Contrary to what you may think, split-dollar life insurance is not an insurance policy, at least not in the classic sense. It is a type of arrangement that allows two parties, typically an employer and an employee, to split life insurance protection costs and benefits. The premium payments, rights of ownership, and proceeds payable on the death of the insured are often split between the company and a key employee. In many situations, however, the employer pays all or a greater part of the premiums in exchange for an interest in the policy’s cash value and death benefit. Cash values accumulate, providing repayment security for the employer, who is paying the majority of the premium. In this scenario, business owners have the opportunity to provide an executive with life insurance benefits at a low cost. Another option for companies to consider is to use split-dollar policies in place of insurance-funded nonqualified deferred compensation plans.
The split-dollar arrangement is attractive to employers because it provides a way to recruit and retain top performers. In turn, employees have the opportunity to acquire future protection with a flexible policy that meets their needs. In addition, this type of policy can be used as a viable strategy for transferring wealth between a parent and child and for estate planning.
There are two basic types of split-dollar life insurance policies: endorsement, in which the employer owns the policy and reaps the benefits, but the employee chooses the beneficiary or beneficiaries and how the death benefit is paid out; and collateral, in which the employee owns the policy. In this situation, the employer’s premium payments are treated the same as interest-free loans. The employee assigns the policy to the employer as collateral for these loans. On the employee’s death, the loans are paid from the face value of the policy. Any proceeds that remain are paid to the beneficiary or beneficiaries.
The Way It Was
Split-dollar arrangements date back to the 1930s. Over time, the Internal Revenue Service (IRS) came to view any gain or equity from a split-dollar policy, known as equity collateral assignment split dollar, as an interest-free loan and therefore taxable. The IRS regarded equity benefits as being profitable mainly for the party paying the lowest amount of the premium cost, and it introduced new regulations, to seek more overall transparency.
In 2003, the IRS finalized the new regulations on split-dollar policies, which are still in effect today. While validating the use of split-dollar policies in estate planning between donors and donees, the changes have curbed the use of equity collateral assignment split dollar for funding nonqualified executive compensation.
Variations on a Theme
The following two tax regimes emerged from the 2003 IRS regulations; they affect the structure of a split-dollar policy for business owners and estate plans and depend on who owns the policy:
- An economic benefit (or equity) regime allows the business owner/employer or the donor to pay the annual premium as the owner of the insurance policy. Alternatively, an irrevocable life insurance trust (ILIT) can be the policy owner, in which case the gift of an economic benefit is made annually to the trust.
If an employer owns the policy, the employer’s premium payments would provide equity or economic benefits that are taxable each year. The employee is responsible for the taxes. Benefits could include, among others, an interest in the policy cash value or the cost of life insurance protection.
- In a loan regime business arrangement, if the employee owns the policy, the employer’s premium payments are considered loans to the employee. In this case, the employee would be taxed on the difference between the actual interest amount and the amount that would have accrued at the market interest rate.
Look Before You Leap
It is important to note that a split-dollar life insurance arrangement requires specific adherence to complex tax rules and regulations. Before establishing the policy, be sure to consult with your team of qualified insurance, legal, and tax professionals to determine how split-dollar life insurance may benefit you, your company, and your key employees.