Over the past few months, we have had several clients using split-dollar arrangements for a variety of applications. A couple clients utilized split-dollar for future income, including a tax-exempt organization using split-dollar with its top executives to avoid the excise tax on high compensation, and three other clients engaged in split-dollar to purchase life insurance in a grantor trust to use to pay future estate taxes. Split-dollar life insurance offers a wide range of versatile applications that can benefit both employers and individuals seeking to plan just like our consulting clients.
While these plans are commonly established to reward key employees or for company shareholders to make tax-efficient use of retained earnings, they can also be configured for private arrangements between individuals, individuals and trusts, or even between two trusts, making them a strategic part of a well-structured estate plan.
In an employment setting, a company may cover the life insurance premiums for an employee's or a shareholder’s policy. This split-dollar arrangement not only helps the employee or shareholder achieve their future income and/or wealth-transfer objectives but also serves as an asset for the company in the form of an outstanding loan. As we have found with our clients, split-dollar arrangements are flexible and can be tailored to suit the specific interests of both employers and employees/shareholders.
Types of Split-Dollar Plans
Split-dollar plans can be categorized into different structures, including economic benefit arrangements with endorsements, loan arrangements with collateral assignments, and non-equity collateral assignments. Occasionally, a switch-dollar strategy is also employed.
Economic Benefit with an Endorsement: In this arrangement, the employer owns the life insurance policy and shares the death benefit with the employee. The employee can designate beneficiaries for a portion of the policy's death benefit through an endorsement. The employer pays the policy premiums annually, and the employee includes the "economic benefit" of the endorsed death benefit as taxable income. In the event of the employee's death during the endorsement split-dollar plan's tenure, the beneficiaries receive the endorsed portion of the death benefit, with the employer retaining the rest. If the plan is terminated, the employer can either keep the policy and remove the endorsement or transfer it to the employee. Generally, there is no cost to the employee unless the policy is transferred to them. This endorsement split-dollar plan is often used to provide a cost-effective death benefit as a fringe benefit or for key person protection.
The economic benefit cost is determined based on factors such as the employee's age, death benefit amount, and IRS-provided risk factor tables. This cost increases as the employee gets older, prompting some participants to reassess the plan's costs and consider alternatives as they age, such as converting to a survivorship policy.
Loan Regime with a Collateral Assignment: In this setup, the employee owns the policy while the employer covers the premiums. Each premium payment is treated as a loan from the employer to the employee, with the employee providing collateral through a policy assignment. The employee is required to pay interest on the loan annually, either out-of-pocket or as imputed income, which may incur income tax liability. The collateral assignment safeguards the employer's interest in the policy until the loan is repaid. Until the loan is settled, the employee can access the policy's cash value beyond the loan balance. In the event of the employee's death, the death benefits either repay the loan to the employer or result in forgiveness of all or part of the debt. If the plan is terminated, the employee must repay the loan using the policy's cash value or other funds, unless the employer forgives it. This plan allows the employee to own the policy while retaining access to its cash value.
The collateral assignment offers a balanced approach that benefits both the employer and the employee. Employers can use it to provide attractive fringe benefits and recover premium costs through the death benefit, while employees enjoy ownership of the life insurance, tax-exempt death benefits (when structured properly), and potential access to cash buildup.
Non-Equity Collateral Assignment: This "hybrid" structure involves the employee owning the life insurance policy, with the employer paying premiums and expecting future repayment. In this scenario, the employee agrees to reimburse the employer an amount equal to the policy's cash value or cumulative premiums when the plan terminates. Similar to the endorsement split-dollar plan, the employee pays annual income tax on the death benefit cost related to their entitled death benefit.
If the employee passes away while the plan is active, the employer receives either its paid premiums or the policy's cash value from the death benefit, with the remaining going to the designated beneficiaries. If the plan terminates before the employee's death, the employer is repaid either the cash value or premiums paid, or they may choose to forgive part or all of the debt, which could be taxable income for the employee.
The non-equity collateral assignment split-dollar plan is useful when the employee wants to own the policy, values the death benefits for wealth transfer purposes, and requires assistance in paying premiums. Employers and employees should evaluate these plans to determine when the policy's cash value exceeds the total premiums paid and consider switching to a loan regime plan if necessary.
Switch-Dollar Plan: This plan often starts as a non-equity collateral assignment split-dollar plan and may later transition into a loan regime split-dollar plan. For survivorship policies, the switch typically occurs upon the first insured's death, while for single-life policies, it occurs when the policy's cash value surpasses the premiums paid or when the economic benefit cost surpasses the loan interest costs. During the switch, the loan amount equals the outstanding repayment obligation from the non-equity collateral assignment split-dollar plan, which is the greater of the premiums paid by the employer or the policy's cash value. Future premiums are treated as a loan by the employer.
Upon the employee's death, the split-dollar loan is repaid to the employer from the death benefits, with the remainder going to designated beneficiaries. In the event of plan termination, the loan is repaid using a combination of the policy's cash value and the employee's other assets. Similar to the loan regime split-dollar plan, the employer may choose to forgive part or all of the loan.
The switch split-dollar plan is commonly used for survivorship policies due to increased costs when the insured individual passes away. For single-life policies, it can help reduce income tax liabilities. Deciding when to execute this switch is crucial and requires careful monitoring, making it an essential consideration for both employers and employees.
Things to Think About
In addition to exploring the various split-dollar plan options, it is important for employers and employees to consider the income and estate tax implications. When employers own the life insurance policies under endorsement or non-equity collateral assignment split-dollar plans, they must ensure they meet specific requirements to maintain the tax-exempt death benefit for designated beneficiaries. The employee should also consult with their estate planning attorney to assess whether an irrevocable life insurance trust could purchase the policy or if the split-dollar plan might have unintended gift and estate tax consequences or liquidity issues.
Certain legal restrictions, such as those imposed by the Sarbanes-Oxley Act, may limit the use of loan regime or switch split-dollar plans, especially for directors and executive officers of publicly traded companies. Additionally, some types of life insurance policies may not be suitable for loan split-dollar plans due to federal laws.
Finally, it's worth noting that the principles discussed in this article can be applied in a pure estate planning context as well. For instance, intergenerational split-dollar plans involving dynasty trusts and non-dynasty trusts may follow a similar framework, albeit with fact-specific variations. The concepts outlined here remain relevant in such scenarios.
At Life Insurance Strategies Group, LLC, we do not sell products. We help our affluent individual and institutional clients make decisions involving complex life insurance transactions. If we can help, reach out to us at www.lifeinsurancestrategiesgroup.com.
At Life Insurance Strategies Group, we do not sell products. We help our individual and institutional clients make decisions involving complex life insurance transactions.
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