Loan Regime Split-Dollar Between Business, as Employer, and Insured Executive’s ILIT – First Year

Facts. A split-dollar loan agreement was established between X. Co. and executive E’s ILIT after the effective date of the final regulations (September 17, 2003). ILIT owns the policy (non-MEC) and is a grantor trust with regard to E for federal income tax purposes. X Co. paid the first annual premium to the insurance carrier. The split-dollar loan is nonrecourse to E and E’s ILIT and is secured only by a collateral assignment of the policy cash values filed with the life insurance carrier. The loan is an interest-free demand loan. The applicable blended short term AFR (annually compounding) that applies to test the sufficiency of interest under the loan is 0.22%.

Economics:

Potential Tax Outcomes. Based on the above:

• X Co.
  •  Has been reporting annual compensation income to E equal to the forgone interest under the loan (which is potentially eligible for a compensation deduction), but has also been reporting annual interest income from E in a corresponding amount.
  • Receives $1,500,000 as repayment of the loan, which should not be subject to tax as a return of principal.
• Executive E:
  • Has been reporting annual compensation income equal to the forgone interest under the loan, with a corresponding gift to the ILIT.
  • Has not been able to deduct the interest deemed paid by him to X Co. on the loan.
  • Should not incur income tax (as grantor of the ILIT) when the ILIT makes a withdrawal of $1,500,000 of the policy cash value to repay X Co.
  • Should not incur any gift tax upon the ILIT’s repayment of the loan.
  • Has been making corresponding, imputed gifts to the ILIT of the annual forgone interest he has reported as income.
    • Depending on the terms of the ILIT, including the number of beneficiaries who hold Crummey withdrawal powers, if any, E may have been able to shelter the imputed gifts as annual exclusion gifts.
      • If E intended the ILIT to be fully exempt from GST tax, he likely should have been allocating a corresponding amount of his federal GST tax exemption to the imputed gifts to preserve the ILIT’s GST tax exempt status.

Termination of a Loan Regime Split-Dollar (without Equity)

Facts. A split-dollar loan arrangement was established between X. Co. and executive E’s ILIT after the effective date of the final regulations (September 17, 2003). ILIT owns the policy (non-MEC) and is a grantor trust with regard to E for federal income tax purposes. The split-dollar loan is nonrecourse to E and E’s ILIT and is secured only by a collateral assignment of the policy cash values filed with the life insurance carrier. The ILIT and X Co. have properly filed nonrecourse representations for the loan. The split-dollar arrangement will terminate upon E’s termination of employment, when repayment of the loan is due using either policy cash values or other assets of the ILIT, as the policy owner. The split-dollar loan is a hybrid, performance based below market loan (see Question D. 50), and the annual forgone interest has been imputed to E each year of the loan. E is ready to terminate employment. The policy has not performed well, so there is insufficient cash value for use in reimbursing reimburse X Co.

Termination. The policy owned by the ILIT will be surrendered for its cash value, with the proceeds paid to X Co. in partial reimbursement of the loan. X Co. will forgive the remainder of the loan balance.

Economics:

Potential Tax Outcomes: Based on the above:

• X Co.
  • Has been reporting annual compensation income to E equal to the forgone interest under the loan (which is potentially eligible for a compensation deduction), but also has been reporting annual interest income from E in a corresponding amount.
  • Receives $1,150,000 as repayment of the loan, which should not be subject to tax as a return of principal.
  • Reports $350,000 as compensation income to E and takes a corresponding income tax deduction (subject to limitations under IRC §162(m) regarding reasonableness of the compensation).
  • Should review the possible application of IRC §409A to the arrangement as the application of that section can be triggered by forgiving or waiving repayments amounts under a split-dollar loan.
• Executive E:
  • Has been reporting annual compensation income equal to the forgone interest under the loan, with a corresponding gift to the ILIT.
  • Has not been able to deduct the interest deemed paid by him to X Co. on the loan.
  • Should not incur income tax (as grantor of the ILIT) when the ILIT surrenders the policy for $1,150,000 of policy cash value to repay X Co.
  • Has compensation income of $350,000.
    • Assuming tax at a maximum income tax rate of 40%, the termination of the arrangement could result in a top federal income tax liability of $140,000.
    • This is phantom income to E. Unless X Co. agrees to bonus the tax liability to E as additional compensation (which, again, may not qualify for a corresponding compensation deduction due to reasonableness requirements), E will need to come up with his own cash to pay the liability.
  • Makes a corresponding, imputed gift of $350,000 to the ILIT.
    • Depending on the terms of the ILIT, including the number of beneficiaries who hold Crummey withdrawal powers, if any, E may have been able to shelter the imputed gifts as annual exclusion gifts.
    • Otherwise, if annual exclusion gifts are not available, E could incur federal gift tax of up to $140,000, assuming application of a top 40% gift tax rate or must use $140,000 of his federal gift tax exemption (if he has any remaining) to shelter the gift.
    • In addition, if E intends for the ILIT to be fully exempt from GST tax, he likely will need to allocate $350,000 of his federal GST tax exemption (if he has any remaining) to preserve the ILIT’s GST tax exempt status.
    • Termination of the loan arrangement could result in a combined federal income and gift tax liability to E of $280,000.