The Economics Of

Historically, one substantial benefit of split-dollar plans involved the evaluation of the death protection provided to the recipient. In general, death protection evaluation relates to what term insurance might cost on the life of the insured. Obviously this is ordinarily based on the age and medical condition of the insured.

Under Revenue Ruling 66-110, the IRS had previously permitted the use of the insurer's published one-year term rates for standard insureds. Many insurers created term products with rates that were substantially less costly than the underlying mortality costs inherent in their cash value policies. As a result, the taxable amounts received by the employee in many cases were far smaller than the real costs within the actual policy. This was particularly true for insureds of impaired health, since the imputed costs were dependent only upon the age, not the actual health, of the insured.

For new plans, unless the insurer maintains a term rate under more stringent rules than applied under Revenue Ruling 66-110, the applicable rates are found in Table 2001, (subject to update by future guidance). The Table 2001 rates generally lie somewhere between standard (i.e. smoker) and non-smoker mortality rates, for male insureds, of actual cash value policies. As a result, the mortality rate "arbitrage" of split-dollar plans is largely nonexistent for those who may qualify for non-smoker or better underwriting. One exception may lie in the area of survivorship split-dollar planning.

Survivorship split-dollar-the last best place?

The discussion above might lead one to conclude that economic benefit split-dollar plans may be of limited use as a strategy for employers or donors to provide life insurance to favored recipients. While this may be true generally, there remains, in the area of survivorship split-dollar, a viable use for such arrangements.

For survivorship split-dollar plans, the value of the death protection, while both insureds are alive, is extrapolated from Table 2001. Previously this calculation conventionally used government Table 38, based upon mortality dating from the 1940′s. Thus, for survivorship plans, the costs have been significantly reduced.

Perhaps more importantly, the calculation of the economic benefit differs fundamentally from the derivation of mortality costs underlying modern survivorship life insurance contracts. This is because the split-dollar calculation is undertaken on an annual basis, where it is known that both insureds are living. Thus the cost is based on the probability that both insureds die during the year. After the first death, the rules require that the economic benefit calculation be based on the single life rate for the surviving insured.

In contrast, most survivorship policies do not change mortality rates based upon the death of one of the insureds. Rather, in a given year the insurer's rates look to the probability that the second insured will die, based only upon the insurer's knowledge that both were alive as of the policy issue date.

After the first year, these rates, as a matter of mathematical probability, should be higher than the joint Table 2001 rate. The upshot is that economic benefit split-dollar will generally provide mortality arbitrage so long as both insureds are alive. Thereafter, the single life Table 2001 cost will exceed the actual policy costs.

The question thus arises as to what action to take at the first death. If the sponsor is to retain its then-current interest in the cash value, the plan might be converted into a loan split-dollar plan, with a note owed by the recipient to the sponsor. This will terminate economic benefit tax treatment, substituting taxation based upon the interest implications of the note and potential application of the below-market interest rules.

Not to be overlooked is that if the sponsor's investment in the contract is less than its cash value at the time of conversion, a taxable gain may be recognized. (This may be avoided if at the time of conversion the recipient is a so-called "defective" grantor trust as to the grantor-sponsor.)

Conclusion

Economic benefit split-dollar plans are not dead. Irrespective of the economics, they provide a structure for one party to hold the cash value of a life insurance policy, while conveying death protection to another. In many situations, however, the alternative of some form of loan arrangement may prove superior from the economic standpoint. Prudent planning will often entail examination of both alternatives.