When a client isn't inclined to bear the full premium of a life insurance policy, then you, as advisor, might do well to propose a time-honored tradition: sharing the cost with someone else. Many insurance and financial service professionals are doing just that.
Split-dollar life insurance, an arrangement in which the costs and benefits of a policy are shared among parties–typically between an employer and key employee within a business; and between a parent and child in estate planning scenarios–is alive and well.
And, sources tell National Underwriter, for good reason. The technique lends itself to multiple business and wealth transfer planning objectives, many of them involving business owners who are looking to attract, reward and retain management talent.
Split-dollar, for example, lets an employer provide an executive with a life insurance benefit at low cost and low outlay to the exec. The technique can be used as an alternative to an insurance-funded non-qualified deferred compensation plan. In the wealth planning arena, split-dollar life insurance often is an ideal vehicle with which to move assets out of an estate tax efficiently.
"Split-dollar is increasingly used in the estate planning arena for gifting purposes," says Stephen "Bo" Wilkins, a partner at Nease, Lagana, Eden & Culley, Inc., Atlanta, Ga. "You can squeeze the value of a policy premium gifted to a trust down to its pure economic benefit. That allows you to transfer the policy to the third party owner on a gift-tax friendly basis."
The Good and the Bad
Advantages aside, the regulatory landscape of the decade past has been a mixed blessing for the various split-dollar planning techniques, observers say. Whereas IRS regulations finalized in 2003 validated private split-dollar for estate planning, the regs also dampened enthusiasm for a once popular strategy, equity collateral assignment split-dollar, as a vehicle for funding non-qualified executive compensation.
For the uninitiated, the final regulations created two mutually exclusive tax regimes for split-dollar plans based on who is named the policy owner of the insurance contract: (1) an economic benefit regime for endorsement arrangements, wherein the employer of a business or the donor of an estate is the owner of the insurance policy; and (2) a loan regime for collateral assignment plans, wherein the employee or donee (such as a trust) is the policy owner.
When deciding on a regime, clients have to weigh the relative tax costs. Under an economic benefit regime, the taxable economic benefit is determined using premium tables governing term rates published by the IRS in Notice 2001-10.
Under the loan regime, premium payments are treated as a series of "loans" to the employee or donnee. Assuming (as is usually the case) the loan is governed by below market loan rules, then the loan is characterized as one bearing interest, subject to the applicable federal rate (AFR). And this "foregone interest" is taxable.
Key employees thus now must pay a tax on a previously tax-free fringe benefit: their share (or equity) of a policy's cash value. For this reason, sources say, the 2003 regs chilled businesses' interest in loan regime plans used in executive comp planning.
"The 2003 regulations changed the game," says Wilkins. "To do equity split-dollar now, you have to use the loan regime, which isn't as attractive as the more tax-efficient technique available previously."
Have the rules effectively eliminated loan regime plans in executive compensation planning? Some think not. Richard Landsberg, a director of advanced sales at Nationwide Financial, Columbus, Ohio, believes the impact of the 2003 regs has been overblown. While changing its tax treatment, the loan regime technique is still a good deal, he says, because of the plan's large benefit relative to its costs.
"The industry convinced itself that the end of civilization occurred [with the finalized regulations]," he says. "But when you crunch the numbers, it's still a highly leveraged transaction: The corporate dollars spent funding the plan are small compared to the benefit to be received. Whereas previously the technique was between 90% and 95% leveraged, now it's between 65% and 85%, depending on interest rates."
Point noted. But other regulations governing non-qualified deferred compensation plans and finalized in 2009, encapsulated in Internal Revenue Code Section 409A — complicated matters for advisors seeking to use split-dollar in the corporate realm. The rules contain numerous provisions respecting the application of both grandfathered and non-grandfathered split-dollar arrangements.
Most significant for advisors, sources say, is IRS Notice 2007-34, which offers guidance on the application of 409A to split-dollar and was issued in tandem with the finalized regs. Among other things, the notice stipulates that loan regime split-dollar plans be treated as non-qualified deferred compensation — and hence subject 409A's restrictions on the timing of deferrals, distribution elections and permitted distribution events, plus interest and tax penalties for running afoul of the regulations — if amounts on a split-dollar loan are "waived, cancelled or forgiven."
Sidestepping 409A
Amid the regulatory minefield, some advisors have latched onto a version of the endorsement split-dollar technique as a deferred comp alternative, thereby escaping 409A's requirements. Steven Kroeger, a senior director for advance sales at Crump Life Insurance, Roseland, N.J., says the strategy lends itself to a short-term deferral exception to the rules –409A(1)(b)(4) — which stipulates that compensation paid within 2 1/2 months of the close of the calendar year when the comp was earned (typically when the key employee reaches age 65) is not considered deferred compensation.
Under the endorsement arrangement, the employer owns the policy and is chiefly responsible for paying the premiums. When the insured (key employee) dies, the employer receives the greater of the premiums paid or accumulated cash value in the policy; the remaining death benefit is paid to the employee's beneficiaries.
