Paul O'Neill's Sweet Deal
Investment News ~ January 21, 2002
Paul O'Neill's sweet deal
Sara Hansard
The Internal Revenue Service has backed off of a plan to close a loophole in the tax
code through which some of the nation's richest executives - including Treasury
Secretary Paul O'Neill - stand to reap huge windfalls virtually tax free.
The Treasury Department and the tax agency issued a policy notice closing the
loophole last January just as the Bush administration was taking office.
But corporate and insurance industry lobbyists unleashed a firestorm of protest, and
the Treasury Department, under Mr. O'Neill's aegis, issued a modified directive three
weeks ago.
It could not be learned whether Mr. O'Neill recused himself on the issue; a Treasury
department spokeswoman did not return several calls seeking comment.
The new notice, however, essentially grandfathers in certain key tax aspects of
split-dollar insurance policies, which corporations typically buy for select senior
executives.
The move will save those executives from a potentially large tax liability if their policies
predate a Monday deadline set by the IRS.
As of 2000, Mr. O'Neill still had a split-dollar life insurance policy that his former
employer, Alcoa Inc. of Pittsburgh, arranged for him in 1988.
The IRS says that it intends to have formal rules drafted by 2004 that will affect all
split-dollar policies.
In the meantime, the new notice has touched off a scramble among financial planners
to put split-dollar insurance arrangements in place for their clients before the Jan. 28
deadline.
Split-dollar insurance policies, which have been around since the 1950s, once were a
simple way for companies to provide life insurance for key executives.
But over the years, they've evolved into complex financial instruments involving dozens
of different strategies, all with the net effect of providing executives with millions of
dollars virtually tax free.
``A tax game is being played,'' says J.J. MacNab, an insurance analyst who owns
MacNab Consulting in Bethesda, Md. ``It's a way corporations could give huge
benefits to employees without the employees paying any taxes on it.''
According to the financial disclosure report he filed for 2000, Mr. O'Neill had between
$250,000 and $500,000 in assets in an ``Alcoa Split Dollar Insurance Employee
Benefit Plan for Senior Executives.'' Northwestern Mutual Life Insurance Co. provided
the policy.
Although there are myriad variations, the policies essentially work like this: The
corporation buys a life insurance policy in the name of a key executive and pays the
premiums. The executive agrees to repay the company upon death or retirement out
of the cash value that accumulates in the policy.
At the end of the deal, the executive ends up with a policy typically worth millions of
dollars in addition to whatever cash value is left after the premiums are repaid.
``In the early days, whole life policies were used that accumulated very little in the
way of cash value,'' says Ms. MacNab.
But in the 1970s and '80s, she says, employers started using a slew of new
insurance products, including variable-universal life policies, which generated huge
cash values from investments in equities.
In addition, the face value of the insurance policies soared into the millions of dollars
as they came to be recognized as more of a tax play than as life insurance.
``Treasury never adapted. It never rewrote the rules,'' says Ms. MacNab. ``They didn't
assume that there was going to be cash value going to the employee. The rules were
very outdated.''
Mr. O'Neill has set up an irrevocable insurance trust to receive a lump sum at his
death. It will benefit his children and grandchildren, according to the disclosure report.
Last year, he earned between $100,000 and $1 million in dividends on those assets,
according to his disclosure report.
insurers pleased
The IRS' initial notice, drafted during the Clinton administration, was poorly written and
raised as many questions as it answered, according to Ms. MacNab and other tax
experts.
But essentially it held that if the corporation bought the policy for the executive, the
yearly premium would have to be treated as taxable income by the executive.
In cases where corporations structured the premium payment as an interest-free loan,
then the imputed interest would have to be treated as taxable income.
In either case, the policy change could have saddled executives with hefty tax bills.
Ms. MacNab estimates that Mr. O'Neill's split-dollar premium could be as high as
$100,000 each year.
The most recent notice from regulators stipulated that contracts issued before next
Monday would not be taxed differently than they have been until 2004 - by which time
new rules are to have been issued.
New contracts issued after next Monday will carry new tax burdens.
Laurie Lewis, chief counsel at The American Council of Life Insurers in Washington,
describes the new ruling as ``unequivocally better'' than the ruling issued one year
ago.
``There are ways to read this notice that would indicate that your tax burden shouldn't
change for some policyholders,'' she says.
The ACLI hailed the decision by the government to revoke the rules issued a year ago.
The industry complained that the ruling would have affected business already in place,
raising the amount of income that employees would have to report and on which to
pay taxes.
Meanwhile, ``the race is on to get as many plans entered into before Monday to
preserve maximum future flexibility in options,'' says Michael Weinberg, president of
The Weinberg Group Inc., an estate planning firm in Denver.
``There's a lot of confusion among financial planners as to what to do,'' he says.
``You want to have your plan in place by Jan. 28, so everyone's rushing now. There's a
lot of activity to get these plans in place,'' he adds.
Questions remain concerning the effect of different tax treatments for different types of
loans, and record keeping will be more difficult, says Mr. Weinberg.
``This is a whole new regime for how you end up purchasing life insurance with
employer help,'' he says.
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