The answer depends on when the grandfathering provisions parties entered into the equity split-dollar arrangement. If an employer and employee entered into an equity split-dollar plan before January 28, 2002, and the plan was terminated on or before December 31, 2003 by the employee repaying the employer’s premium advances (i.e., a rollout), any then existing policy equity was not subject to tax. That provision was a big opportunity for employees in mature plans with a substantial equity buildup to roll out of the plan with no tax on the excess equity, but for more immature plans with little or no equity buildup this provision provided no real benefit. If the immature plan were terminated by December 31, 2003, the employee would be faced with the prospect of paying the full amount of future premiums with after-tax dollars (or finding some other source for future premium payments), and those same amounts would also be subject to gift taxation if the policy were owned by an ILIT.
As an alternative to terminating an immature equity split-dollar plan entered into prior to January 28, 2002 (i.e., one without substantial equity buildup), the parties to the plan could agree to switch to a loan regime prior to January 1, 2004. Converting to a loan before January 1, 2004 avoided taxation to the employee of policy equity existing both at the time of the switch and at a later rollout. This loan safe harbor required that the beginning loan balance include all pre-2004 employer premium payments as of the beginning of the taxable year in which the switch occurs (although interest need not retroactively accrue on these prior employer payments), and that subsequent employer premium payments be treated as additional loans. This is the safe harbor that was most frequently used by immature old split-dollar plans and the technique has come to be called switch-dollar.
Note, not all old plans needed to be rolled out or switched to a loan by December 31, 2003 to enjoy the benefits of taxation under the loan regime. Old plans that did not have equity by December 31, 2003 can delay the switch to a loan until just before the plan accrues equity in a future year (i.e., the cross-over point) without causing adverse tax consequences. The reason for delaying the switch to a loan and continuing in split-dollar is to preserve the use of favorable REB rates for as long as possible instead of having to use loan interest rates. This delayed switch is another facet of the switch-dollar technique.
Understanding the grandfathering provisions intends to help consumers make wiser policy choices
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM