Most people simply require a personal life insurance policy to financially cover their family if they die. However, some people, notably business owners and important employees, may require a life insurance plan to protect their company from the financial consequences of their death.
Some firms meet this requirement by offering split-dollar life insurance, which is a contractual agreement between two or more persons to share ownership and benefits of a permanent life insurance policy with a cash value component. Companies most commonly utilize split-dollar life insurance plans to mitigate the financial impact of losing a key executive (such as a CEO) or as a benefit in executive compensation packages.
What is Split-Dollar Life Insurance?
Split-dollar life insurance is a contract in which two people agree to split the expenses and benefits of a permanent life insurance policy. The agreements are frequently made between an employee and an employer, with the split-dollar plan appearing in an executive salary package. These packages became less frequent once their tax treatment changed in 2003.
While you may no longer be offered a split-dollar life insurance benefit, wealthy Americans still employ private versions in estate planning. If you’re ready to jump through some financial hoops, you can still get some tax breaks.
Split-Dollar Plans: Their History and Regulation
Split-dollar plans have been around for a long time. The IRS issued new regulations in 2003 that defined two types of permitted split-dollar arrangements: economic advantage and loan. 2 While some tax benefits were eliminated that year, split-dollar plans continue to provide benefits such as:
- Term insurance: This is based on the IRS’s interim table of one-year term premiums for $1,000 of life insurance protection (Table 2001 rates), which may be less expensive than the real cost of the coverage, especially if the employee has health conditions or is rated.
- The capacity to spend corporate funds on personal life insurance: Benefits can be leveraged through plans, especially if the firm is in a lower tax bracket than the employee.
- Low-Interest Rates: Low-interest rates are available in the relevant federal rate (AFR) at the time the plan is implemented is lower than current market interest rates. Loan plans might keep the interest rate that was in force when the plan was adopted, even if interest rates rise in the future.
- Options for reducing gift and estate taxes.
How Does Split-Dollar Life Insurance Work?
It is frequently a type of company-owned life insurance that benefits both you and your employer in commercial circumstances. The policy’s cost and the benefits of cash value increase are split between an employee and their employer.
Every split-dollar policy requires two or more people to participate and divide the costs and rewards. However, agreements can differ in the following ways:
- Who pays the insurance premiums?
- Who is the policy’s owner?
- How the death benefit and monetary value are split
- Who chooses the recipients?
- When and under what conditions does the agreement expire?
All of these specifics should be included in the contract that establishes the split-dollar life insurance agreement.
While split-dollar life insurance policies are typically used for commercial purposes, they can also be used for personal life insurance coverage. It is, however, only effective if you need to reduce your estate taxes. Most people won’t have to worry about this because federal estate taxes apply only to assets valued at more than $11.7 million (some states have lower limits).
Who Owns a Split-dollar Life Insurance Policy?
You and the other party participating in the agreement decide who owns the split-dollar life insurance. However, each ownership model has pros and cons. A policy may be held by:
- You: You can own a life insurance policy while someone else pays part or all of the premiums.
- Your employer: Your employer, like key person insurance, can own the policy and use their portion of the payout to reimburse business expenses linked to your death.
- A business partner: In their buy-sell agreement, small business partners may add a split-dollar clause. The clause specifies what happens if one of the owners leaves the company.
- A trust: If you place your life insurance policy in an irrevocable life insurance trust, it will not be counted as part of the value of your estate.
- A family member: Another way to reduce future inheritance taxes is to transfer ownership of a permanent policy to a loved one.
There are two kinds of ownership agreements between companies and their employees:
- Agreement on economic benefit and endorsement
- Loan and collateral assignment regime
#1. Agreement on economic benefit and endorsement
If your employer owns the life insurance policy and pays the premiums in a split-dollar agreement, but you and your beneficiaries receive some of the benefits, those benefits are assigned to you via an endorsement agreement.
The term “economic advantage” refers to the way the IRS taxes the policy. The policy is taxed as employee pay and is computed on a yearly basis based on the benefits in your policy and the premiums paid by your employer.
#2. Loan and collateral assignment regime
If you own the life insurance policy in the split-dollar arrangement but your employer pays the premiums and receives some of the policy benefits, you use a collateral assignment agreement to assign those benefits to your employer.
The IRS sees your employer’s premium payments as an annual, interest-free loan to you (a loan regime). Their share of the policy benefits loan repayment. You pay tax on the interest that would have been levied if this were a typical loan (known as the applicable federal rate or AFR).
Loan regime arrangements are more difficult to set up, but provide bigger tax benefits because the value of your policy benefits is not taxed.
The contract specifies how and when your split-dollar plan will cease in either case. When you leave a firm for another job or retire, the company usually either terminates your policy or gives you the opportunity to port it at your own expense.
Benefits and Drawbacks of Split-dollar Life Insurance Plans
Split-dollar contracts are less popular now that tax laws for the benefit became tougher in 2003. It does, however, have some plans in small business and estate planning. The following are some advantages and disadvantages of split-dollar life insurance:
- The employer pays the premiums for a normally expensive permanent policy.
- As an employee benefit, it aids in attracting top personnel.
- Can protect your permanent insurance policy from estate taxes?
- Cash value may supplement retirement savings.
- If you leave your work, your employer must surrender your policy or you will be responsible for paying the premiums alone.
- When compared to regular investments, cash value accounts typically offer a poor rate of return.
- Making tax filing more difficult for the individual or the employer
- Permanent policies are more expensive than term policies and are typically unnecessary.
Employees with Split-dollar Life Insurance
Employees gain greatly from split-dollar arrangements. Extra life insurance coverage can be beneficial, particularly for high-earners who are more likely to be provided such arrangements by their employers.
Aside from coverage, you may be able to access the cash value of your policy — as well as the taxes associated with it. This cash value is money that you can withdraw or borrow from later in life or in retirement. Each policy is structured differently, and your employer will give you with further information about your benefits.
The more common kind of split-dollar life insurance is a collateral assignment. You will own the policy and make payments with employer loans. The IRS sees each premium payment as a new loan, which can complicate accounting.
In general, the tax treatment of split-dollar life insurance is complicated. To close loopholes, the IRS devised guidelines for split-dollar agreements. This required identifying a list of ways corporations might treat the agreements. With fewer buckets into which to fit all of these configurations, more intricate work in organizing and execution is required to make them fit.
Employee and Employer Advantages
Let’s look at the advantages of both collateral assignment and endorsement split-dollar plans.
Potential Employer Advantages
- You decide who gets benefits when they get them, and how much they get.
- There are fewer restrictions or limitations than in standard qualified plans.
- Low administrative and start-up costs
- The opportunity to return your company’s investment when a valued employee departs, retires, or dies.
- The employer pays the life insurance premiums.
- They can customize the plan to match their own requirements.
- Through partial withdrawals and loans, they may get tax-free income.
- Possibility of tax-deferred rise in cash values
Estate Planning using Split-dollar Life Insurance
Employee benefit plans do not always provide split-dollar life insurance. Private split-dollar life insurance contracts can also be formed by wealthy individuals. An irrevocable life insurance trust, or ILIT, is frequently used in these private agreements.
In exchange for reduced future control, ILITs allow you to place your life insurance proceeds in the hands of a tax-advantaged trust. The “irrevocable” component means that you are effectively locking anything in the trust out of your own grasp. The fundamental advantage of an ILIT is that it is not included in your estate, therefore avoiding estate taxes.
This is irrelevant to the vast majority of individuals. Estate taxes apply only to the very rich and kick in when a person’s assets after death surpass $11.58 million.
Cancelling Split-Dollar Life Insurance Plans
Split-dollar insurance plans expire when the employee dies or at a future date specified in the agreement (often retirement).
Depending on the agreement, the employer recovers either the premiums paid, cash value, or the amount owing in loans in the event of the employee’s early death. When the payback is made, the employer releases any restrictions on the policy. The remainder is paid to the employee’s named beneficiaries, which can include an ILIT, as a tax-free death benefit.
If the employee meets the terms and conditions of the agreement, all restrictions under the loan agreement are lifted, and ownership of the policy is transferred to the employee under the economic benefit arrangement.
The employer may reclaim all or a portion of the premiums paid or cash value, depending on how the agreement was written. The employee is now the owner of the insurance policy. The policy’s value is taxed as remuneration to the employee and is deductible to the employer.
What Is The Value of a $25000 Life Insurance Policy?
When the policyholder dies, the insurance company pays the full death benefit of $25,000. Money deposited into the cash value is now the insurer’s property. Because the cash value is $5,000, the life insurance company’s true liability cost is $20,000 ($25,000 – $5,000).
What Is The Value Of a $10,000 Life Insurance?
A $10,000 policy has a face value of $10,000. This is typically the same as the death benefit. When you pay your premiums for most whole life insurance plans, some of the money goes into an investment account. This account contains the cash value of the life insurance policy.
Split-Dollar Life Insurance FAQs
What is a split dollar life insurance plan?
A contract between two or more parties to split ownership and benefits of a permanent life insurance policy with a cash value component is known as split-dollar life insurance.
What is the benefit of split dollar life insurance?
A split-dollar arrangement can be helpful in estate liquidity planning to minimize income, estate, and gift taxes.
What is one of the major disadvantages of split dollar plans?
Under the split-dollar plan, your company will normally not obtain a tax deduction for its portion of premium payments. Employees may be required to pay income taxes on the value of the economic benefits offered to them each year, depending on how the agreement is constructed.
How are split dollar life insurance policies taxed?
If the policy is owned by the employer (or another person responsible for paying the premiums), the arrangement will be taxed under the “economic benefit analysis.” The arrangement will be taxed as a “split-dollar loan” if the employee owns the policy.
What are the benefits to the employee of a split dollar plan?
The key advantage of a split-dollar plan is that the premium is paid by the employer. Loans and withdrawals are tax-free, and cash values can increase tax-deferred.