Splitting the Difference: Why Careful Structuring and Regular Monitoring of a Split-Dollar Life Insurance Plan Might Benefit Employers and Employees

At a Glance

• For an employer, split-dollar life insurance plans can be a useful way to attract and retain key hires.
• For employees, split-dollar plans can be a valuable estate-planning vehicle for employees wishing to negotiate additional fringe benefits from their employers.
• Understanding of the various types of split-dollar plans, discussing the advantages and disadvantages and any restrictions with an attorney, and monitoring and reviewing the plan and potential benefits are important steps for both employers and employees.

Split-dollar life insurance can serve a multitude of uses. In times of a tight and competitive hiring market, employers may consider split-dollar life insurance as one of many diverse strategies to attract and retain desired employees. These plans are best established for key employees as a fringe benefit, but other uses include private split-dollar setup between individuals, an individual and a trust, or two trusts. This intergenerational split-dollar can supplement a well-designed estate plan.

This article will focus on split-dollar as an employment incentive – though the fundamental concepts apply across the board. In the compensation setting, a business may pay life insurance premiums for a policy on the employee’s life. This split-dollar plan may not only accomplish an employee’s wealth-transfer goals, but also may establish a business’s replacement fund for a valuable employee. These split-dollar arrangements can vary depending on the interests of the employer and employee, and both employers and employees should consider educating themselves on the various structures, benefits and considerations as part of their employment negotiations and wealth-transfer planning.

Types of Split-Dollar Plans

Split-dollar plans are typically structured as an economic benefit arrangement with an endorsement or as a loan arrangement with a collateral assignment. In some cases, a non-equity collateral assignment (NECA) or a switch-dollar strategy might be used.

Economic Benefit With an Endorsement: Under an economic benefit/endorsement split-dollar plan, the employer is the policy owner and the employer-owner shares the death benefit with the employee-participant. Under this plan, a business allows the employee-participant to name a beneficiary on all or a portion of the policy by filing a supplemental form (the “endorsement”) with the life insurance carrier, naming their desired beneficiaries of the portion of the death benefit. The employer-owner pays the policy premium annually, and the employee-participant includes the “economic benefit” of the endorsed death benefit as taxable income. If the employee-participant dies while the endorsement split-dollar plan is still in effect, the designated beneficiaries receive the endorsed portion of the death benefits (most often the full amount) with the employer-owner receiving the remaining portion. If the endorsement split-dollar plan is terminated, the employer-owner can keep the life insurance policy and remove the endorsement, or they can transfer the policy to the employee-participant. There is no cost to the employee-participant unless the policy is transferred to them. This endorsement split-dollar plan is most often used to provide a low-cost death benefit to the employee-participant as a fringe benefit or where the employer wishes to own the policy and/or obtain key person protection.

The economic benefit cost is calculated based upon the employee-participant’s age, the death benefit and the risk factor provided in the Table 2001 published by the Internal Revenue Service (IRS). This economic benefit increases each year as the employee-participant ages, so many employee-participants might benefit from reviewing these plans and their costs and then deciding whether to terminate the split-dollar plan or change to another type of arrangement. Some employee-participants may also try to lower the economic benefit rates by making the endorsement split-dollar plan with a survivorship policy.

Loan Regime With a Collateral Assignment: In a loan regime split-dollar plan, the employee-participant owns the policy, and the employer pays the premiums. Each premium payment is treated as a loan from the employer to the participant (or trust, as the case may be), and the employee-participant provides the employer with an interest in the policy through a collateral assignment. The employee-participant must pay interest on the loan each year, either out-of-pocket or as accrued or imputed income; if imputed income, the employee-participant may owe income tax on this interest. The collateral assignment is filed with the insurance carrier, protecting the employer’s interest in the policy until the employer is repaid. Until the employer is repaid, the employee-participant can only access the cash value of the policy in excess of the loan balance (the “equity”), and, upon the employee-participant’s death, the death benefits either repay the loan to the employer or the employer forgives all or a portion of the debt. Similarly, if the plan is terminated, the employee-participant must repay the loan using the policy’s cash value or other funds, unless the employer forgives the loan. The loan regime plan allows the employee-participant to own the policy, but also to provide access to the policy’s cash value.

The collateral assignment balances benefits to the employer with benefits to the employee. From the employer’s perspective, in addition to providing a nice fringe benefit to attract and retain employees, the employer can selectively provide the benefit to employees and its premium costs can be recovered through the death benefit.  From the employee’s perspective, the employee owns the life insurance, receives a tax-exempt death benefit (when properly structured) and, depending upon the structure of the insurance, can access some of the cash build-up.

Non-Equity Collateral Assignment: One “hybrid” structure is the non-equity collateral assignment split-dollar plan. In this structure, the life insurance policy is owned by the employee-participant, and the employer pays the premiums with expectations of repayment in the future. In this case, the employee-participant agrees to repay the employer the greater of the policy’s cash value or cumulative premiums paid when the plan terminates. Like the endorsement split-dollar plan, the employee-participant pays income tax each year on the death benefit cost associated with the death benefit they are entitled to receive.

If the employee-participant dies while the plan is still intact, the employer will receive the greater of its premiums paid or the policy’s cash value from the death benefit, and the employee-participant’s designated beneficiaries will receive the remainder. If the plan terminates prior to the employee-participant’s death, the employer is repaid the greater of the cash value or premiums paid, or the employer can forgive this debt in whole or in part; any forgiveness may be income taxable to the employee-participant. This NECA split-dollar plan may be beneficial where the employee-participant wants to own the policy, the death benefits are important for the employee-participant’s wealth transfer goals, and the employee-participant needs help paying the premiums. Employers and employees may consider reviewing these plans to determine if, and when, the policy cash value exceeds the total premiums paid. The parties may then determine if changes, such as switching to a loan regime plan, might be desirable.

Switch-Dollar Plan: A switch-dollar plan starts as an NECA split-dollar plan, and, at a future date, may switch to a loan regime split-dollar plan. Many survivorship policies switch at the death of the first of the insured to die whereas, for a single-life policy, the switch occurs just before the policy’s cash value exceeds the premiums paid, or when the economic benefit cost exceeds the loan interest costs. At the time of the switch, the loan amount will equal the outstanding repayment obligation under the NECA split-dollar plan, which is the greater of the premiums paid by the employer or the cash value of the policy; the future premiums paid will be considered a loan by the employer. Upon the employee-participant’s death, the split-dollar loan is repaid to the employer from the death benefits (with the remaining benefits paid to the designated beneficiaries), or, if the plan is terminated, the loan is paid from a combination of the policy cash value and the employee-participant’s other assets. As with a loan regime split-dollar plan discussed above, the employer may also forgive all or a portion of the loan.

This switch split-dollar plan is often used for survivorship policies because of the increased costs at the death of the insured, or, for single-life policies, to decrease the income taxes owed. Reviewing when to affect this switch is an important part of monitoring these policies, and may be a valuable consideration for the employer and employee.

Other Considerations

In addition to researching these split-dollar plan options, employers and employees should consider the income and estate tax implications of these plans. For example, if employers own the life insurance policies under the endorsement or NECA split-dollar plans, both parties should ensure that the certain requirements are met to keep the tax-exempt death benefit for the designated beneficiaries. The employee-participant may also consider discussing the proposed split-dollar plan with their estate planning attorney to determine if an irrevocable life insurance trust might purchase the policy, or if the split-dollar plan has other unintended gift and estate tax consequences or liquidity issues. Employers and employees might be limited from using the loan regime or switch split-dollar plans because of the Sarbanes-Oxley Act and its prohibition against personal loans to directors and executive officers of publicly traded companies. Other types of life insurance policies may also not be appropriate for loan split-dollar plans because of other federal laws.

Split-dollar plans can be a useful way to attract and retain executives or key persons for an employer, and they can be a valuable estate planning vehicle for employees wishing to negotiate additional fringe benefits from their employers. Understanding the various types of split-dollar plans, discussing the advantages and disadvantages and any restrictions with an attorney, and monitoring and reviewing the plan are important steps for both employers and employees.

Finally, while the focus of the above has been on the employer-employee use of split-dollar, the same concepts apply in a pure estate planning context. For example, for intergenerational split-dollar plans, a dynasty trust and a non-dynasty trust might enter into a similar arrangement. The value and appropriate structure in those cases is very fact-specific, but the above concepts apply.