in a material modification, causing the loss of grandfathered status. The “non-material” modifications listed in the final regulations provide little guidance, as they are generally ministerial, administrative, or non-discretionary in nature. Notably, even though comments to the proposed regulations requested that the IRS include 1035 exchanges as non-material modifications, the final regulations failed to do so.

Some commentators have suggested that the IRS could test 1035 exchanges of policies subject to grandfathered split-dollar arrangements on a facts and circumstances basis, potentially considering whether the 1035 exchange significantly affects the economics of the policy or the parties to the arrangement; without additional guidance, however, it is difficult to generalize what the IRS would consider as a significant economic change for purposes of a material modification. Further, some practitioners believe the omission of a 1035 exchange from the list of non-material modifications implies that the IRS considers it a material modification.

Practical Note: Until definitive guidance is issued, parties to a grandfathered split-dollar arrangement who contemplate a 1035 exchange should weigh the potential benefits of the exchange versus the tax consequences of the loss of grandfathered status. As better insurance products coming on the market, however, the existence of a grandfathered split-dollar arrangement should not cause an automatic rejection of a 1035 exchange, but should be a factor in the review. Given the fiduciary duties often associated with trust administration and investment management, ILIT trustees, in particular, will want to ensure they review all the pros and cons of a 1035 exchange in this situation, including the potential for loss of grandfathered status, and document their deliberations and final decision.

Will the IRS Privately Rule on What Qualifies as a Material Modification?

It is unlikely. Since 2005, the IRS has refused to rule on whether a split-dollar arrangement has been “materially modified” for purposes of the final regulations, which means parties to a grandfathered split-dollar arrangement likely cannot obtain comfort for a proposed transaction, including a 1035 exchange, through a private letter ruling.

Should 1035 Exchanges Still be Considered for Grandfathered Arrangements?

Yes, since a change in the grandfathered status of a split-dollar arrangement may not be detrimental in every situation, depending on the particular facts and circumstances.

For example, with a grandfather equity split-dollar arrangement where the policy is owned by the insured or his or her ILIT, the major determining factors likely will be (1) whether the policy has significant equity, (2) the reimbursement amount then due to the business, and (3) the need or desire for an on-going split-dollar arrangement to fund premiums on continuing life insurance coverage. If the policy has no equity, the parties could consider modifying the grandfathered agreement by switching it to a split-dollar loan arrangement under the final regulations . The existing reimbursement right due to the business will become a split-dollar loan under the final regulations. The parties then could accomplish a 1035 exchange of the policy and fund future premiums through additional split-dollar loans.

Practice Note: Each case will warrant an analysis of the potential tax consequences of a material modification, the policy owner’s current coverage and premium funding requirements, income and gift tax consequences of future premium payments or the measure of annual economic benefits provided, and the options for a current or subsequent exit of the arrangements.