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Split Dollar Arrangements: Strategies for competitive business

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Split Dollar for Successful Businesses

What is Split Dollar?

Split dollar is a cost- and tax-effective way to split the premiums and benefits of a permanent life insurance policy between two or more parties, such as an employer and an employee.

How can Split Dollar Help my Business?

A split dollar arrangement can be used by an employer to provide valuable life insurance death benefit protection for select key people. It can also be used to fund a cross-purchase buy-sell arrangement between business owners.

If you own a closely held business you know the importance of rewarding, retaining, and recruiting key people. They are as integral to the success of your business as the product or service you provide.

Split dollar arrangements can enhance current incentive programs and provide additional fringe benefits—at a low tax cost to the participant.

Who can use Split Dollar?

The employer can be a C or S corporation, partnership, LLC, or even a sole proprietor. The insured may be the employee or anyone in whom the employee has an insurable interest (such as a spouse, parent, child, or business associate). Family or private split dollar arrangements may also be structured between family members (parents and children) or between insureds and their irrevocable life insurance trusts (ILITs). Please note that private or family split dollar arrangements are beyond the scope of this guide.

How Does Split Dollar Work?

In the business context, split dollar refers to a written agreement between the business and an insured key person (sometimes a shareholder) to split the rights and costs of a permanent life insurance policy.

Typically, the business pays the premiums, but the death benefit—and cash values—will be split. The employer has the right to be repaid its costs (sometimes more), while the insured can name the beneficiary of a portion of the policy’s death benefit.

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Splitting the Death Benefit

splitting the death benefit graphic. Employer typically receives its premiums back; or the cash surrender value (if larger). Employee typically has the right to name a beneficiary for the balance of the death benefit.

Splitting the Cash Value

Splitting the Cash Value graphic. Employer typically receives its premiums back; or the cash surrender value (if larger). Some split dollar plans allocate policy gains (if any) to the Employee

Each arrangement will be tailored to the situation and goals of the parties involved. Within the bounds established by the IRS, there are many possible versions of split dollar, depending on such factors as:

  • Ownership – Who owns the policy?
  • Repayment – How much will the business be paid from the policy?
  • Taxation – Which IRS-approved method applies for income tax purposes?

These variables mean there are many ways to structure a split dollar arrangement. This strategy guide focuses on two of the most commonly used in the business context: Economic Benefit split dollar and Loan Regime (Collateral Assignment) split dollar.

Economic Benefit (Traditional) Split Dollar Arrangement

There are two types of economic benefit arrangements: endorsement and collateral assignment.

With an endorsement arrangement, the employer owns the policy but allows the employee to name the beneficiary of a portion of the policy death proceeds. The employer retains all other rights to the policy. Taxation under the “economic benefit” method results in a tax to the employee each year, based on the value of the insurance protection provided that year.

With a collateral assignment arrangement, the employer "owns" all of the policy cash value. This is often referred to as a"non-equity" arrangement. Both types have the same tax consequences.

  1. The employer owns the policy when using the endorsement arrangement.
  2. The employee’s rights are limited.
  3. Economic benefit taxation.

Economic Benefit (Endorsement Method) Split Dollar Arrangement

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Loan Regime (Collateral Assignment) Split Dollar Arrangement

Under this arrangement, the employee owns a permanent life insurance policy. The arrangement treats each premium payment made by the employer as a loan to the employee. In exchange for the loan, the employer has a collateral assignment against the policy to ensure recovery of the loan principal. If loan interest is forgiven by the employer, the employee pays income tax on the forgiven amount. A second option is for the loan interest to accrue.

  1. The employee owns the policy.
  2. The employer’s rights are limited to repayment of the loan principal. 
  3. Loan arrangement taxation.

Loan Regime (Collateral Assignment) Split Dollar Arrangement

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Advantages and Disadvantages

Split Dollar can be Advantageous for the Right Employer

Employer Advantages

  • Selectivity – You decide who participates and the benefit levels for each employee. Split dollar gives you the flexibility to choose a group of executives or just one key person with the versatility to have a different benefit for each.
  • Easy to establish and administer – IRS approval is not required, and administration is minimal.
  • Split dollar is an asset – With the economic benefit arrangement, the policy cash values are an asset on the business’ balance sheet, and the cash value grows on a tax-deferred basis. With a loan arrangement, it is recorded on the corporate books up to the amount owed back.
  • Cost-effective – Unlike other fringe benefits, the business normally recoups the cost, and the death benefit proceeds are generally received income tax free.
  • Leverage – A split dollar arrangement may cost less than the after-tax compensation dollars required to provide an equivalent benefit.
  • Employee productivity and loyalty – Key people will feel valued and will be more productive. “Golden handcuff” provisions can be included by promising a future deferred compensation benefit informally funded with policy cash values, giving them incentive to remain loyal to the business.
  • Versatility – Split dollar arrangements can be used in a variety of ways to meet an executive’s or a business owner’s estate planning and business needs.

Employer Disadvantages

  • No Immediate Tax Deductions – Your business will not receive a tax deduction for its share of premiums payments under a split dollar arrangement.
  • Compliance with IRC Section 101(j) – In the event the insurance is owned by the business, the Notice and Consent requirements of IRC Section 101(j) must be met to keep the death proceeds income tax free.
  • Interest rate sensitive – Under a loan arrangement, each premium payment is treated as a new loan subject to the current Applicable Federal Rate (AFR).

Split Dollar can be Advantageous for the Right Employee

Employee Advantages

  • More meaningful – The employee enjoys insurance protection when he or she needs the coverage the most.
  • Cost- and tax-effective – Under the economic benefit (endorsement) method, the employer generally pays the entire premium; the employee is taxed based on his or her share of the death benefit at a very attractive “term” rate.
  • Tax-free death benefit – Death benefit proceeds are generally received income tax free by the employee’s beneficiary.
  • Versatility – In addition to the financial protection life insurance in a split dollar arrangement provides, it can also be designed to help supplement retirement or estate planning needs.

Employee Disadvantages

  • Annual Taxation – Employee taxed annually on either economic benefit value or can be taxed if loan interest amount is forgiven, depending on style of split dollar arrangement.
  • Age – Economic benefit costs are calculated based upon the employee’s age. The cost can become cumbersome at some point.
  • Retirement value limited – Economic benefit endorsement method split dollar (by itself) is intended primarily to provide a supplemental life insurance benefit. Other arrangements such as nonqualified deferred compensation or executive bonus may be better design options for providing supplemental retirement income to a valued key person.
  • Owner of a Pass-Thru Entity – Split dollar as a strategy works best for owners of a C Corporation because of the pass-through nature of income/expenses of a pass-thru entity.
  • Interest rate sensitive – Under a loan arrangement, each premium payment is treated as a new loan subject to the current AFR. If interest rates increase this can increases costs to the employee.

How to Exit or Roll Out of a Split Dollar Arrangement

If you are considering a split dollar arrangement, the discussion should always include an exit or rollout strategy when the arrangement terminates. Here are some options to consider. Note that not all options will be available in all split dollar situations.

Economic Benefit Split Dollar (Endorsement or Collateral Assignment Arrangement)

Employer Keeps the Policy

When the arrangement terminates no transfer of the policy is required. The employer as policyowner may keep or surrender it as best suits future employer goals. If the arrangement is a collateral assignment, the employer via the collateral assignment can take over the policy (making themselves the owner of the policy).

Employer Transfers the Policy to Insured

The policy can be "rolled out" to the insured. The insured’s position as employee or stockholder will affect how the ownership change is treated.

  • For example, when a key person retires, the employer may owe the employee money under a deferred compensation agreement, in which the policy might be transferred in satisfaction of that deferred compensation obligation.

A generous employer might choose to transfer the policy to the insured even if there is no deferred compensation arrangement. In either case, the employee would pay tax on the fair market value of the policy at that time and the company would receive an offsetting deduction.

Employer Sells the Policy to the Insured

The employer may agree to sell the policy to the insured for a cash payment or a note payable equal to the employer’s cash value interest.

Death Benefit

In the event the employee dies while an arrangement is still in place, the terms under the split dollar agreement would determine the amount paid to the employer and the death benefit payable to the named beneficiaries.

Loan Regime (Collateral Assignment) Split Dollar Arrangement

Forgiveness of the Loan

For loan arrangements, the employee owns the contract but owes the employer money upon termination of the split dollar agreement, which typically occurs at the key person’s retirement. The employer could forgive the outstanding loan balance, in which case the employee would pay taxes on the amount of the loan forgiven. The company would receive an offsetting deduction. In addition, since the employee is now the owner of the policy, they can use a withdrawal from the policy or outside funds to pay the taxes due.

Repayment of the Loan

The insured can repay the employer using cash or other out-of-pocket assets besides the policy.

Death Benefit

In the event the employee dies while an arrangement is still in place, the terms under the split dollar agreement would determine the amount paid to the employer and the death benefit payable to the named beneficiaries.

The parties to the split dollar arrangement should consult with tax and legal advisors regarding what options are available and what the potential tax consequences will be.

Why Consider Split Dollar?

Employee Fringe Benefit

Split dollar arrangements can provide key people and owners with life insurance protection at a lower annual cost to the insured than similar amounts of group term coverage or personally owned level term insurance.

Fund Cross-Purchase Buy-Sell Arrangement

Using a split dollar arrangement, a business can assist owners in acquiring life insurance coverage on other owners, in order to fund their buy-sell arrangement. Structured properly, it can reduce the personal out-of-pocket costs for the parties while obtaining permanent coverage instead of mere term protection.

Estate Planning

Split dollar arrangements can be structured to provide the executive and/or the business owner with estate liquidity at a low out-of-pocket cost (the income tax on the term value). Combining the arrangement with an irrevocable trust may also keep the death benefit out of the executive/owner’s estate. Use of business funds for the premium frees up personal cash for other needs.

Complement to a Supplemental Retirement Benefit

Employers use nonqualified deferred compensation and supplemental retirement benefit arrangements to help retain and reward a key person. These options represent a promise to provide compensation in the future to either the employee or the employee’s beneficiary upon triggering events such as retirement, disability, death, and separation from service after a number of years.

Although these arrangements can be great incentive tools, all benefits paid as deferred compensation, including a promised pre-retirement death benefit, are taxable as ordinary income to the recipient beneficiary. In contrast, a pre-retirement death benefit paid under a properly designed split dollar arrangement will be received income tax free by the employee’s beneficiary.

A combination approach (dynamic duo) - The pre-retirement death benefit is provided via a split dollar arrangement (income tax free death benefit), while post-retirement living benefits are provided under a deferred compensation arrangement. This approach creates an overall structure often more attractive to the participating key person than would the deferred compensation arrangement alone.

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if the employee dies pre-retirement, tax free life insurance benedits are paid under the split dollar agreement to the employee's beneficiaries. If the employee retires, taxable retirement income payments are paid to the participant under the deferred compensation agreement.

Split Dollar Details

How the IRS Looks at Split Dollar Arrangements

Economic Benefit (Endorsement Method) Split Dollar Arrangement (Employer Owns Policy)

During the arrangement, the employee has the right to name the beneficiary of a portion of the death benefit. The employee has no interest in the cash value.

The IRS regulations provide that the employee receives a taxable economic benefit each year—namely the insurance protection—since the employer paid all of the premiums.

The employee is taxed on the value of insurance protection each year.

The taxable value of the annual insurance coverage (measured in dollars per $1000 of coverage) is based on an IRS table or the insurance company’s applicable one-year term insurance rates.

As an insured ages, the cost of coverage increases for the same amount of death benefit.

If the arrangement terminates while the insured is still alive, the employer keeps the policy. The employee has no rights in the contract but is no longer taxed.

Loan Regime (Collateral Assignment) Split Dollar Arrangement (Employee Owns Policy)

During the arrangement, the employer pays the premium to the insurance company. Each premium payment is treated and documented as a loan to the employee.

The loan bears interest at a stated rate. Loans with a certain duration use the AFR appropriate to that term (short-, mid-, or long-term), while demand loans use a blended short-term federal rate.

Loan arrangements can be structured in many ways—for example, with accrued interest or interest paid each year. Interest can be forgiven annually and claimed as income on the employee’s tax return.

For most loan arrangements, the employee owes interest but does not actually pay interest to the employer. In this situation, the IRS taxes the employee as if compensation had been received from the employer. The employee is taxed on the loan interest amount each year.

If the employer receives interest from the employee, the employer is taxed on that amount.

The employer secures its interest with a collateral assignment on the policy, which ensures that significant rights in the policy remain with the employer while the split dollar arrangement is in place.

The tax consequences of an accrued interest split dollar loan arrangements are based on the below-market rate tax rules.

Split dollar arrangements are varied in many ways, including income and gift taxation. Clients should consult with tax and legal advisors to determine how a particular arrangement will be taxed.

A less common method is the economic benefit collateral assignment method in which the employer will retain a right to its money back through a collateral assignment rather than being named the actual owner on a life insurance policy.

Split dollar arrangements are easy to set up and administer, but one size does not fit all. Your financial professional will work with you through the process to minimize your efforts while maximizing the efficiency of your split dollar arrangement. To facilitate implementation, MassMutual can provide specimen agreements for use by your advisors. For legal reasons, MassMutual cannot prepare the actual agreements for your split dollar arrangements.

* The information provided is not written or intended as specific tax or legal advice. MassMutual, its subsidiaries, employees, and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.

Participating whole life insurance policies are issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111-0001.