F—Split-Dollar Insurance

Split-dollar insurance is an agreement between two parties to allocate between them the costs and benefits of a life insurance policy. It is not a particular type of life insurance policy. When adopted by an employer split-dollar insurance allows the employer to provide valuable life insurance protection for selected employees.

Split-dollar insurance can be provided for the employees of a corporation, a partnership, or a sole proprietorship. Split-dollar is generally not appropriate for partners or employee-stockholders of S corporations because of the pass-through nature of taxation (except to reallocate premiums among owners and when used with a life insurance trust to reduce the value of gifts to the trust). In contrast, private split dollar involves an agreement between individuals,
or between an individual and a trust. 

Under regulations issued by the IRS there are two ways for an employer to establish a new split-dollar plan. Based upon policy ownership the split-dollar regulations use a formalistic, yet straight forward, approach in providing two “mutually exclusive regimes” (or methods) for the taxation of split-dollar plans. The economic benefit regime (as in the typical endorsement arrangement) applies where the employer owns the contract. The loan regime (as in the typical collateral assignment arrangement) applies where the employee owns the contract. However, as an exception to the general rule, even if the employee owns the contract the split-dollar plan is subject to the economic benefit regime if all cash values belong to the employer. This is useful in majority stockholder situations when it is desired to remove all employer death benefits from the insured’s estate

(1) Loan regime. Under this method the employee purchases and is the owner of a life insurance contract. The employee-purchased policy is then collaterally assigned to the employer to secure employer premium payments. Each employer premium payment is treated as a loan from the employer to the employee. The employee will either: (a) pay to the employer a market rate of interest on these loans; or (b) receive additional compensation equal to the foregone interest. Under this regime, policy cash values will inure to the benefit of the employee. Upon death, the employer will receive an amount equal to premiums paid plus any accrued interest. The named beneficiary will receive the balance. In recent years, with interest rates at or near historical lows, loan regime split dollar became a very popular planning tool. Loan regime split dollar remains effective in many situations, but existing split dollar plans that utilized short-term loans should be examined to be sure they remain appropriate with current interest rates.

(2) Economic benefit regime. This method offers a straightforward means of providing to the employee a supplemental executive life insurance death benefit during the years prior to retirement. It is often (although it can be structured as a collateral assignment arrangement owned by the employee) implemented as follows:

DURING LIFETIME. The employer purchases and owns a permanent life insurance policy insuring the employee’s life. Pursuant to the split-dollar agreement the employer typically pays the entire premium (an “employer pay all” plan) and owns all cash values. Each year income is imputed to the employee in an amount equal to the “economic benefit” of the insurance protection received by the employee. Failure of the employee to report this economic benefit, or to contribute an equal amount of premiums, will result in the death benefits being taxed as ordinary income to his beneficiary (i.e., they will not qualify as tax-free life insurance death benefits). Assuming the employee will live to normal retirement age or beyond the taxable economic benefit will get very expensive. This means that an “exit strategy” must be in place if the employee’s death benefit is to be maintained after retirement.

The employee is responsible for paying taxes to the IRS on this imputed income. Provided it is reasonable compensation, the employer could consider paying a bonus to assist the employee in paying taxes on the imputed income.

UPON DEATH. The death benefit payable to the employer can vary according to the provisions of the split-dollar agreement. Unlike with collateral assignment split dollar, the employer need not be entitled to a death benefit equal to the greater of the cash values or the cumulative premiums paid. By endorsement to the policy, the employee’s personal beneficiary is entitled to the death benefits in excess of the amount paid to the employer.

Provided the employer is willing to have no interest in either the cash values or the death benefit, executive bonus offers a simpler approach to obtaining needed life insurance protection. It is easier to install, in that there is no required formal agreement between the employer and the employee.