IRS Blended Interest Rate for Demand Loan Split Dollar Plans Falls to Under 1%

The blended interest rate used to calculate taxable income on demand loan split dollar plans is falling to a historic low 0.82%. The new rate, effective from July 1, 2009 until June 30, 2010, makes those plans less expensive than ever before. You can find the official IRS notice here (it’s at the very end).

[Updated 7/1/2010: The blended rate, effective from July 1, 2010 until June 30, 2011, is 0.59%. The official IRS notice is here. Look for Table 6.]

Background

Split dollar is a way to pay life insurance premiums, not a type of insurance. The plan is often between an employer and employee and allows the employer to provide low cost life insurance to key employees. But it can also be between a family member with money and a family member who needs life insurance protection but can’t afford it herself. One party to the plan pays all or part of the premiums and the other gets life insurance protection. When the plan ends, all or part of the premiums are repaid out of the policy proceeds.

For the sake of simplicity, let’s refer to an employer and employee. However ‘employer’ could be, for example, a grandparent and ‘employee’ could be a grandchild.

Split dollar plans are taxed under one of two set of rules. The ‘economic benefit’ rules apply if an employer pays any part of the premium and owns the policy. If the employee is the owner, the economic benefit rules still apply if the employee gets only the death benefit. The ‘loan’ rules apply in all other cases.

Loan plans are taxed either as ‘term’ loans or ‘demand’ loans. A term loan is one that is due at the end of a set period. That period can be a specific date or it can be an event. For example, if the employee must repay the employer on December 31, 2020, or when the employee retires, that is a term loan.

A demand loan must be repaid whenever the employer asks for the money.

The same rules apply if the plan is between family members.

Demand Loans

When the employer pays a premium, it is treated as lending that money to the employee. The balance of the loan increases with each premium. For example, if the annual premium is $10,000, the loan balance after the first year is $10,000. But after 10 years it is $100,000. In other words, the ‘principal’ to which the interest rate is applied grows each year that premiums are paid.

If the plan doesn’t set an interest rate higher than the IRS blended rate, the law lets the IRS assume the rate is equal to the blended rate. If the employee doesn’t pay the interest, he must include the unpaid amount as extra income. In a family plan, unpaid interest is a gift from the grandparent to the grandchild.

The imputed interest will be modest in early years but as the total amount of premiums paid grows, it can become quite large – especially if interest rates go up.

Over the past 25 years, the median blended rate has been 4.98%. That means half the time it has been higher than 4.98% and half the time it has been lower. However, the rates have been much lower in recent years. If you look just at just the last ten years, the median rate was 2.96%. The rate has gone down in each of the last three years.

To better understand the impact of a constantly changing rate, consider a split dollar arrangement with a $10,000 annual premium paid over 20 years. This chart shows you how much extra taxable income an employee would have (or how big the taxable gift would be).

The employer would pay $200,000 in premiums over 20 years. The total taxable income (or cumulative gifts) using the actual blended rate each year would be $80,824.

You can see the significant impact of changing rates by looking at the interest paid in the last three years.

Consider, however, if the 1990 rate of 8.19% applied. Instead of $1,640 taxable income, the employee would have to pay tax on an extra $16,380 – ten times more.

Final Thoughts

The very significant decrease in interest rates will make split dollar plans set up under the demand loan rules very attractive. Of course, you need to carefully consider what will happen when rates increase. The IRS can’t go much lower; it can go lots higher. Fortunately, over the last 25 years, when rates have gone up, the average increase has been only 1.03%. The largest annual increase (in 1994) was only 1.78%. It may be worth the gamble to take advantage of low rates now if you believe they’ll increase slowly over the next several years.

What do you think? Leave a comment or email me.

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3. IRS Rules on Taxation From Sale of Life Insurance to Investors
4. IRS Answers Questions about Employer-Owned Life Insurance
5. 17 Questions and Answers about Notice and Consent and Employer-Owned Life Insurance