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Split-Dollar Life Insurance: The Essential Primer

For employers and high-earning employees, split-dollar life insurance can be an attractive financial tool. These insurance arrangements provide flexibility and financial advantages that make them useful for employment and estate planning. This essential primer shows you what split-dollar life insurance is, how it works, the parties involved, and why it may be helpful. You’ll also become aware of some important tax considerations.

Key takeaways:

What is a split-dollar plan?

Split-dollar life insurance is an arrangement where two parties with a shared financial interest agree to split the ownership, costs, and benefits of a whole life insurance policy. These arrangements can be customized to meet the parties' needs and have advantages as an employee benefit and an estate planning strategy.

Types of split-dollar arrangements

For employers who wish to attract and retain high-earning executives, there are two primary types of arrangements:

  • Economic benefit arrangement. In this arrangement, the employer typically pays the entire premium, while the employee is entitled to receive a portion of the policy's death benefit or cash value.
  • Endorsement (loan) arrangement. Here, the employer provides a loan to the employee to pay the premiums. When the policy pays out (either upon the employee's death or the termination of the arrangement), the employer repays the loan amount plus interest, and any remaining value goes to the employee's beneficiaries.

How does split-dollar insurance work?

The key to a split-dollar life insurance arrangement involves sharing the ownership, premium payments, and policy cash value. Here’s how it works.

Essential elements

Split-dollar life insurance approaches the standard elements of a traditional whole-life policy with flexibility to benefit the parties involved.

  • The agreement. The employer and employee enter into a formal split-dollar agreement that outlines the terms and responsibilities of each party.
  • Ownership. The employer often owns the life insurance policy and pays a portion of the premium. In contrast, the employee retains an interest in the policy by contributing premium payments or through the right to the policy's cash value.
  • Premium payments. The employer may pay a portion of the premiums while the employee pays the remaining amount, or the employee can choose not to pay anything. This split in premium payments is a chief characteristic of split-dollar insurance.
  • Death benefit. Upon the insured employee's death, the policy's death benefit is paid out to their named beneficiaries, which can be the employee's family or estate. This is an attractive feature for the employee.
  • Cash value. The policy may accrue cash value over time. When the policy is terminated, surrendered, or upon the insured's death, the cash value is distributed according to the terms of the agreement.
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Setting up the agreement

The parties involved must first negotiate and formalize the terms and responsibilities to establish a split-dollar life insurance arrangement. In this agreement, the parties typically focus on:

  • Premium allocation. How the insurance cost will be divided between the owner and the non-owner, and how those contributions will be calculated.
  • Policy control. The rights and responsibilities of the owner and non-owner in managing the policy. This includes who has access to cash value, the right to change beneficiaries, and the control over policy loans.
  • Income tax consequences. How the economic benefits received by the non-owner will be treated for tax purposes.

Paying premiums

The owner of the policy makes the premium payments, which can be made in various methods:

  • Direct premium payments from the owner's funds
  • Loans from the owner to the non-owner to cover premium costs
  • A combination of the above methods, with various sharing ratios

Exit strategies

Exit strategies are essential components of split-dollar life insurance agreements because they help plan for several unexpected scenarios, including:

  • Policy termination or discontinuation
  • Changes in ownership or beneficiary designations
  • Repayment of loans
  • Estate planning considerations
  • Tax implications upon the insured's death

Exit strategies should be detailed and agreed upon in the initial arrangement to ensure a smooth and predictable transition when the policy ends or undergoes significant changes.

Who are the parties involved in split-dollar life insurance?

There are three parties involved in split-dollar life insurance:

OwnerThe life insurance policyholder may be an employer, a high-net-worth individual, or any party willing to provide the financing. The owner controls the policy, designates the beneficiary, and retains certain rights.
InsuredThe person whose life is insured under the policy. This can be the employee, a family member, or a business partner. The insured's health and age affect the policy's cost and underwriting.
BeneficiaryThe person or entity who will receive the death benefit upon the insured's passing. This is typically a family member, trust, or business entity.

Why is split-dollar life insurance helpful?

Split-dollar life insurance offers a range of benefits to the parties involved, making it a versatile financial tool for various objectives, including:

  • Employment advantages. From the employer's perspective, split-dollar life insurance can aid in attracting and retaining talented individuals with an additional incentive for long-term employment. For employees, split-dollar insurance provides an opportunity to secure life insurance protection with potentially lower out-of-pocket costs.
  • Wealth transfer and estate planning. Split-dollar life insurance can facilitate the tax-efficient transfer of wealth from the owner to the beneficiary. The death benefit often provides the beneficiary significant income tax and estate tax advantages.
  • Flexible funding options. Owners can choose from various funding methods and allocation structures to customize the policy to their financial goals and tax considerations.
  • Loan access. The ability to access policy loans can provide financial flexibility for the owner and the non-owner, whether for personal expenses, business investments, or other needs.
  • Customization. The terms of the split-dollar arrangement are highly customizable, allowing parties to tailor the agreement to their unique financial objectives and circumstances.

Split-dollar life insurance taxation

Understanding the tax implications of split-dollar life insurance is essential since it may vary depending on the specific arrangement and how the premiums and benefits are divided. Here’s how specific arrangements are taxed:

Economic benefit arrangements

There are three parties involved in benefit arrangements:

EmployerThe portion of premiums paid by the employer is not tax-deductible as a business expense. However, the employer could be subject to income and payroll taxes on the economic benefits provided to the employee.
EmployeeThe portion of premiums paid by the employee is not tax-deductible, and the value of the economic benefits received is considered taxable income to the employee.
Death benefitThe death benefit paid to the beneficiaries is generally income tax-free, assuming the arrangement complies with IRS guidelines.

Endorsement (loan) arrangements

Parties involved in endorsement arrangements:

EmployerThe premiums paid by the employer are not tax-deductible as a business expense, but the interest received on the loan is taxable income to the employer.
EmployeeThe premiums paid by the employee are not tax-deductible. However, the employee's taxation varies depending on whether the loan from the employer is repayable or non-repayable.
Death benefitLike economic benefit arrangements, the death benefit is generally income tax-free, provided the arrangement is structured correctly.
Repayable loanIf the employee is required to repay the loan plus interest upon policy termination or the insured's death, the employee does not face immediate taxation. However, when the policy pays out, the employee's beneficiaries will repay the loan and interest, and the remaining death benefit is tax-free.
Non-repayable loanIf the employer forgives the loan, the amount forgiven is considered taxable income to the employee. This income may be spread over several years to ease the tax impact.

Split-dollar life insurance arrangements must comply with Internal Revenue Service (IRS) guidelines to ensure favorable tax treatment. These include having a formal written agreement, an appropriate split of premiums and benefits, minimum interest rates on loans, and reporting taxable events accurately and on time.

It’s essential to consult with financial and tax professionals to ensure that your split-dollar life insurance arrangement aligns with your specific goals and complies with relevant tax regulations. When used effectively, split-dollar life insurance can provide a valuable combination of protection, tax benefits, and financial planning opportunities.

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