What is a Split Dollar Arrangement?
Split dollar is a technique for sharing the costs and benefits of a life insurance policy between two or more parties. The most common split dollar arrangements are between employers and employees, and between parents and children. The employee’s or child’s contribution may be through services or with cash.
The basic idea of any split dollar arrangement is that the life insurance policy underlies an economic agreement between the parties. The issues between the parties are ones of contract law, including terms of enforcement, compensation and collateral. The parties cannot avoid these issues by stepping into the shoes of an insured. Because these arrangements are economic in nature, a split dollar agreement is not an estate planning technique that can (for example) provide an estate tax exclusion.
Under the typical employer/employee arrangement, the employer pays both the premium for an insurance policy and owns the policy. At the employee’s death, the employer recoups its premiums and a stated interest on the premiums (if any has been agreed upon). The balance then goes directly to the employee’s named beneficiary. Under the parent/child arrangement, the child is either the owner, or might pay all or part of the premium. In either standard arrangement, the insured employee/child can be given some greater rights afforded under a life insurance policy, such as the right to make a withdrawal of cash values , or to borrow against cash surrender values.
From a technical perspective, a split dollar arrangement could simply be a form of inter-partnership financing. The spilt dollar agreement is a contract regulating how the partnership will share a cash flow, and can fall under partnership income tax principles.
A split dollar agreement should discuss the allocation of the risk of policy has over time. If the company pays all the premiums and owns the policy, then the cost of insurance charge is determined by the insurer when it calculates the cost of insurance charge to be paid by the company each year. The cost is based on the insured’s age (or ages) and the insurer’s experience. While the insurer will charge its standard rates, the company can expect an increase in the cost of insurance when the insured reaches age 75.
An alternative is to state that the cost of insurance is based on the company’s actual cost of insurance. This approach should only be used with great care. The agreement should contain a specific contractual formula for determining the cost of insurance. If there is no clearly written formula, the insurer, the company and a court will very likely conclude the cost of insurance is a situation in which the insurer could recover from the company both the good times and the bad. That means the company might pay the insurer more than its actual cost of insurance (regardless of whether it purchased term or whole-life insurance).
Types of Split Dollar Arrangements
Split dollar programs can be set up to align with the needs of the employer and employee. While the amount of the benefit, which is being provided, is often similar in the different forms of split dollar agreements, the effects of the different types of agreements on the parties involved can be very different. In addition, the tax and accounting issues concerning the different types of agreements can have significant differences, not only from each other, but also a significant difference than what might otherwise apply.
In a split dollar agreement, an employee, or other individual, pays part of the premium for the life insurance coverage. The employer funds the remaining portion of the premium. In a collateral assignment split dollar agreement, the employer will own the policy, and the insurance company will pay the death benefit proceeds to the employer, to the extent of the employer’s contribution, with the balance, if any, payable to the employee or other individual’s beneficiary. The employer will have a loan obligation to the insurance company for the amount paid, as premiums, on the policy until it has recovered its total contribution to the policy, plus its interest.
So, a collateral assignment split dollar agreement is legally similar to a split dollar loan between the employer and the insurance company. The classification of the agreement depends on the manner in which the insurance company is obligated to pay the death benefit proceeds.
In contrast to the collateral assignment split dollar agreement, the endorsement split dollar agreement results in the insurance company directly paying the death benefit proceeds to the individual (i.e., the employee of the employer), with the insurance company immediately being reimbursed by the employer for the premium paid (both by payment and forgiveness of the policy’s loan obligation), until the total amount paid by the employer under this agreement has been fully reimbursed to the employer.
The typical endorsement split dollar agreement also contains an agreement from the employer to pay the policy premiums after termination of the employment as long as the employee continues to pay them, and the right of the employer to reimburse itself the amounts it paid, plus interest, from the employee separately, if the policy is terminated or the employee receives a policy benefit while still employed by the employer.
Several years ago, the IRS and Treasury issued proposed regulations addressing, at least in significant part, the tax and accounting treatment of the different types of split dollar agreements. That guidance is still in proposed form. But, where guidance does exist on the tax and accounting of collateral assignment split dollar and endorsement split dollar, it is very different from the general rules that apply to other types of agreements between parties, even where the agreements are similar. The IRS and Treasury are still working on the income, payroll tax, excise tax and income tax withholding issues, as well as the accounting issues. It is uncertain when all that work will be completed, and what other issues might be addressed prior to conclusions being finalized, and the pronouncements being issued.
Advantages of Split Dollar Arrangements
The benefits of split dollar agreements to businesses, both privately-owned and publicly-traded, include tax advantages, cost savings and enhanced employee retention.
Tax Advantages
Compared to options for providing the same level of employee benefits, there are often favorable tax results when using commercial life insurance as the benefit funding mechanism. The ultimate protection provided by an employer-funded life insurance policy is that the death benefit can be received by the beneficiary income tax free. In addition, if properly structured, the policy earnings can be accumulated income tax free within the plan. This income tax deferral provides a means for the company to grow an important employee benefit asset.
Cost Savings
A properly structured split dollar arrangement will help keep the cost of a life insurance plan low. Because the company’s interest in the policy grows at a fixed rate of return — based on the amount of premium called for under the plan — it has a bigger ownership claim in the policy over time. This means the insurance company can use lower rates to determine the cost of coverage.
Enhancing Employee Retention
In many instances, the best way to retain critical employees is to develop an employee benefit package that is difficult to replicate by another employer. Much of the time, a company’s most valued employee assets are those employees who are fully trained, performing well and closely tied to the success of the organization.
In order to retain these assets, an employer should have an enhanced employment package that includes valuable deferred compensation and other fringe benefit agreements, such as ERISA-compliant benefit plans and split dollar arrangements.
Potential Drawbacks of Split Dollar
Employers considering using the split dollar method to provide life insurance benefits or to finance life insurance policies must understand the risks associated with these arrangements. The most significant risk from the employer’s standpoint is that the IRS may conclude that a particular split dollar arrangement is neither a transfer of substantial benefits nor an inducement to purchase a policy but is instead a method of compensation to the employee. In that case, the employer will be required to pay FICA employment taxes (Social Security and Medicare Taxes) on all amounts contributed, and this could result in substantial additional costs to the employer. Treas. Reg. Section 31.3121(s)-1(c) provides that the employee will be considered to have compensation attributable to a split dollar arrangement that is includible in gross income and subject to FICA employment tax in situations where the employer does not transfer substantial benefits or induce the employee to purchase a life insurance policy, but instead the employer provides the benefits with a significant motivation of paying deferred compensation or providing a nonqualified deferred compensation plan.
An employer who pays FICA employment taxes on employer split dollar payments must also continue to pay Federal Unemployment Tax or FUTA taxes on the 0.0765%. Finally, the employer will have to pay Federal Income Tax on its split dollar payments .
Employers should also note that the IRS tends to test split dollar arrangements against the guidelines for determining whether an arrangement is an employer "Transfer of Value." See Rev. Rul. 64-328, 1964-2 C.B. 62 (concluding that a unilateral grant of an option to purchase shares of employer stock by an employer to an employee to enhance the employee’s performance cannot be construed as consideration and therefore is a transfer of substantial benefit); Rev. Rul. 66-110, 1966-1 C.B. 12 (noting that an employer’s contribution of commercial insurance policies to a deferred compensation plan had "little economic substance" and was a transfer of value); and Clem v. Commissioner, 2 T.C. 881, 1943 WL 642 (T.C. 1943) (describing a transfer of stock options and covenant not to compete as being a transfer of value).
Finally, the IRS has very strict guidelines for the tax treatment of the death benefits of a life insurance policy purchased with split dollar financing. The amount to be included in income upon payment of the death benefit can be reduced by the policy’s cash surrender value, for which premiums were paid. If the insurance company pays the death benefit to the employer (who is the policy owner), then the excess benefit amount is further reduced by the present value of any split dollar interest that the employer must pay to the employee’s estate. However, if the employer pays the death benefit, the present value of the split dollar interest is treated as income to the employee.
Structuring a Split Dollar Arrangement
When all parties are ready to proceed, the first step in establishing a split dollar arrangement is the preparation of the agreement. The emerging industry standard is to incorporate the split dollar arrangements in a separate agreement that operates in conjunction with an insurance policy. There are a number of different arrangements for configuring the policy and agreement into the split dollar arrangement. The devil is in the details and having competent legal, tax and insurance professionals to help structure the arrangement is imperative. Sometimes, the arrangement may be a three-way split dollar arrangement comprising the employer, the key employee and the insurance company issuing the policy. Once again, good advisors are needed to help align the interests of all the parties.
In addition, the parties will need to determine whether they want to implement the arrangement as a loan or a purchase of an asset. While the purchase/sale scenario is more common, the use of a loan is also appropriate and can give rise to certain tax advantages to the employer and the employee. Some employers will want to finance the premiums through a companion policy, that is, a separate policy insuring the employer’s interests owned by the employer, and paid for by the employer, to fund the purchase of the policy insuring the key employee under the split dollar arrangement. Other times, the employer will want the employee to pay the premiums, which will reduce the income tax burden for the employee in the future.
Assuming the parties are using the common two-party loan regime, the initial documents need to include the loan, the security agreement, the policy, and the split dollar agreement.
Practical Applications
Case Study 1: Retirement Planning for Business Owners
During a recent review meeting with an Elder Law attorney, it was discovered that a client, who had a multi-million dollar business that he had been working in, in one form or another, since he was 21 years old, had not incorporated the business into his estate plan. The insurance and financial professionals determined that the business owner would most likely need to sell his business to pay for his retirement and get involved with Estate taxes if he passed away.
A split dollar agreement was discussed, and the trusting insurance and financial professionals were able to incorporate the business into the estate plan. The business in the buy-sell agreement was valued at $5 million dollars. The business had a large cash flow, but a high expense ratio. However, a sizeable part of the cash flows that the practice received intimidated a valued book of business that was transferable to another practitioner. So, at some point, the owner of the company would have to exercise the buy-sell agreement.
This strategy allowed the business owner to incorporate the value of his practice into a financial plan with a predictable eventual exit strategy.
Case Study 2: Charitable Giving and Avoiding Estate Taxes
Another life insurance professional was able to get a successful business woman to donate some stock from her successful textile recycling plant to the United Way as a charitable gift trust . This case study illustrates how Ms. A can avoid the double taxation caused by both a partnership agreement and a buy/sell agreement. Her partnership agreement requires partners A and B to pay each other $200,000 for their partnership interests when one dies. However, the insurance professional was able to convince A that life insurance would allow her to donate to a charity while avoiding the estate tax, and the double taxation that comes with it.
The answer for the business woman which may also be usable for Ms. C who has a successful canvassing company was a philanthropic strategy that avoided the double taxation in the buy/sell agreement. The United Way had the pre-existing donor advised fund allowing Ms. A to donate $500,000 in stock (valued at market value) to her donor advised fund. The United Way was able to obtain a $3 million dollar insurance policy on Ms. A since the partnership and buy/sell agreements died with the death of the partnership and buy/sell agreements. No longer liable under the agreement, the donor advised fund was created on behalf of Ms. A.
Had the key man insurance policy been purchased prior to the partnership and buy/sell agreements being established, the value of the partnership and/or the buy/sell agreements would be subtracted from Ms. A’s estate resulting in additional taxation for her beneficiaries.