Life Insurance: Dividing Policies And Understanding The Process

Life insurance is a crucial financial tool that ensures your family's financial future and safety. While most people opt for a simple individual life insurance policy, there are instances where splitting up life insurance is beneficial. This is where the concept of split-dollar life insurance comes into play. Split-dollar life insurance is a strategy where two or more parties share the costs and benefits of a permanent life insurance policy. It is often used as an employer benefit or in estate planning. The agreement outlines how the life insurance policy will be shared among beneficiaries, with the most common use case being to protect businesses from the financial risk of losing a high-value employee.

Who owns a split-dollar policy?

The owner of a split-dollar life insurance policy is determined by the agreement between the involved parties. There are two types of ownership agreements between businesses and employees: economic benefit and endorsement agreement, and collateral assignment and loan regime.

Under the economic benefit arrangement, the employer owns the policy, pays the premium, and assigns certain rights or benefits to the employee. The employee can designate beneficiaries who will receive a portion of the policy's death benefit. The value of the economic benefit the employee receives is calculated annually.

On the other hand, under the loan arrangement, the employee owns the policy, and the employer pays the premium. The employee gives an interest in the policy back to the employer through a collateral assignment, which restricts what the employee can do without the employer's consent. Typically, the employer recovers the loans made upon the employee's death or at the termination of the agreement. The premium payments by the employer are treated as loans to the employee.

In both types of agreements, the details of how and when the split-dollar plan ends are specified in the contract.

How does a split-dollar plan get taxed?

The taxation of a split-dollar plan depends on who owns the policy.

When the employee owns the policy

If the employee owns the policy and the employer pays the premium, the employee would normally designate some of the benefits to the employer with a collateral assignment agreement. The premium payments are taxed as if the company is giving the employee an interest-free loan, called a loan regime. The employee is taxed on the interest-free element of the loan.

When the employer owns the policy

If the employer owns the policy and the employee and their family are to receive some of the benefits, that is designated by an endorsement agreement. Those benefits are taxed as an economic benefit, meaning it is considered a form of pay and calculated annually. The employee is taxed on the value of the "economic benefit" of the policy, equal to the value of a term life policy with an equivalent death benefit.

What are the pros and cons of split-dollar life insurance?

Split-dollar life insurance is a contract between two or more parties to share the costs and benefits of a permanent life insurance policy. It is often used by employers to attract and retain top talent, and by individuals for estate planning. Here are some pros and cons of split-dollar life insurance:

Pros

• Cost-sharing: The employer often pays all the premiums, but costs can also be split between the employer and employee.
• Payout for both parties: The death benefit is usually split between the employer and the employee's beneficiaries, with the employer recouping their costs.
• Tax efficiency: Split-dollar plans can provide tax advantages. Premium payments by the employer may be deductible as a business expense, and the cash value in the policy grows tax-deferred.
• Enhanced employee retention: Offering split-dollar plans can help employers recruit and retain high-value executives, increasing loyalty and reducing turnover.
• Extra compensation for key employees: Employees can receive a substantial life insurance policy paid for by their employer, along with access to the policy cash value, providing extra money for retirement.
• Protects both parties in the event of the insured's death: If the covered employee dies, the employer and the employee's heirs receive a payout, as laid out by the agreement.

Cons

• Complex to set up and manage: Split-dollar life insurance arrangements are more complex than regular life insurance policies and typically require the help of financial and legal professionals.
• Fewer tax benefits: The government has tightened regulations, and employees must now report premium payments as taxable income or pay market interest for any loans.
• Expensive policies: Split-dollar policies tend to be for larger permanent life insurance policies with sizable premiums, resulting in ongoing costs for the company or individual.
• Potential for friction between employers and employees: Both parties must clearly understand their taxation responsibilities and benefits to avoid confusion, disagreements, and legal battles.

How does split-dollar life insurance work for estate planning?

Split-dollar life insurance is a strategy that allows the sharing of the cost of a premium for a permanent life insurance policy. It is often used as an employer benefit or in estate planning. It is a formal agreement between two or more parties to share the ownership, costs, and benefits of a permanent life insurance policy.

In the context of estate planning, split-dollar life insurance, also known as private split-dollar life insurance, is an agreement between individuals or involves an irrevocable life insurance trust (ILIT). The contracts protect life insurance proceeds from estate tax. Depending on how the plan is executed, a gift tax may apply, which is levied on assets gifted between family members.

There are two types of split-dollar plans: economic benefit arrangements and loan arrangements. In economic benefit arrangements, the employer owns the policy, pays the premium, and assigns certain rights or benefits to the employee. The employee can designate beneficiaries who will receive a portion of the policy's death benefit. The value of the economic benefit the employee receives is calculated annually.

On the other hand, loan arrangements are more complex. In this type of plan, the employee owns the policy, and the employer pays the premium. The employee gives an interest in the policy back to the employer through a collateral assignment, which restricts what the employee can do without the employer's consent. The premium payments by the employer are treated as a loan to the employee, and the interest rate on the loan depends on how the arrangement is structured.

When creating a split-dollar plan for estate planning, it is important to consult with a qualified attorney, tax advisor, or a fee-based life insurance consultant to ensure compliance with legal and tax requirements.

Who should consider split-dollar life insurance?

Split-dollar life insurance is a strategy that allows the sharing of the cost of a premium for a permanent life insurance policy. It is a contract between two or more parties to split the ownership, costs, and benefits of a permanent life insurance policy. It is often used as an employer benefit or in estate planning involving life insurance.

• Business owners wanting to protect the company in the event of the death of a high-value employee: Split-dollar life insurance can help businesses address the financial risk of losing a key executive or employee unexpectedly. It provides a benefit to both the employer and the family of the deceased, while only requiring one life insurance policy.
• Business owners wanting to provide an attractive benefit to attract and retain high-value employees: Split-dollar life insurance can be a desirable benefit for high-value employees, as it provides them with additional life insurance coverage. It can be a competitive incentive in benefits packages for top employees.
• Individuals wanting to minimize estate taxes: Split-dollar life insurance can be used as an estate planning tool, particularly for wealthy families passing on significant financial assets to their heirs. It can help shield a permanent policy from estate taxes and provide tax-free income through loans and withdrawals.
• Small business partners: Small business partners may include a split-dollar contract in their buy-sell agreement, which outlines what happens if one owner exits the business.
• Family-run businesses: Family-run businesses may want the additional time and financial support that split-dollar life insurance can provide in the event of the unexpected death of a high-value employee or family member.

It's important to note that the popularity of split-dollar life insurance has decreased since 2003, when new laws changed the way taxes are treated in these agreements, making them less common in compensation packages. However, they still offer certain advantages and can be beneficial in specific situations.

Frequently asked questions