A split dollar insurance arrangement divides premiums, ownership interests, and benefits of a permanent life insurance policy between two parties. It can be used to fund a life insurance policy on a gift or income tax efficient basis, and it also provides a financing party the opportunity for reimbursement of premiums or access to policy cash values.
Two instances often lead to split dollar planning:
Funding premiums on a gift tax efficient basis in an irrevocable trust for the benefit of an insured’s family.
Using permanent life insurance as a tax-efficient tool to retain and reward key employees.
Split Dollar Arrangements
When entering a split dollar arrangement, an attorney establishes an agreement that clearly decides each party’s rights and responsibilities with respect to the insurance policy. Under a split dollar arrangement, one party typically pays all or a portion of the premium on a life insurance policy, while the other party is entitled to a share of policy values.
The taxation of all split dollar arrangements are governed by Treasury Regulations. Because of this there are two basic structures: economic benefit regime and loan regime. Economic benefit arrangements have one party fund premiums on a policy and endorse a portion of death proceeds to another party. The deemed cost of the insurance benefit received by the other party is called the “economic benefit,” and is determined based on IRS actuarial guidelines. In a loan regime split dollar, premium payments are treated like loans by one party to the other party, and subject to general tax rules governing debt instruments, including adequate interest accrued or paid on the loan.
For the most part, the applicable tax regime is determined by who owns the insurance contract. The arrangement is generally subject to the economic benefit regime if the premium payor owns the insurance policy and endorses a portion of the death benefit to another party. If the premium payor funds premiums of a contract owned by another individual, loan regime rules generally apply. However, there is one notable exception to the ownership rule. The economic benefit regime applies to split dollar arrangements if the premium payor is entitled to all policy lifetime values, and the nominal policy owner never has interest in the policy’s cash values and is only entitled to death benefit protection.
Private Split Dollar
A private split dollar arrangement is normally used for estate planning between family members, such as an individual and a trust benefiting the individual’s heirs. Under this arrangement, an individual donor funds insurance premiums on the life of the donor, or on the life of another individual. The policy can be owned by the donee, or a trust for the benefit of family and other specified beneficiaries.
This arrangement is for:
Insurance death proceeds are generally removed from the taxable estate of the donor for federal and possibly state estate tax purposes; and
The gift tax value of any premium payment is reduced significantly—this can be useful in situations with large premiums.
Economic Benefit Regime
The donor pays the premium in an economic benefit split dollar arrangement, and the donee/trust receives the cost of the term insurance as a gift. The donee/trust is entitled to the death benefit proceeds in excess of the donor’s interests. For split dollar purposes, the donor is considered the owner of the policy; but, for estate tax purposes, the title of the policy is held by the donee/trust.
The deemed term insurance cost of an economic benefit split dollar arrangement is generally considered a gift to the donee/trust.
Because of the gift tax efficiency that comes with establishing insurance coverage under the economic benefit regime, these arrangements are commonly employed with single life universal and survivorship universal life insurance products. These policies are also commonly employed in the estate planning context given their increase of death benefits relative to premiums, which provides liquidity for estate tax purposes.
Under a loan regime split dollar arrangement, the donor makes loans to the donee on specified terms at a stated interest rate. The loan should provide for interest at the applicable federal rate, which is dependent on the term of the loan. The interest is typically accrued if the donee/trust does not have assets outside the life insurance policy.
Because premiums are advanced in the form of a loan, there is generally no gift when premiums are paid. However, loan forgiveness in the future may be considered a gift. If the loans are forgiven, care needs to be taken, otherwise the validity of a loan arrangement may be called into question. Any loan principal paid to the donor is considered a tax-free return of investment. However, loan interest paid to the donor is taxable income for them unless the donee is a grantor trust of the donor. This is true whether it is paid during the insured’s lifetime or at death.
Under a split dollar loan arrangement, all the premiums and accrued interest remain payable to the donor. As a result, an increasing share of policy proceeds may need to be repaid at death, resulting in a smaller amount of death benefit proceeds for the heirs. For this reason, an increasing death benefit whole life policy with increasing cash values may be more suitable for this kind of arrangement. Another advantage to a high cash value product in this situation is the potential to use policy values to repay loans during the insured’s lifetime.
Employer Sponsored Split Dollar
If a split dollar arrangement is used in an employment context, the employer funds a life insurance policy for an employee as part of the employer’s retention and compensation strategy for that employee.
Economic Benefit Regime
Under an economic benefit regime split dollar arrangement, the employer is the actual owner of the life insurance policy on the employee’s life. The employee includes the policy’s term cost in their taxable income and the employer pays the premium. Depending on the terms of the arrangement, the employee may also need to pay the term cost. The employer’s interest in the policy is the greater of its cumulative premiums paid or the policy’s cash value. The employee’s beneficiaries are entitled to the death benefit in excess of the employer’s interests.
The employer pays the premium, which is considered the investment in the contract. The employee can pay directly the term cost of the death benefit, but if the employer pays the term cost, the employee can include the cost in their taxable income, and the employer receives a deduction for the cost paid. The employee accrues no basis in the policy, and death proceeds are typically received income tax free by both parties or their beneficiaries.
Split dollar arrangements sponsored by employers do not usually have gift tax implications. However, when an employee’s trust is involved, payment of the term cost by the employer is considered income to the employee and a gift from the employee to the trust. As a result, direct payment by the employee of the term cost is a gift to the trust.
In a loan regime split dollar arrangement, The owner of the life insurance policy is usually the employee. The employer makes loans to the employee at a stated interest rate and any extra equity in the policy of the outstanding loan accrues to the benefit of the employee. When the insured dies, the loan is repaid to the employer, and the employee’s beneficiaries receive the death benefit in excess of the outstanding loan.
The employer pays the premium, which is considered a loan to the employee and the employee pays interest on the loan, annually or cumulatively. The loan principal paid to the employer is a tax-free return of investment; however, loan interest paid to the employer is taxable income to the employer, whether paid during the insured’s life or at death
To the extent the insured possesses incidents of ownership in the policy, death proceeds will be included in the insured’s estate, with a deduction for the amount that goes to the employer. If the split dollar arrangement is between a trust established by a majority shareholder/insured and the corporation, the death proceeds will be included in the majority shareholder’s estate if the corporation is given any incidents of ownership in the policy.