Split-Dollar Life Insurance Arrangements Need to be Reviewed for Section 409A Compliance by December 31, 2008

December 5, 2008

The final date of the transition rules under Section 409A for deferred compensation plan is December 31, 2008. A split-dollar life insurance arrangement (“SDA”) may provide for deferred compensation that is subject to Section 409A. If an SDA is subject to Section 409A, it is very likely that the SDA will need to be revised by December 31, 2008 to comply under Section 409A. This McGuireWoods client alert is a reminder of the approaching deadline.

Newer Split-Dollar Life Insurance Arrangements

An SDA that has been put in place after 2004 should have taken Section 409A into consideration from the beginning. As with most SDA tax issues, there is different treatment under Section 409A of endorsement versus collateral assignment SDAs.

Under an endorsement SDA, the policy owner is currently taxed on the economic benefit. However, other features of the SDA can create deferred compensation, such as a right to access the cash surrender value. Provisions that create deferred compensation need to comply with the Section 409A requirements, such as payments only being available on a permissible event like separation from service. An endorsement-style SDA that only provides for death benefits is excludable from Section 409A as a death-benefit plan.

For a collateral assignment SDA, the treatment of the premiums as a loan would generally avoid Section 409A implications. However, the employer can create Section 409A issues by waiving, canceling or forgiving the loan.

SDAs Grandfathered under Split-Dollar Rules

The tax rules for SDAs were substantially changed in 2003 and many SDAs are grandfathered under the prior law. That grandfathering does not necessarily mean that the SDA is also grandfathered for Section 409A purposes. If premium payments have been made after 2004, a portion of the SDA may be subject to Section 409A.

Whether benefits under an SDA are grandfathered for Section 409A purposes is determined under the normal Section 409A grandfathering rules. To be fully grandfathered under the Section 409A rules, all benefits must have been earned and vested (or be subject to a legally binding right with no risk of forfeiture) before 2005 and the SDA cannot be materially modified after October 3, 2004. For example, if future premium payments are contingent on the insured continuing in employment after 2004, the SDA would not be fully grandfathered for Section 409A purposes.

If an SDA is not fully grandfathered for Section 409A purposes, the SDA must be amended if necessary to comply with Section 409A by December 31, 2008. In most cases, the Section 409A amendments can be made without losing the grandfather treatment under the SDA tax rules.

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For additional information on the effect of Section 409A on split-dollar arrangements, please contact us.