Legal Memorandum: Employee's Basis in a Life Insurance Policy

Issue: Under federal law, what effect does a revision in an employee life insurance plan where the employee will no longer contribute to the premiums and will receive a lump sum payment representative of previous premium contributions, have on the employee’s basis in the policy?

The employee’s basis in a life insurance policy is determined by his or her contribution to the policy.  Treas. Reg. 1.1015-4 (1997)]; see also Thomas C. Bilello, Reverse Split-Dollar Life Insurance:  What Are the Tax Effects?, 24 Est. Plan. 27, 32 (Jan. 1997) [hereinafter Bilello].  Therefore, in addition to the other potential tax consequences to the employee, the employee’s 0% contribution and the employer’s 100% contribution to the premiums under the revised plan will decrease the employee’s basis in the policy.

The decreased basis is potentially important at one of two points:  (a) when the policy proceeds enter the estate for tax purposes after the employee’s death, or (b) when an employee chooses to terminate participation and cash-in the policy for its cash surrender value.  Normally, only point (b) would result in a taxable event under either the original or revised equity split-dollar arrangement.  However, to the extent that the employer’s "gift" of the past premium amounts exceeds the policy indebtedness, it also could be treated as a taxable event under (a), that is as a transfer for value under I.R.C. § 101(c), and could impact the estate tax calculations.  See Bilello at 32.

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