Split-Dollar Life Insurance is Alive and Well – At Home and in the Office
Split-dollar life insurance is not, as many people mistakenly think, a type of life insurance. Rather, it is a manner in which a life insurance policy is owned. A split-dollar agreement, or arrangement, is generally entered into between an employer and an employee, or two individuals (or a trust), to share the costs and benefits of a permanent life insurance policy. Specifically, the parties to a split-dollar arrangement (“SDA”) agree, in writing, to split the premiums, as well as the policy’s death proceeds, and, if applicable, the cash value. The type of life insurance used for an SDA can be whole life, universal life, second-to-die (survivorship), or any other cash value policy.
Split-dollar strategies are very effective in the estate planning and wealth transfer context, where they offer several powerful tax advantages.
Separately, some of Apexium’s corporate clients successfully employ split-dollar to reward and retain key employees, without giving them equity.
Split-Dollar in the Office
Many small businesses struggle to find affordable, easy and effective ways to reward and retain key employees. This is especially the case when granting equity is not realistic. A so-called endorsement split-dollar life insurance policy is often a viable, yet little known solution, that can be offered to select employees and does not require IRS, DOL or government oversight.
Assume a business (the “Firm”) has a highly compensated and valuable employee, age 40. Chances are the employee would benefit from and appreciate having an interest in a cash value life insurance policy insuring his/her life. In the context of our example, an endorsement SDA, where the Firm pays the premium, will obtain the desired result- which is to provide a current and a future benefit to the employee while assuring that the Firm will ultimately be repaid for the cost of providing the benefit. The current benefit to the employee is that he or she will have the ability to endorse a portion of the death benefit of the policy insuring his/her life to the employee’s beneficiaries (typically heirs or a trust for their benefit). The future benefit to the employee is that if the employee remains with the Firm for the requisite amount of time, he or she can obtain ownership of the policy after the Firm has been reimbursed what it paid in premiums.
The initial step is for the Firm and the employee to enter into the SDA, which is a written document. In our example, the Firm pays the premium and owns the policy, which is designed primarily for cash accumulation. Thus, the Firm maintains control over the policy. The employee is provided notice of the policy and consents to the application and the policy’s issuance. The policy is issued with beneficiary designations that note that the death benefit will be shared, or split, between the Firm and the beneficiary selected by the employee. In some instances, the Firm will provide the insurance carrier with a split-dollar endorsement form so the carrier knows about the SDA and the parties’ respective interests in the policy. During the duration (the “Term”) of the SDA, which in our example is 25 years (from the employee’s current age of 40 to the employee’s retirement age of 65), the employee is taxed on the value of the “economic benefit” he/she receives. The economic benefit is the term cost of the amount of the death benefit the employee is able to endorse to his/her beneficiaries. It is calculated using either the federal government’s table, known as the 2001-10 rates, or the carrier’s alternative rates for term insurance (see example below for illustrative purposes). Frequently, an SDA is structured so that if the employee dies during the Term, the Firm is repaid the premium it paid from the death proceeds, and the balance is then paid to the employee’s beneficiary. Another way of structuring the SDA is to provide a so-called, key-man insurance element, wherein a greater portion (more than the premium) of the death benefit will be paid to the Firm, so that it can use the money to help replace the deceased employee. For example, if the employee dies during the Term, the death benefit will be split 50/50.
Assuming the employee is still employed at the end of the Term, the SDA terminates and the Firm is reimbursed the amount it paid in premium from the cash value. The policy is then “paid” to the employee, who can access the cash as a retirement benefit or maintain the policy’s full death benefit. The premium payments are not deductible to the Firm, but it gets a deduction when the policy is paid to the employee. The employee, in turn, is taxed on the fair market value of the policy as ordinary income at the end of the Term, when he/she receives ownership of the policy.
Here are some numbers to put our example in context. Assume the Firm applies for and pays the premiums on a cash value policy insuring the employee (the “Policy”). The Policy has premiums of $25,000 dollars per year for 20 years, and assumes a 6.5% annual rate of return. The Policy is designed for maximum cash value appreciation, and has a low initial death benefit of $703,260. If the employee dies during the first year, his or her beneficiaries would receive $678,260, which is the death benefit less the first year premium. The term cost for the economic benefit the employee receives for the first year is approximately $350. This is phantom income to the employee that must be reported by the Firm. At the end of the Term, at the assumed rates, the cash value would be $1,091,775 (in reality, it will be more or less). After the Firm is repaid the $500,000 (the cumulative premiums), the employee still receives the Policy with a death benefit of about $1,000,000 and cash value of about $660,000.
The employee benefits from very low cost (or free if the employee’s salary is grossed up) life insurance coverage during his or her working years, while the SDA is in force. Although the employee typically has to pick up the term cost of the death benefit as income, it is a nominal amount and certainly less than if the employee was paying for the coverage him or herself.
The split-dollar strategy enables the employer to “retain” the employee because if the employee severs his or her employment during the Term, the SDA terminates and the employee forfeits his or her interest in the Policy. Thus, the Firm has a golden handcuff on the employee because if the employee leaves, he or she loses a valuable benefit.
….and at Home
Over the past several years many of our individual clients have used a strategy known as private split-dollar to transfer wealth in a tax efficient manner. According to Apexium Partners Rob Brown and Cory Chmelka, a private SDA generally entails the client (the person or couple doing the wealth transfer planning) creating an irrevocable trust for the benefit of children, grandchildren and/or other heirs. The insured is usually the client, or clients, if a survivorship life insurance policy is used. The client and the trust enter into an SDA which will be governed by one of two tax regimes. The Internal Revenue Code and the regulations thereunder permit private split-dollar under either an “economic benefit regime” (which uses the term cost of insurance, much like in the business context above) or a “loan regime” to determine applicable income taxes consequence of the arrangement.
In most cases, either option will offer a very favorable way to have an irrevocable trust own life insurance without having the client make significant gifts to the trust, which would otherwise be necessary to pay the premiums. Under the economic benefit regime, the trust, pursuant to the terms of the SDA, only pays the portion of the premiums that is equivalent to the term cost (on the value of the life insurance protection). If the trust lacks the money to pay the term cost, the client can gift the needed sums to the trust via lifetime or annual exclusion gifts. In a loan regime, the premiums, which are paid by the client, are considered a loan to the trust. The trust would pay the client interest, but the client can gift the trust the money to pay the interest. The loan is secured by the policy.
Here is an example, using numbers, of a private split-dollar strategy using the loan regime. Assume the client is a widow, age 65, who has a need for life insurance. She desires about 20 million dollars of coverage. The cost is $400,000 a year, for 20 years, with total premiums of eight million dollars (if the client lives to age 85 or beyond). The client prefers that the insurance be owned by an irrevocable trust so the proceeds will not be subject to estate tax in her estate. The client, however, has exhausted substantially all of her lifetime gifts, and consequently cannot gift the $400,000 to the trust to pay the premiums. Under the loan regime SDA, the client, and not the trust, pays the premium. If we assume a low interest rate (in 2016, the trust could have used the blended federal rate of .73%) of 1%, the trust would have to pay interest to the client in year one of $4,000. In year two, the interest due to client from the trust would be $12,000, and year three, $24,000. The client can make annual exclusion gifts to the trust so it has the cash to pay the interest. Assuming the loan’s principal, $8,000,000, is not repaid prior to the death of the client, upon her death the trust will pay back the loan from the death proceeds. This will leave the trust with 12 million in cash. If we assume a 50% estate tax, the eight million repayment will, after estate taxes, net the heirs four million; so the private split-dollar obtained 16 million dollars outside the client’s estate without using any lifetime gifts.
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