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Split Costs, Split Benefits: Understanding Split-Dollar Life Insurance Strategies

Split Costs, Split Benefits: Understanding Split-Dollar Life Insurance Strategies

March 26, 2024

Split-dollar life insurance offers a wide range of versatile applications that can benefit both employers and individuals seeking to secure their financial future. While split-dollar plans are commonly established to reward key employees or for company owners seeking to obtain future liquidity for a variety of needs, they can also be configured for private arrangements between individuals, individuals and trusts, or even between two trusts, making them a valuable addition to a well-structured estate plan.

In a corporate setting, usually “C” corporations with retained earnings, a company may cover the life insurance premiums for an owner or for an employee's cash value life insurance policy. This split-dollar arrangement not only helps an owner, or an employee, achieve their wealth-transfer objectives but also serves as a contingency fund for the company, ensuring financial security for valuable team members. These split-dollar arrangements are flexible and can be tailored to suit the specific interests of both employers and employees. It is advisable for both parties to educate themselves about the available structures, benefits, and considerations during employment negotiations and wealth-transfer planning.

The executive benefit specialists at Cedar Point Financial Services LLC assist clients and their advisors in implementing and monitoring split-dollar arrangements.

The Different Types of Split-Dollar Plans

Split-dollar plans can be categorized into different structures, including:

· economic benefit arrangements with endorsements,

· loan arrangements with collateral assignments,

· and non-equity collateral assignments.

Occasionally, a switch-dollar strategy is employed to reduce costs associated with the plan.

Economic Benefit with an Endorsement

In this arrangement, the employer owns the life insurance policy and shares the death benefit with the insured employee. The employee can designate beneficiaries for a portion of the policy's death benefit through an endorsement. The employer pays the policy premiums annually, and the employee is taxed on the "economic benefit" of the endorsed death benefit as taxable income. In the event of the employee's death during the endorsement split-dollar plan's tenure, the employee’s beneficiaries receive the endorsed portion of the death benefit, with the employer retaining the balance. If the plan is terminated, the employer can either keep the policy and remove the endorsement or transfer it to the employee. Generally, there is no cost to the employee unless the policy is transferred to them. This endorsement split-dollar plan is

often used to provide a cost-effective death benefit as a fringe benefit or for key person protection for the employer.

The economic benefit cost is determined based on factors such as the employee's age, death benefit amount, and IRS-provided tables. This cost increases as the employee gets older, prompting some participants to reassess the plan's costs and consider alternatives as they age, such as converting to a survivorship policy.

Loan Regime with a Collateral Assignment

In this split-dollar setup, the employee owns the life insurance policy while the employer covers the premiums. Each premium payment is treated as a loan from the employer to the employee, with the employee providing collateral through a policy assignment. The employee is required to pay interest on the loan annually, either out-of-pocket or as imputed income, which likely triggers an income tax liability. The collateral assignment safeguards the employer's interest in the policy until the loan is repaid.

Until the loan is settled, the employee can access the policy's cash value beyond the loan balance. In the event of the employee's death, the death benefit either repays the loan to the employer or results in forgiveness of all or part of the debt. If the plan is terminated, the employee must repay the loan using the policy's cash value or other funds, unless the employer forgives it. This plan allows the employee to own the policy while retaining access to its cash value.

The collateral assignment offers a balanced approach that benefits both the employer and the employee. Employers can use it to provide attractive fringe benefits and recover premium and plan costs through the death benefit, while employees enjoy ownership of the life insurance, tax-exempt death benefits (when structured properly), and potential tax-free access to cash value buildup.

Non-Equity Collateral Assignment

This "hybrid" structure involves the employee owning the life insurance policy, with the employer paying premiums and expecting future repayment. In this scenario, the employee agrees to reimburse the employer an amount equal to the policy's cash value or cumulative premiums when the plan terminates. Like the endorsement split-dollar plan, the employee pays annual income tax on the imputed death benefit cost related to their entitled death benefit.

If the employee passes away while the plan is active, the employer receives either its paid premiums or the policy's cash value from the death benefit, with the remaining going to the employee’s designated beneficiaries. If the plan terminates before the employee's death, the employer is repaid either the cash value or premiums paid, or the employer may choose to forgive part or all the debt, which could be taxable income for the employee. The non-equity collateral assignment split-dollar plan is useful when the employee wants to own the policy, values the death benefits for wealth transfer purposes, and/or requires assistance in paying

premiums. Employers and employees should evaluate these plans to determine when the policy's cash value exceeds the total premiums paid and consider switching to a loan regime plan if necessary.

Cedar Point Financial Services LLC can evaluate for each individual or corporate client if a split-dollar arrangement can help achieve planning goals and, if so, determine which arrangement is most suitable.

It is Time for a Switch?

A switch-dollar technique is most often applied when a split-dollar plan starts as a non-equity collateral assignment arrangement and later transitions, or switches, into a loan regime split-dollar plan. As noted, the switch is usually made to control costs.

For survivorship policies, the switch typically occurs upon the first insured's death, while for single-life policies, it occurs when the policy's cash value surpasses the premiums paid or when the economic benefit cost surpasses loan interest costs. During the switch, the loan amount equals the outstanding repayment obligation from the non-equity collateral assignment split-dollar plan, which is the greater of the premiums paid by the employer or the policy's cash value.

Future premiums are treated as a loan by the employer. Upon the employee's death, the split-dollar loan is repaid to the employer from the death benefit, with the balance going to designated beneficiaries. In the event of plan termination, the loan is repaid using a combination of the policy's cash value and the employee's other assets. Similar to the loan regime split-dollar plan, the employer may choose to forgive part or all of the loan.

The switch split-dollar plan is commonly used for survivorship policies due to increased costs after the first insured individual passes away. For single-life policies, it can help reduce income tax liabilities. Deciding when to execute this switch is crucial and requires careful monitoring, making it an essential consideration for both employers and employees.

Is it time for a “switch”? Cedar Point Financial Services LLC evaluates existing split-dollar arrangements to determine if a switch in the treatment of a split-dollar plan can generate significant savings.

Know Before You Go

For corporate applications, in addition to exploring the various split-dollar plan options, it is essential for employers and employees to consider the income and estate tax implications. When employers own the life insurance policies under endorsement or non-equity collateral assignment split-dollar plans, they must ensure they meet specific requirements to maintain the tax-exempt death benefit for designated beneficiaries. The employee should also consult with their estate planning attorney to assess whether an irrevocable life insurance trust could

purchase the policy or if the split-dollar plan might have unintended gift and estate tax consequences or liquidity issues.

Certain legal restrictions, such as those imposed by the Sarbanes-Oxley Act, may limit the use of loan regime or switch split-dollar plans, especially for directors and executive officers of publicly traded companies. Additionally, some types of life insurance policies may not be suitable for loan split-dollar plans due to federal laws.

Finally, it's worth noting that the principles discussed in this article can be applied in a pure estate planning context as well—splitting life insurance costs and benefits between trusts and individuals or between two trusts, for example. Furthermore, intergenerational split-dollar plans involving dynasty trusts and non-dynasty trusts may follow a similar framework, albeit with fact-specific variations. The concepts outlined here remain relevant in such scenarios.

We are Here to Help

Split-dollar life insurance plans offer valuable incentives for attracting and retaining executives and key personnel while serving as effective retirement and/or estate planning tools for employees seeking additional fringe benefits from their employers. Understanding the various plan types, discussing their advantages and disadvantages with an attorney, and regularly reviewing and monitoring plans are crucial steps for both employers and employees. At Cedar Point Financial Services LLC, we work with clients’ legal, accounting, and other advisory professionals in developing and implementing strategies that optimize their retirement planning and legacies to family and community.