What is a Split Dollar Program?
A split dollar arrangement is a plan in which a life insurance policy’s premium, cash values, and death benefit are split between two parties. A split dollar arrangement can be helpful in estate liquidity planning to minimize income, estate, and gift taxes. This type of plan has been used for years to help individuals with the funding of large premiums, and/or to reduce the cash flow required to fund a much needed life insurance policy.
These types of plans have also been used by tax exempt corporations as an executive benefit to encourage employees to remain with the company. In some instances, a corporation can also use a Split Dollar plan to fund the replacement of a valuable executive. In 2003 Final Split Dollar Regulations changed the Split Dollar landscape in some important ways. A properly structured Split Dollar plan still remains a viable and important planning approach.
History of Split Dollar
Generally, under a split dollar plan, a permanent life insurance policy’s death benefit and cash values are split between the owner and non-owner of the life insurance contract. Typically, one party has the cash flow to fund the majority of the policy premiums. Cash values in the policy can potentially accumulate and pledged to the party paying the greater part of the premium as security for repayment. Any cash value growth beyond the premiums paid is gain from the transaction. Historically, this gain (equity) has been viewed by the IRS as potentially escaping taxation and benefiting the party paying the smallest portion of the premium. For many years, the IRS has viewed the ability to shift this policy equity without consequences as potentially abusive. Moreover, the IRS has indicated repeatedly that a split dollar plan with equity (referred to as equity collateral assignment split dollar) is essentially an interest-free loan and should be taxed as such. In addition, the Final Regulations outline how different types of split dollar arrangements must be structured and taxed going forward.
Final Split Dollar Regulations
The final regulations apply to arrangements entered into after September 17, 2003. A split dollar arrangement entered into prior to this date is not governed by the final regulations unless it is materially modified after September 17, 2003. If you have a split dollar program issued prior to this date we can provide full administration and review and consult with your tax advisors regarding the options now available to you.
According to the final regulations, existing split dollar arrangements, established prior to September 18, 2003, will continue to be governed under the original economic benefit rules outlined in Revenue Ruling 64-328 and Revenue Ruling 66-110. However, if an existing equity collateral assignment arrangement is terminated during lifetime or converted to a loan arrangement in the future, any policy equity will be subject to income taxation at that time. Depending on how the arrangement is structured, it is very likely that the IRS will also subject such equity to gift and generation-skipping transfer taxation.
New Split Dollar Arrangements Subject to Final Regulations
The final regulations categorize split dollar plans into two mutually exclusive regimes: the economic benefit regime and the loan regime. How you structure your particular split dollar plan will be based on certain factors.
Economic Benefit Regime. Under the economic benefit regime, you or your company will advance the annual premium each year, and if an Irrevocable Life Insurance Trust (ILIT) is the policy owner, you will also make a gift of the economic benefit amount each year to the trust. The economic benefit amount can be significantly lower at younger ages because it is based on the annual “term” cost of the death benefit and not the policy’s full premium.
In a corporate context in which you or your ILIT is the owner of the policy and your company lends you or your trust the premium, you must annually report the economic benefit cost as income. In a family or corporate context in which a trust is owner of the policy, the economic benefit amount also constitutes a gift for federal gift tax and generation-skipping transfer tax purposes.
Under the final regulations, the calculation of the annual economic benefit rates for single life policies involves the use of the government Table 2001 rates or the insurer’s alternative term rates, whichever are lower. Moreover, the economic benefit rates associated with a survivorship policy can be significantly lower than the rates for a single life policy, making a split dollar plan with a survivorship policy an extremely tax-efficient planning strategy. Although economic benefit costs increase with age, it can be advantageous from a tax standpoint to structure a split dollar plan using economic benefit rates since the economic benefit initially represents only a fraction of the premium.
Loan Regime. Generally, under the loan regime, you or your company loan the annual premium to you or your trust. The loan is repaid either during lifetime using a portion of the policy’s net cash value and other available funds, or at death using the life insurance proceeds. The loan balance is equal to cumulative premiums paid in addition to capitalized loan interest, if any. The ILIT has two choices in how the loan is structured: pay loan interest (or capitalize it) at a fair market rate, or be deemed to have paid such interest under IRC §7872, the below-market loan rules.
Unlike a split dollar plan under the economic benefit regime, a loan arrangement includes a loan interest component that is applied to the cumulative premiums paid instead of an economic benefit cost related to the death benefit as discussed above.
What is Split Dollar Life Insurance?
- Split dollar is a means by which two parties share the costs and benefits of a life insurance policy. It is a sharing of the three major components of a life of a policy (premium, cash value and death benefit). The IRS has ruled on Split Dollar beginning in 1964. In 2001 the IRS reviewed the Split Dollar approach and came up with new regulations on September 11th2003. The final regulations were the adoption of Notice 2002-8.
- The are three components of a typical arrangement. First the policy which is owned by the executive. Second is the collateral assignment form from the insurance carrier that assigns the rights of the policy to the employer and lastly the Split Dollar agreement signed by both parties that spell out the specific rights of each party regarding premium payments, interest charged and rights to death benefit amounts.
- Split dollar plans are frequently used by employers to provide supplemental benefits for executive to help retain key employees.
Mechanics of Loan Regime Split Dollar
Overview of Loan Regime Split Dollar
Notice 2002-8 characterized the arrangement as a loan from the employer to the employee to pay the premium on the policy.
How It Works
- The employee owns the life insurance contract, names a personal beneficiary and assigns the policy as collateral to the employer, in return for the employer’s premium payments.
- The Split Dollar Agreement determines what occurs in the event of termination, retirement, vesting requirements and death benefits. Generally, at the employee’s death, the employer receives a portion of the death benefit (usually equal to the total premiums plus interest) and the employee’s beneficiary receives the balance.
- If the event of termination or retirement the employer receives back the total premiums paid plus interest, up to the policy’s cash surrender value subject to the vesting schedule either immediately or at theemployeesdeath.
- The most common approach is to have the loan interest rate determined by the long term Applicable Federal Rate (AFR). The employee pays the AFR either each year or accumulates the interest and repays the loan with interest from the death benefit.
Benefits of Using Split Dollar Life Insurance
Benefits for the Company
- Tax-free death benefit may entice the employee to stay with the company.
- Company keeps the assets used to fund the death benefit on its books.
- Cash values will strengthen the company’s balance sheet.
- During workingyearsthe company may receive additional keyperson death benefits in addition to premium repayments.
- Company’s interest is protected by a collateral assignment.
- The company recovers its outlay when the split dollar loan is repaid – either during life or upon the death of the employee.
Benefits of Using Split Dollar Life Insurance
Benefits for the Employee/Owner
- Split dollar provides the employee a substantial amount of tax-free death benefit at minimal cost*.
- Employee benefits from today’s historically low interest (AFR) rates.
- Employee can be the owner of the policy and can retain all policy rights except for the company’s right to receive backit’scash outlay and interest.
- The growth of the policy’s cash value in excess of premiums can be accessed by the employee on a tax-free basis as a supplemental retirement income benefit.
- The employee can remove the death proceeds from his/herestate by use of a third-party owner (e.g.irrevocable trust).
*The only cost is the interest cost for the premiums borrowed.
Diagram of Loan Regime Split Dollar