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Split Dollar Life Insurance Arrangements For Small Businesses and Key Employees

A split dollar plan is NOT about a specific life insurance product but rather is a contractual strategy for using life insurance.

Split dollar life insurance DEFINITION: a plan that allocates the costs and benefits of a life insurance policy in a specific manner by contract in order to maximize tax advantages for the employer AND employee.  

Because split dollar plans offer tax advantages, these plans are highly regulated by the IRS and are therefore more “involved” than simpler strategies such as executive bonus plans. This is also the reason that the tax laws governing split dollar plans have undergone changes in recent years (2003) and remain under careful watch by lawyers and advanced market insurance practitioners.

How Split Dollar Life Insurance Plans Work

The term “split dollar” refers to sharing the economic benefits (of a permanent life insurance policy) between different parties.  Usually, parties to a split dollar arrangement are a closely held or family business and a key employee.

Split dollar plans can provide planning flexibility for a closely held business in a number of ways including:

  1. Providing financial incentive to a key employee
  2. Funding certain buyout arrangements
  3. Estate and business succession planning for the business owner

To achieve the above benefits, a split dollar plan provides a way of paying for AND owning permanent life insurance by ALLOCATING the cost of premiums AND the benefits of the policy between the employer AND the employee.

Because a large part of our mission at insuranceandestates.com is to empower small business owners, this article is focusing on the benefits and pitfalls that are most relevant to closely held businesses.  

However, you should at least be aware that split dollar plans are also used in other venues such as educational institutions (universities) or healthcare organizations, as a way to provide incentives for key personnel.   In fact, large universities such as the University of Michigan, reputedly use these plans for large compensation packages for coaches.  Jim Harbaugh’s life insurance policy is estimated to be worth $75 million dollars.

For public companies, the Sarbanes Oxley Act is a huge consideration because there are rules pertaining to making loans to employees.  For smaller companies, concerns arise when defining whether benefits are being realized as an owner/shareholder OR as an employee.

How to Structure Split Dollar Life Insurance Arrangements

How a split dollar plan is structured will depend upon the specific goals and concerns of the business owner AS WELL AS the specific situation of the key employee.  The overall tax situation AND estate planning goals of each party are usually the primary considerations.

Closely Held Business

When creating a split dollar plan for a closely held business, the first important question is how to classify an individual who is involved in ownership of the business AND who is benefiting from the policy.  A related question is the type of business entity that is concerned such as an c corporation, s corporation or an LLC, as the specific entity will typically have an impact on the tax ramifications.  The key question is whether the individual involved in the business is receiving benefits as a business owner (shareholder, partner/LLC member) OR as an employee.

If an individual receives a life insurance benefit as an employee, that benefit will be taxed as regular income.  If the benefit is received as a shareholder/partner or LLC member, the benefit may be taxed as a dividend or return of capital. Because taxation rates for regular income are much higher than dividend tax rates, there can be big advantages in documenting the individual as a shareholder in a corporation.

If the corporation is a “C Corporation“, the shareholder benefit will be taxed as a distribution to the same extent that the corporation has earnings; however these are the earnings of the corporation and not necessarily the shareholder individually.

If the corporation is an “S Corporation” the benefit will also be taxed as a distribution; however, because the S corp is a pass through entity, earnings are reported on the shareholder’s personal tax returns and thus the benefits are realized as after tax income.

Things get a bit more uncertain for split dollar arrangements involving partnerships and LLCs because the IRS rules are very unclear about how to classify the life insurance benefits.  The question seems to be whether it will be deemed a “guaranteed payment to a partner” rather than payment to an employee, which is likely in a partnership or LLC where the individual isn’t acting directly as an employee.

Key Decisions for Designing Split Dollar Plans

A split dollar plan is structured by a contract which will ALLOCATE a number of aspects of the permanent life insurance to either the employer or employee.  The aspects to consider when creating a strategy are:

  1. Who will pay the premiums
  2. Who will have access to the cash values
  3. Who will be the beneficiary of the death benefit
  4. Who will have the authority to make policy decisions (these vary depending upon the type of life insurance used)

Who will pay the premiums?

A closely held business (hereafter “employer”), can pay the entire premium pursuant to a split dollar arrangement.

The employee (employee, shareholder, member, partner is referred to collectively hereafter as “employee”) may either pay nothing for the insurance or may pay a portion of it that relates to that portion of benefits received by the employee.

For example, a common arrangement is for the employee to pay the cost of term insurance relative to the policy and if the policy is permanent life insurance, such as a cash value life insurance policy OR indexed universal life, the cost of term may be substantially less than the actual cost paid by the employer.  This is one reason, among many, that we tend to favor whole life vs term life insurance.

The total costs are usually estimated for IRS purposes by using the Table 2001 annual renewable term rates or the insurer’s alternative qualifying term rates.   Under these kinds of arrangements, the employer pays the balance of the premiums.

Another less common approach is for the employer to pay up to the amount of the increase of the cash value in a given year.  This kind of arrangement would dictate lesser costs in the early years and higher costs as the policy matures and benefits accrue to both employer and employee.

Generally, the logic for these kinds of arrangements are that the employer retains the benefit of the cash value accrual in the policy and is assigned a portion of the death benefit to cover premium costs.

Who will have access to the cash values? 

A split dollar plan must address who will have access to the cash value that accrues in a permanent life insurance policy.  For example, an employer could be entitled to receive the greater of the premiums actually paid OR the cash surrender value of the policy.  Another possibility is for the employer to receive back only the premiums advanced and the employee to receive the cash value in excess of this amount (the equity in the policy).

Who will be the beneficiary of the death benefit?  

When determining who will have access to the cash value, it is important to identify the various goal of the split dollar plan and these are summarized in the questions of death benefit and control over the policy. For example, is the goal to provide the use of cash value to the employee during his/her lifetime as an incentive (golden handcuffs).  Structuring the life insurance on a key person in such a way as to incentivize the key person to remain at the business until fully vested in the life insurance policy is a fantastic way to promote strong employee loyalty.

Alternatively, the goal may be to provide an accruing death benefit to protect the employee’s loved ones and/or the employer, while reserving the right of the employer to use the cash value as a source of business funding. Choosing this route provides an alternative source of liquidity for the business, which may provide a safety net for smaller businesses engaged in a high growth phase where cash is scarce and margins are tight.

Who will have the authority to make policy decisions?

Other contractual issues to be addressed include who will make the policy decisions.  A key decision that relates to who has the right to use the cash value is who pays the interest on policy loans. Typically, this will fall onto the party who is responsible for taking out the loan. However, policy loans can be another incentive an employer uses to maintain the loyalty of a key employee, particularly if the split dollar plan requires any policy loan to be repaid if the employee has not been with the company for the requisite amount of time.

Additional decision making questions, which do not apply to cash value life insurance policies, may apply to universal life policies such as how much premium will be paid on the policy, and, if the policy is a variable policy, who authorizes the specific investment decisions on the policy.  It is due to the issues that may arise concerning these kinds of universal policies that we do not consider them optimal for split dollar strategies.

Two Ways to Structure Split Dollar Plans

There are two primary ways that a split dollar plan is structured which are:

  1. The endorsement approach; and
  2. The collateral assignment approach

The endorsement approach allows the employer the benefit of retaining ownership of the life insurance policy.

Under this approach, the employer owns the policy and pays the premiums AND endorses to the employee the portion of the death benefit that is in excess of the greater of the premiums paid or cash value of the policy.  This approach is sometimes referred to as an “economic benefit” approach which is discussed in more detail below because the employee is only taxed based on the economic benefit that he/she receives.

The employer’s options for valuing the economic benefit include the “equity approach” and “non-equity approach“. Under the former, the employer is entitled to a return of the premiums paid and if the cash value exceeds the premium, this amount goes to the employee.  Under the latter, the employer is entitled to the greater of the cash surrender value OR the premiums paid.

A disadvantage of this approach is that the ownership of the policy may be deemed to a business owner (shareholder, member or partner) and this may cause the policy to be included in his/her estate.  Depending upon the estate circumstances, this could result in unwanted estate tax exposure for family business succession planning.

The collateral assignment approach allows the employee the benefit of ownership of the life insurance policy. Under this approach, the employer pays the premiums and the employee owns the policy either directly OR an irrevocable trust may be established.  Under this split dollar life insurance arrangement, the employer retains a security interest in order to be repaid.

With this approach, because the employee owns the policy, it is most common under current tax laws to structure the arrangement so the employer “loans” the amount of the premiums to the employee.  Each year the premium payment is treated as a separate loan.  Loans can be set up either as a term or demand loan and must have an adequate interest rate pursuant to the AFR.  The interest rate; however, may be below market and should depend upon how the arrangement is drafted and how long it will remain effective.

Two key benefits of the collateral assignment approach

Two asset protection benefits are, one, that an irrevocable trust may be set up for the employee to own the policy, such as an irrevocable life insurance trust OR another type of grantor trust, and this can assure that the policy will not be included in the employee’s taxable estate for split dollar estate planning purposes.

The second asset protection benefit is that the policy will not be deemed as owned by the employer-business entity and thus will not be within the reach of the business’s creditors.

Split Dollar Life Insurance Taxation Concerns

Split dollar plans are closely monitored for changes in the tax laws that could adversely affect these plans.  In 2003, the IRS endeavored to restrict split dollar plans dramatically by creating an “economic benefit regime“.

Economic Benefit Regime

What this means is that the IRS rules look at the economic benefits accruing to both the employer and employee when analyzing the tax ramifications of the plan and then allocate taxes accordingly.  In theory, this is why a loan approach has become preferable since 2003, because if a loan is used, then little economic benefit is being realized by the employer OR employee concerning the payment of premiums.  Similarly, this is why the employee is only paying the amount of applicable term insurance if they are only receiving access to the death benefit while the employer has access to cash values.

Poor Planning

It is very important to cover all aspects of your split dollar plan in detail, because a poorly conceived plan can be “unwound” under the IRS rules and this can lead to major tax consequences for the estates of either the employer or employee.

Also, this article is just scratching the surface of the tax issues that can arise, because if family trusts are used, or buy-sell agreements are involved, numerous tax considerations are brought into the picture.  This is therefore, definitely an area that warrants substantial professional counsel.

Terminating Split Dollar Life Insurance Plans

Split dollar plans usually terminate upon an event specified in the contract, such as retirement, OR upon the employee’s death.  If the employee fulfills the requirements of the loan (under a loan agreement) then all restrictions are released on the policy.  Under an economic benefit arrangement, the policy would be transferred to the employee and the employer would be compensated pursuant to either the “equity” or “non-equity” approaches discussed above.

Best Type of Insurance for Split Dollar Plans

For all of the reasons discussed in our recent post about executive bonus plans, we tend to prefer traditional whole life policies, a/k/a cash value policies, when designing any long term split dollar life insurance executive compensation plan.

Split dollar plans are more complicated than executive bonus plans, as discussed, yet the benefits to employers are very similar. Funding a split dollar plan is a way to reward a key employee while accruing cash value in a whole life insurance policy that can serve as a ready source of funding for the employer.

This funding can be used for a future buyout or even a deferred compensation plan.  Because other kinds of permanent life insurance (i.e. indexed universal life) are simply more speculative as connected to the financial markets with limited guarantees, they simply aren’t as reliable (in our opinion) for executive bonus plans OR split dollar plans.

If you would like more information regarding how split dollar life insurance fits into your small business planning, please give us a call today.

 

 

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