A Split Dollar Life Insurance plan is a sophisticated strategy that can help with the payment of life insurance premiums.
Under a split dollar arrangement, a life insurance policy’s premium, cash value, and death benefit are split between two parties. A Split Dollar arrangement is useful in helping to:
- Minimize income and gift taxes when funding large premium payments,
- Reduce cash flow to fund life insurance coverage,
- Provide an executive benefit by a company to encourage employee(s) to stay with the company, and
- Fund the replacement of a key employee or executive due to an unforeseen loss.
Today, there are two primary uses when considering a Split Dollar life insurance arrangement:
- Private Split Dollar
Private split dollar plans are used to provide estate liquidity to help minimize income, estate, and gift taxes.
- Corporate Split Dollar
Corporate split dollar plans are used to by companies as an executive benefit to help retain key employees or to replace the loss of a valued employee. It can also be used to help fund buy-sell agreements.
SPLIT DOLLAR LIFE INSURANCE ARRANGEMENT HISTORY
Split Dollar life insurance arrangements have existed since 1964.
Under these arrangements, Party A (think employer) would typically fund a majority of the premium payments. Party B (think employee) would then be able to access the cash value and name their own beneficiary to receive proceeds after Party A has been repaid the advanced premiums.
Cash value in a life insurance policy has the potential to grow and accumulate over time. Any cash value growth above the contributed premiums is a gain (or equity) to Party B. Party B’s equity in the policy is non-taxable. The IRS viewed the gain as escaping taxation and potentially abusive.
Since Party B was receiving value in the form of a death benefit and/or equity in the policy, the IRS introduced a series of Revenue Rulings. The Revenue Rulings would require Party B pay a tax based on the value of the death benefit being received.
The Revenue Rulings stated the value of the policy to Party B was equal to the one-year term premium of the face amount or use an IRS published table (PS 58) indicating the value of the policy each year. Even with the Revenue Rulings, Split Dollar life insurance arrangements were economical and attractive for estate planning and executive compensation.
The IRS and Treasury Department still felt the untaxed equity in a split dollar life insurance policy was abusive. In 2001, the IRS published Notice 2001-10 and 2002-8 to address the taxable amounts of split dollar life insurance policies. In September 2003, the Treasury implemented regulations similar to the IRS notices.
The Final Split Dollar Regulations
The final split dollar regulations apply to arrangements entered into after September 17, 2003. Split dollar arrangements established prior to this date are not governed by the final regulations provided they aren’t materially modified after this date. These arrangements continue to be governed by the original economic benefit rules under Revenue Ruling 64-328 and Revenue Ruling 66-110.
New Split Dollar Life Insurance Arrangements Subject to Final Regulations
The final split dollar regulations created two tax regimes for arrangements moving forward – economic benefit and loan regime. How you structure your specific split dollar arrangement will be specific to certain factors and result in different taxation.
Split Dollar Life Insurance – Economic Benefit Regime
Under an economic benefit split dollar arrangement, an employer or individual will advance premiums and endorse or assign certain rights to an employee or Irrevocable Life Insurance Trust (ILIT). If an ILIT is the policy owner, gifts of the economic benefit must be made to the trust each year.
If a corporate entity advances you, an employee, or your trust the premium, the economic benefit cost must be reported annually as income. Or, an employee can make a premium payment equal to the annual term cost, and avoid paying income tax.
The value of the economic benefit is based on IRS issued Table 2001 rates or the insurer’s annual renewable term rates, whichever is lower. Economic benefit rates do increase with age. The economic benefit rates for survivorship coverage can be significantly lower than rates for a single life policy.
Split Dollar Life Insurance – Loan Regime
Loan Regime split dollar allows an individual or company to loan the annual premium to an individual or trust. The individual or trust agrees to repay the loan at a future date using policy cash values, other funds, or at death using life insurance proceeds.
The balance of the loan is equal to the premiums paid. The individual or trust can then pay the loan interest or accrue it over time. When interest is accrued it is added to the outstanding loan balance. Loan interest is calculated using a fair market rate or at an Applicable Federal Rate under IRC §7872.
Unlike an economic benefit split dollar plan, interest on the loan arrangement is based on cumulative premiums paid instead of the economic benefit cost of the death benefit.
SUMMARY OF SPLIT DOLLAR REGIMES
TYPES OF SPLIT DOLLAR LIFE INSURANCE ARRANGEMENTS – ENDORSEMENT AND COLLATERAL ASSIGNMENT
Endorsement Split Dollar
Endorsement split dollar is primarily used when a company owns a policy on your life and endorses some or all of the death benefit to you or your trust. Endorsement split dollar is mostly used for business planning.
It is a cost-effective way to for an employer to provide protection on themselves or a key executive. It can also be used to provide supplemental retirement income.
Oftentimes, endorsement split dollar is used as a non-qualified deferred compensation program to create golden handcuffs. Life insurance is a tax-efficient vehicle that can be used to fund deferred compensation payments for a retiring employee.
Under this arrangement, the participant contributes the term cost of the death benefit for their beneficiaries as a survivor benefit. Alternatively, the company can bonus the annual term cost as additional taxable compensation to the participant.
Benefits of Endorsement Split Dollar
Endorsement Split Dollar is most beneficial as an executive benefit. Since the cost is limited to the economic benefit it offers low-cost death benefit protection and/or supplemental retirement income. It can be used by a corporation to provide key-person protection on a valued employee or owner. And, can be an attractive option when establishing and funding a buy-sell agreement.
Endorsement Split Dollar allows for cost recovery from the death benefit proceeds.
Collateral Assignment Split Dollar
Collateral assignment split dollar is generally used by individuals or companies when the insurance policy is owned by a trust. The life insurance policy is either an individual policy or survivorship policy. The owner of the policy (trust) pledges the cash value and death benefit to repay premiums advanced by the non-owner.
This arrangement is usually established between an individual and their trust. However, an individual’s company can advance premiums using corporate dollars. The policy is then collaterally assigned to the individual or company advancing the premiums as security for repayment of premiums.
Benefit of Collateral Assignment Split Dollar
Collateral Assignment Split Dollar is most often used for estate planning. It can provide estate liquidity while minimize gift taxes and use of an individual’s lifetime exemption. Since economic benefit rates can be low, gift taxes can be minimized while gifts of premiums are leveraged with life insurance. Collateral Split Dollar can also be beneficial for business buy-sell planning.
TYPES OF SPLIT DOLLAR PLANS USING THE ECONOMIC BENEFIT REGIME
While Split Dollar Final Regulations changed how plans are structured, they created new ways to achieve specific planning objectives. Under the economic benefit regime there are four primary designs you can utilize.
- Private Non-Equity Collateral Assignment between a Family Member(s) and Trust;
- Corporate Non-Equity Collateral Assignment between a Company and Employee or Trust;
- Endorsement Split Dollar where the Company Owns the Policy and Provides Benefits to the Employee; or
- Private Switch Dollar
Private Non-Equity Collateral Assignment Split Dollar
A Private Non-Equity Collateral Assignment Split Dollar plan is most appropriate for individuals funding a significant life insurance need who want to minimize gift tax and the use of their lifetime exemption to purchase coverage in their ILIT.
Under this arrangement the individual advances premiums to their Irrevocable Life Insurance Trust (ILIT). The ILIT makes premium payments to the insurance company. The individual makes gifts of economic benefit to the ILIT based on the net death benefit. At death, the ILIT receives the proceeds from the life insurance policy. The individual’s estate receives the greater of the policy’s cash values or premiums paid.
Corporate Non-Equity Collateral Assignment Split Dollar
A Corporate Non-Equity Collateral Assignment Split Dollar plan works best for individuals who want to minimize gift tax and use of their lifetime exemption that are interested in funding premiums from their company.
Unlike Private Non-Equity Collateral Assignment Split Dollar, premiums are funded from the company, not the individual. Under this arrangement the company funds the premium to the ILIT. The ILIT makes premium payments to the life insurance company. The individual makes a gift of the economic benefit to the ILIT. At death, the ILIT receives the death benefit, and reimburses the company for premiums paid. Heirs receive the balance of the trust assets.
Learn more about using an Irrevocable Life Insurance Trust to help accomplish your estate planning goals.
Endorsement Split Dollar
An Endorsement Split Dollar arrangement is used company owns a policy on an employee. This often done to provide additional benefits for the employee’s family, or to fund the replacement of the employee.
With Endorsement Split Dollar the company owns the policy and makes premium payments on a policy insuring an employee. The employer endorses a portion or all the death benefit to the employee. The employee pays a tax on the economic benefit received from the assigned death benefit.
In some cases, the employer will retain a portion of the death benefit as a “key man” policy. At death, the employer receives reimbursement for the advanced premiums. The employees named beneficiary will receive the assigned death benefit.
Endorsement Split dollar can also be used as a buy-sell agreement life insurance funding tool.
Private Switch Dollar
Private Switch Dollar combines the economic benefit and loan regime into a single arrangement. At older ages, the economic benefit regime can exceed the cost of using loan regime split dollar. When this occurs the collateral assignment is terminated and a promissory note is established. The initial loan balance is equal to prior premiums paid (or the cash value, if greater).
Private Switch Dollar can also be used prior to the cash value of the policy moving into a gain position. This occurs when the cash value of the policy exceeds total premiums paid.
Under a Private Switch Dollar arrangement an individual advances premium payments to their ILIT. The ILIT makes premium payments to the insurance company. The insured initially makes gifts of the economic benefit to the ILIT. When the economic benefit costs exceed the loan interest cost a switch occurs to loan regime split dollar. At this point, the individual makes gifts of loan interest to the ILIT, instead of gifts of economic benefit.
At death, the ILIT receives the entire death benefit. The ILIT reimbursement the individual’s estate based on premiums paid or cash value, whichever is greater. Once this is done the ILIT retains the balance of the death benefit for the beneficiaries.
SPLIT DOLLAR PLANS USING LOAN REGIME
Establishing a Loan Arrangement Split Dollar plan makes the most sense when it is economical to do so. Determining if loan arrangement split dollar makes more sense than the economic benefit regime is a function of your age and interest environment.
Under a split dollar loan arrangement plan, an individual lends premiums to their ILIT. The ILIT pays premiums to the insurance company. The individual makes gifts of loan interest to their ILIT typically based on an Applicable Federal Rate (AFR).
The individual also has the option of capitalizing the loan interest. Capitalized loan interest is added to the loan balance of cumulative premiums paid.
At death, the ILIT receives the death benefit from the life insurance company. The ILIT then “pays off” the outstanding loan balance (including any capitalized loan interest) to the insured’s estate. The net proceeds are then held in the ILIT, and distributed to the beneficiaries in accordance with the trust language.
FINAL THOUGHTS ON SPLIT DOLLAR LIFE INSURANCE
Split Dollar Life Insurance arrangements are ideal for companies looking to provide additional benefits to key employees, and for individuals interested in minimizing gift tax and use of their lifetime exemption for estate tax purposes.
There are number of benefits for using a Split Dollar arrangement. Your need for life insurance, age, interest rate environment, and premium sources will dictate which arrangement may work for you.
It is important to work with an attorney and life insurance advisor who understands the intricacies of this arrangement.
The information provided in this post is for informational use only. It does not constitute tax, legal, or accounting advice. This information cannot be used to avoid IRS penalty.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. Partnering with a specialized team of advisors, he is able to help business owners significantly reduce taxes, protect assets, and create tax-favorable income.
He compliments his extensive knowledge of tax strategies and products with an in-depth understanding of the different tax and legal structures for which they are used.
About Jason Mericle
Jason Mericle is the founder of Mericle & Company. He has partnered with a unique team of professional advisors specializing in helping business owners significantly reduce taxes, protect assets, and create tax-favorable income.
Jason compliments his extensive knowledge of tax solutions and products with an in-depth understanding of the different tax and legal structures for which