Comments Concerning IRS Notice 2001–10
II. Tax Rules for Equity SDAs Established Prior to the Notice
We suggest that the Treasury and the IRS consider excluding Equity SDAs established under the collateral assignment method before issuance of the Notice from the rules provided in the Notice, and provide special rules for these arrangements reflecting taxpayers' reasonable expectations in light of previously available guidance.
Revenue Ruling 64-328 may reasonably be interpreted to cover Equity SDAs and their taxation. This ruling describes the employer's right in the SDA as "an amount equal to the CSV, or at least a sufficient part thereof to equal the funds it has provided for premium payments." (emphasis added). The highlighted language describes Equity SDAs. The illustration to Revenue Ruling 64-328 supports this interpretation, as the CSV in year five exceeds the cumulative premiums paid by the employer in previous years. General Counsel Memorandum 32941, issued in conjunction with Revenue Ruling 64-328, appears to acknowledge this result by providing that the policy's investment element should not be taxed when it is credited to CSV. Nothing in Revenue Ruling 64-328 states that CSV exceeding total premiums paid is taxable during the term of the Equity SDA, and subsequent rulings (including Revenue Ruling 66-110) do not address CSV accumulations in an Equity SDA.
One alternative is to provide that CSV under Equity SDAs structured under the collateral assignment method and entered into before the Notice would only be subject to tax under Sections 72 of the Code when the employee withdraws policy CSV or surrenders the underlying policy. 8 This approach does not frustrate taxpayer expectations while allowing for taxation of the CSV or loss of valuable death benefits if the employee benefits from the policy equity at any time. A policy surrender or CSV withdrawal would be taxable under Section 72 except to the extent that the employee has basis in the policy. 9 Changing the dividend option to receive a stream of income would subject the dividends in excess of basis to immediate tax. If the employee takes policy loans, there would be adverse economic consequences to the employee upon failure to pay policy interest, including possible lapse of the policy. 10
Treatment under this alternative should not be available from and after the date that the parties make a material amendment to an existing Equity SDA. Standards for a material amendment could be developed similar to those provided under Section 7702. A material amendment would not include a notice by either party unilaterally to terminate the Equity SDA as contemplated by the operative agreements, or an amendment to change an employee's payment rate under the Equity SDA from the P.S. 58 rate to any other method now allowed under the Notice (or any future guidance). The material amendment rule would allow a rollout for a collateral assignment Equity SDA without taxation only if such action could be taken without amending the contract between the parties. An Equity SDA that has been materially amended would be treated as a new arrangement as of the day of the amendment, and therefore subject to the normal rules under the Notice.
8 Equity SDAs structured under the endorsement method would be subject to tax on rollout consistent with previous private letter rulings as noted above. No special grandfathering treatment is needed for these arrangements so long as it is determined that incremental increases in CSV will not be subject to tax so long as the Equity SDA is in effect.
9 We understand that some taxpayers have calculated in good faith the CSV increase attributable to employer premium payments and reported this amount as compensation on the employee's IRS Form W-2. Taxable compensation should create basis for the employee when computing any tax under Section 72.
10 Policy loans require the payment of interest. Interest that is not paid under the policy accrues as an additional liability. The effect of compound interest reduces the policy death benefit, and would cause the policy to lapse in severe cases. A lapse of the policy would likely cause the employee to be taxed on the accrued interest and the loan principal.