Classic split-dollar plan—which is the original version of split-dollar—involves the splitting of a policy between a business and a participating key employee. The business annually contributes the amount of premium equal to the increase in the Cash-Surrender Value (CSV), while the participant pays the remainder of the premium. The business will receive the CSV at the earlier of the termination of the plan or the participant’s death. The participant holds the right to designate the beneficiary of the policy. Note, although the employee generally must pay a substantial part of the first premium, after the first year the employee’s share of the premium decreases rapidly, and, in some cases, it even becomes zero after a relatively few years. The employee, thus, gets valuable insurance protection (decreasing each year, but still substantial for a long time) with a relatively small outlay for premiums in the early years and at little or no cost to the employee in later years.
Although all of the initial tax authority on split-dollar involves the classic arrangement, it is rarely seen in practice. During the last several decades the types of split-dollar arrangements used generally fall into two categories: collateral assignment arrangements and endorsement arrangements. As discussed later, these two types have several variations.
Collateral Assignment Split-Dollar
Collateral assignment split-dollar involves one party paying a portion of the premium for a policy and as a result receiving a collateral interest in the policy cash value and death benefit (the collateral assignee). The other party owns the life insurance policy (the policy owner) and is entitled to receive any cash value and death benefit not collaterally assigned to the collateral assignee. Depending on the amount of the premium paid by the collateral assignee, the arrangement can be either contributory or noncontributory:
Noncontributory – the collateral assignee pays the entire premium and the policy owner is annually taxed on the REB cost for the portion of the death benefit he or she is entitled to receive.
Contributory – the policy owner pays a portion of the premium at least equal to the REB cost for the portion of the death benefit he or she is entitled to receive (note that unlike classic split-dollar, the policy owner’s share of the premium increases over time), and the collateral assignee pays the remainder of the premium. As a result of paying a portion of the premium equal to the REB cost, the policy owner avoids being annually taxed on this amount. Note that as a result of the Final Split-Dollar Regulations (discussed later), any amount paid by the policy owner may have to be treated as taxable income by the collateral assignee.
As discussed below, there are two types of collateral assignment split-dollar arrangements—equity split-dollar and nonequity split-dollar.
Equity split-dollar has created all of the controversy1 (starting with a ruling in 1996) in the tax treatment of split-dollar life insurance. At the time of the insured’s death or when the plan terminates, the collateral assignee is repaid the lesser of the policy’s Cash Surrender Value (CSV) or the aggregate amount of its premiums (note that another variant of equity split-dollar repays the collateral assignee its cumulative premiums paid, rather than the lesser of the CSV or its cumulative premiums paid). The policy owner receives the excess of the total amount distributed from the policy over the collateral assignee’s share of the benefits. Since the collateral assignee will at most have an interest in the CSV equal to the cumulative premiums paid, any gain in the policy inures to the benefit of the policy owner. This gain, also known as equity, is what gives equity split-dollar its name.
The tax controversy involves the income-tax treatment of the policy owner’s equity component of the CSV, given that the amount of premium it paid, if any, generally only covered the cost of the death protection it was receiving. In other words, the gain is primarily, if not entirely, attributable to the premiums paid by the collateral assignee. Due to the fact that the collateral assignee is only receiving its cumulative premiums paid back, their claim in an equity split-dollar arrangement is similar to the nature of an interest free loan. So much so, in fact, that the IRS has provided guidance in the Final Split-Dollar Regulations (discussed later), providing that such arrangements can only be done as loan arrangements going forward. Therefore, it is no longer possible to enter into a new equity split dollar arrangement.
With non-equity split-dollar, at the time of the insured’s death or when the plan terminates, the collateral assignee is entitled to receive back the greater of the policy’s cash value or its cumulative premiums paid (note that another variant of non-equity split-dollar repays the collateral assignee just the cash value, rather than the greater of the cash value or its cumulative premiums paid). As a result, the policy owner has no interest in the cash value and is provided with a death benefit only. The entire cash value, including any equity, belongs to the collateral assignee. As a result, there is no tax controversy with non-equity split-dollar and it was unaffected by the IRS guidance that makes it impossible to enter into new equity split-dollar arrangements. Nonequity split-dollar remains a viable planning technique.
Endorsement Split-Dollar Plan
Endorsement split dollar involves the policy owner (generally an employer) paying most or all of the premiums and endorsing a portion of the death benefit to the insured (generally an employee), who is permitted to name a personal beneficiary. The policy owner will thus own the entire cash value, and the insured is provided with a death benefit only. Endorsement split-dollar, therefore, achieves similar results as non-equity collateral assignment split dollar, but the ownership of the policy is different. The insured’s portion of the death benefit is typically equal to the net amount at risk (the difference between the total death benefit and the cash value). However, in the authors’ opinion it may be possible for the employer to endorse the entire death benefit, as long as the employee is annually taxed on the REB cost for the entire endorsed death benefit. Note that similar to collateral assignment split-dollar, endorsement split-dollar can be either contributory or noncontributory with respect to the insured’s portion of the premium payments.
Reverse Split-Dollar Plan
Reverse split-dollar is a variant of endorsement split-dollar where the roles of the parties to the arrangement are reversed. If the parties are an employer and employer (which is typically the case), the employee would own the policy and endorse a portion of the death benefit to the employer. Reverse split-dollar is almost always contributory, as the employer, in turn, pays a portion of the premium equal to the REB cost. However, the rates used by the employer were generally based on the P.S. 58 tables, which were very outdated and were very expensive rates. In addition, the employer, instead of paying an increasing REB rate, will pay a levelized premium that results from adding up the P.S. 58 costs for a term of years and dividing that amount by the number of years involved. The employer is essentially overpaying in the early years and underpaying in the later years. The gist of reverse split-dollar is that the combination of using higher REB rates and levelizing the employer’s premiums enables money to be moved tax-free from the business to the employee (generally the business owner).
Notice 2002-592 is believed to have ended the viability of reverse split-dollar. In Notice 2002-59, the IRS stated that one party cannot use inappropriately high current term insurance rates (i.e., REB rates), prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The IRS also indicated that a party participating in a split-dollar life insurance arrangement may use the premium rates in Table 2001 or the insurer’s lower published premium rates only for the purpose of valuing current life insurance protection for Federal tax purposes when, and to the extent, such protection is conferred as an economic benefit by one party on another party, determined without regard to consideration or premiums paid by such other party. Thus, if one party has any right to current life insurance protection, neither the premium rates in Table 2001 nor the insurer’s lower published premium rates may be relied upon to value such party’s current life insurance protection for the purpose of establishing the value of any policy benefits to which another party may be entitled.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM