A split-funded annuity is a type of annuity in which a portion of the principle is used to support immediate monthly payments and the remainder is saved to fund a deferred annuity.
What is one of the major disadvantages of split dollar plans?
Let’s imagine you want to provide low-cost life insurance to a few essential executives. Is it possible to do so without giving your other staff the same benefit? With a split dollar life insurance policy, you can. In fact, such an arrangement might give your company with a number of advantages. It can aid in attracting and retaining personnel, as well as rewarding important leaders and funding severance and other benefit plans.
An arrangement between an employer and an employee to share the expenses and benefits of a life insurance policy is known as split dollar life insurance. The parties specifically agree to obtain an insurance policy on the employee’s life and to split the cost of the insurance premiums, as well as the policy’s death proceeds, cash value, and other advantages, in writing. Whole life, universal life, second-to-die (survivorship), or any other cash value life insurance policy can be employed. Split-Dollar is a way of purchasing life insurance rather than a motive to do so. In a corporate situation, it may be necessary for the employer to provide a valued fringe benefit in order to retain or recruit a crucial employee. For the employee, the split-dollar agreement offers survivors with life insurance protection at a cheaper net cost than purchasing policies on their own.
There are two types of split dollar deals. The employer is formally designated as the owner of the life insurance contract, and the contract is endorsed to indicate the percentage of the death proceeds payable to the employee’s beneficiary, according to the endorsement form. The employee is formally designated as the contract’s owner under the collateral assignment form, and the employer premium advances are secured by a collateral assignment of the policy.
Note: Under the Sarbanes-Oxley Act of 2002, lending money to a public company’s officers or directors is illegal. This may make it impossible for certain businesses to employ the collateral assignment form.
Split dollar life insurance is used in gift and estate planning, and it can be a significant portion of the remuneration package for many senior employees. You don’t have to insure all of your employees since the coverage, amounts, and terms of a split dollar agreement are generally exempt from ERISA’s anti-discrimination provisions. Dollar split plans can be used for a variety of purposes, including:
- A split dollar plan enables an executive to purchase life insurance with company funds.
- Your company’s investment in the plan is fully protected. If the covered employee dies or his or her job is terminated, the policy proceeds reimburse your company for the premiums paid.
- Split dollar plans can be tailored to the goals of both the employer and the employees.
- The death benefit from a split dollar plan (both the employer’s portion and the amount that goes to the employee’s beneficiary) is usually tax-free.
Any interest component in the installment payments will normally be taxable if the death proceeds are paid in installments.
- Under the split dollar plan, your company will normally not receive a tax deduction for its portion of premium payments.
- Employees may be required to pay income taxes on the value of the economic benefits offered to them each year, depending on how the agreement is constructed. If the employer’s premium payments are viewed as a series of loans to the employee, the employee must pay the employer a reasonable rate of interest. If the employee fails to do so, the employee is considered to have received taxable income up to the amount of interest due.
The taxation of split dollar arrangements is currently governed by two mutually exclusive sets of rules. The employer is viewed as transferring “economic advantages” to the employee if the employer owns the policy (an endorsement form arrangement). The value of the life insurance cover given by the employer, as well as any cash value (if any) to which he or she may have access, must be included in the employee’s salary (to the extent that it has not been taken into account in a prior taxable year). The employer is viewed as lending premium payments to the employee under the loan system. The taxation of arrangements in which the employer’s premium advances are backed by a collateral assignment of the policy is governed by the loan regime.
Before you enroll into a split dollar life insurance agreement, consult with your tax expert to see how the current restrictions may affect your company.
How does a split dollar agreement work?
A permanent life insurance policy’s death benefit and cash values are usually split between the owner and non-owner of the life insurance contract under a split dollar plan. In most cases, one party has enough cash on hand to cover the majority of the coverage premiums. Since 1964, these arrangements have existed as a way for one party to assist another in the purchase of life insurance. The IRS issued adjustments to Split Dollar regulations in 2003, now known as Final Loan Regime Split Dollar rules, as the use of these programs altered over time to give significant living benefits through cash accumulation.
What is a split dollar plan policy?
Over the last four decades, so-called “split-dollar” life insurance arrangements, in which two or more parties share the expenses and benefits of a life insurance policy, have become increasingly prevalent. The popularity of these arrangements has been fueled by favorable tax treatment. Changes in the taxation of split-dollar plans were recently revealed by the IRS, and these changes cast doubt on the future utility of some of these arrangements while also posing a risk of potentially disastrous tax repercussions for participants in certain existing split-dollar plans.
Many split-dollar techniques that were created previous to the IRS’s change of heart will simply not work.
Individuals and businesses who are currently parties to a split-dollar life insurance contract should have it examined as soon as possible to see how the changes will effect their contract.
For some, the new tax laws will have very minimal ramifications, but for others, the split-dollar agreement should be discontinued or at least substantially adjusted possibly before January 1, 2004, the IRS’s deadline for terminating or modifying some programs without unfavorable tax consequences.
BACKGROUND
Today, there are several different types of split-dollar plans, all of which involve two or more people or corporations splitting the costs and benefits of permanent life insurance. A split-dollar “policy” is not an insurance policy; rather, it is a contract between the parties that spells out their responsibilities for splitting the costs and their rights to a share of the insurance proceeds. An insured person may engage into an agreement with family members or a trust for the benefit of the family, but the majority of split-dollar plans involve a fringe benefit program in which an employer aids an employee in acquiring a life insurance policy for the benefit of the employee’s family. These employment-related split-dollar contracts were sometimes utilized as a form of deferred pay and sometimes as a way for the insured employee to prepare his or her estate.
Split-dollar life insurance plans, unlike many other fringe benefit programs, are not based on legislation or judicial law.
Instead, the IRS issued a Revenue Ruling in 1964 that largely regulated the tax effects of split-dollar life insurance products.
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Despite the fact that a Revenue Ruling is a very weak legal authority, split-dollar insurance has become such a popular notion that almost every business has implemented some form of split-dollar insurance for one or more of its employees.
In a split-dollar agreement, the employer pays all or most of the policy premiums in exchange for a share of the cash value and death benefit. Previously, the IRS held that the “term cost” of life insurance protection must be recognized as income by the insured employee. “Term cost” simply refers to the cost of a one-year term policy on the covered employee with the same death benefit, i.e., how much it would cost the employee to purchase the same amount of insurance protection for a year under a term policy. 2 In some cases, the employee is responsible for the term costs. Term expenses are often modest until a person reaches a certain age, and they are typically far lower than the actual premiums paid on the policy.
Assume a 40-year-old male employee signed a split-dollar agreement with his company before January 28, 2002, in which the employer pays all premiums, and the employer paid a $10,000 premium on a $1,000,000 life insurance policy guaranteeing the employee’s life in 2004.
The cheapest premium for a $1,000,000 term insurance policy covering a 40-year-old male, according to the insurance firm issuing the policy, is $200.
Even though the business paid $10,000 in premiums, the employee would have to declare $200 in taxable income on his 2004 personal income tax return as a result of the split-dollar agreement.
When a split-dollar plan is part of an employee’s estate plan, the insured employee will often create an irrevocable life insurance trust (ILIT) to hold the split-dollar plan’s policy.
If done correctly, the life insurance proceeds are removed from the employee’s gross estate for estate tax purposes.
When an ILIT has a life insurance policy, the employee is regarded to have given a taxable gift to the ILIT in the amount of the policy’s term cost (the same amount taxed to the employee).
Split-dollar agreements have been popular since they rely on term costs to value the taxable income to the employee (and the gift to the ILIT).
In effect, the employee receives the benefits of a permanent life insurance policy for a fraction of the cost of a low-cost term coverage.
The term cost of a policy, however, ceases to be a bargain at some point in the employee’s life, and some form of exit strategy has always been an important aspect of split-dollar life insurance planning.
Consider the price of a $5 million term life insurance policy on an 85-year-old man.
(Even if the employer no longer has to send a check to the insurance carrier because the policy has enough value to carry itself, the IRS has always held that the term cost is deemed income to the insured employee as long as the plan exists.)
Without an exit strategy, an employee who lived to a ripe old age and was insured with a sizable split-dollar policy would be forced to recognize tens of thousands of dollars in phantom income each year and, if an ILIT was involved, suffer the implications of making huge phantom taxable gifts.
Split-dollar agreements resemble interest-free loans in appearance.
The IRS, on the other hand, stated in the 1964 Revenue Ruling that split-dollar transactions would be regarded a taxable fringe benefit to the employee rather than an interest-free loan by the IRS.
As a result, an employee might give considerable benefits for his or her family for a very modest income and gift tax consequence by taking advantage of the employer’s generosity.
RECENT CHANGES
Despite widespread acceptance, the IRS has always been able to change its approach to the taxation of split-dollar arrangements simply by issuing new Rulings due to a lack of statutory and legal basis. The IRS has indicated in recent years that it is reconsidering the tax treatment of split-dollar agreements, particularly the sort of split-dollar structure known as “Split-dollar equity.” The employer is only repaid for premiums paid from proceeds or cash value under an equity split-dollar arrangement. The policy’s cash surrender value finally surpasses the employer’s reimbursement right, and this difference is referred to as the policy’s excess value “Equity in policy.” Because the IRS viewed policy equity to be a benefit offered to an employee, the IRS was upset that it dodged income taxation. The IRS, on the other hand, struggled to come up with a legal basis to justify taxing this equity.
The IRS issued split-dollar arrangement notices in 2001 and 2002, each with updated explanations of how the IRS intended to tax split-dollar arrangements.
The IRS’s intention to publish new regulations codifying a comprehensive approach to the taxation of split-dollar life insurance based on two mutually exclusive tax regimes was announced in the second of these notices, Notice 2002-8 (which revoked the 2001 Notice), which was issued on January 28, 2002.
Proposed regulations were released in late 2002, however the final version has yet to be released. Unfortunately, much of the widely recognized taxation theory on which most existing split-dollar plans are built is in disagreement with the methodologies stated in the Notice and proposed regulations.
All new arrangements will come under one of two split-dollar taxation regimes, according to the draft regulations, whenever the final regulations are implemented.
Which regime will apply to a certain arrangement will be determined by who owns the policy (an almost insignificant issue in the prior system).
If the policy is owned by the employer (or another person responsible for paying the premiums), the arrangement will be taxed “Analysis of economic benefits.”
The arrangement will be taxed as a business if the employee owns the policy “A dollar-for-dollar loan.”
With the key caveat that under equity arrangements subject to the economic benefit analysis, policy equity will be taxable income to the employee, the economic benefit analysis substantially parallels the previous approach to split-dollar taxes.
All premiums paid by the employer will be classified as a loan to the employee under the split-dollar loan treatment.
If the loan does not have an acceptable rate of interest (as established by the laws), the regulations establish a complicated system of presumed interest that flows from the employee as revenue to the employer as interest.
Regrettably, the tax implications of current agreements are less obvious.
Policy equity will be taxed as it accrues under the proposed regulations unless the premiums are classified as a loan.
It is also clear that policy equity will not be taxed for current plans as long as the agreement is in effect.
What is unclear is how an existing plan’s equity will be taxed if the plan is terminated during the employee’s lifetime.
If the employee dies while the agreement is in effect, the policy equity may be tax-free, but for many split-dollar participants, this is a small consolation because most equity plans were designed to be terminated when the policy had built up enough cash value to repay the employer while still retaining enough value to carry itself without further contributions from the employee.
The income (and presumably gift) tax ramifications of soaring term costs as the insured grew older were avoided by terminating the split-dollar plan before death.
Given the ever-increasing term costs, continuing the split-dollar plan for the rest of the employee’s life is just not a practical choice in most cases.
If the IRS pursues taxation policy equity when current plans are terminated, the tax consequences could be shocking.
For example, if a life insurance policy subject to an employment-related split-dollar agreement has $5,000,000 in cash value at the time of rollout, and the employer is entitled to a return of $1,500,000 for premiums paid, the employee must recognize $3,500,000 in additional taxable income that year.
If the insurance was owned by an ILIT, the employee would be judged to have made a taxable gift of $3,500,000 to the ILIT that year.
Furthermore, there would be a $3,500,000 generation-skipping transfer (GST) subject to the GST tax if the ILIT was meant to provide for grandchildren and future generations.
To make matters worse, if the policy was owned by the ILIT, the employee would be unable to pay the tax due to the termination of the split-dollar arrangement.
For equity split-dollar plans established on or before January 28, 2002, and not modified after that date, there are two safe harbor requirements.
The first safe harbor stipulates that policy equity will not be taxed if the arrangement is terminated before January 1, 2004. The second safe harbor allows equity agreement participants to switch to loan treatment prior to January 1, 2004, with no taxation on policy equity.
These safe harbors may provide a realistic solution for split-dollar participants in specific situations.
In other circumstances, however, the parties may need to rethink their strategy in order to attain their initial objectives.
Some commercial lenders are starting to offer life insurance purchase financing that will allow participants to avoid split-dollar agreements entirely.
SPECIAL PROBLEM FOR PUBLIC COMPANIES
There is another difficulty that management must deal with in publicly traded organizations. On or after July 30, 2002, it is prohibited for a publicly traded business to loan monies to officers, directors, and certain other senior personnel under the terms of the Sarbanes-Oxley Act. Although there are signs that split-dollar arrangements are likely subject to the Sarbanes-Oxley Act’s restrictions, the Department of Labor, which has jurisdiction over this matter, has not directly addressed this question. As a result, most publicly traded firms have taken the stance that on or after July 30, 2002, no payments on a split-dollar contract insuring the life of any of their employees covered by the Sarbanes-Oxley Act can be made. Because the final stance of the Department of Labor has not yet been announced, these split-dollar arrangements for publicly traded corporations have not been canceled. Publicly traded firms’ split-dollar plans, on the other hand, are subject to the same income, gift, and generation-skipping tax issues as non-publicly traded companies’ split-dollar plans. If the employer wants to take advantage of the safe harbor rules, management must resolve the tax issues (possibly without the benefit of Final Regulations) and the Sarbanes-Oxley Act issues (possibly without a final position from the Department of Labor), and make these decisions before January 1, 2004.
REVIEWING EXISTING ARRANGEMENTS IS VITALLY IMPORTANT
Because the safe harbor provisions are set to expire on January 1, 2004, and because all subsequent split-dollar arrangements must choose between compensation and interest-bearing loan treatment, every split-dollar arrangement should be examined as soon as practicable. Many of the tax advantages that split-dollar arrangements once provided are vanishing, and finding adequate alternatives will necessitate careful and imaginative planning. Split-dollar arrangements, which were once a simple and uncomplicated world, have now evolved into a complex and frustrating collection of difficulties that all parties involved should address as soon as possible.
Who pays the premiums in a split dollar plan?
The employer is the owner of the endorsement split dollar plan. The company pays the premiums, and the employee is identified as the beneficiary.
Are Split dollar Plans tax deductible?
Split-dollar plans end when the employee dies or when the agreement specifies a future date (often retirement).
Depending on the agreement, the employer recovers either the premiums paid, cash value, or the amount owing in loans in the event of the employee’s untimely death. When the payback is made, the employer releases any restrictions on the policy, and the remainder is paid out as a tax-free death benefit to the employee’s named beneficiaries, which can include an ILIT.
If the employee meets the agreement’s terms and conditions, all loan limitations are lifted, and ownership of the policy is transferred to the employee under the economic benefit arrangement.
The employer may be able to collect all or a portion of the premiums paid or cash value, depending on how the agreement was written. The insurance policy is now owned by the employee. The policy’s value is taxed as remuneration to the employee and is deductible for the employer.
Is Split dollar subject to Erisa?
When a corporate Split Dollar plan is employed under either the loan or economic benefit regime, it is considered a “employee welfare benefit plan,” and thus is free from ERISA’s participation, funding, and vesting restrictions.
Who are the parties in a split dollar arrangement?
The death payments, cash values, and premium costs of a single life insurance policy are split between two people in a split dollar arrangement. Employer and employee, or corporation and shareholder, are the two partners in a standard (or classical) split dollar agreement.
What is a 162 bonus plan?
A 162 Executive Bonus plan provides a company to provide important executives with tax-deductible life and/or disability income insurance.
The CEOs own the insurance policies, which they pay for with cash bonuses. In fact, the employer may pay the premiums directly to the insurance carrier and then deduct the amounts from the executives’ W-2 earnings.
The executive has complete ownership of the insurance, including the ability to choose his or her own beneficiaries and access the cash value of the policy (except when a Restricted Executive Bonus Arrangement is used, as explained below).
- There are no administrative costs, IRS approval, or onerous government reporting requirements with this plan.
- It’s possible that it’ll be supplied on a selective basis, allowing the business to pick and choose which employees would take part.
- The executive is the policy’s owner, with complete control over the policy and its policycash values (possibly subject to a REBA, described below).
- The bonus plan allows you to save money that would otherwise be spent on personal life insurance.
The executive is responsible for paying taxes on the premium amounts paid (directly or indirectly) by the company in a “Single Bonus” design.
In a “Double Bonus” arrangement, the company pays the premium and gives the executive a cash sum to cover the tax on the premium. As a result, the executive’s full bonus is effectively tax-free.
If cash value life insurance is employed, the plan may include a Restricted Executive Bonus Arrangement (REBA). The REBA precludes the executive from accessing the cash values of the plans without the employer’s permission.
Employers frequently adopt this strategy to keep key staff on board. Typically, the employer and the executive negotiate a written agreement that specifies particular “qualifying” events that will result in the executive’s release from the agreement. The REBA, for example, might be ended in the event of the executive’s death, disability, or retirement, or after a set amount of time, such as ten years. This strategy generates a golden handcuff effect, incentivizing the executive to stay with the company.
- If the bonuses are considered reasonable remuneration, the corporation can deduct them from its taxes.
- When the bonus is received, executives will owe income tax on the bonused amount.
- Beneficiaries of the executive’s death benefits are usually exempt from paying income taxes.
- If the executive retains instances of ownership in the policy, the policy will be included in the executive’s estate.
- A documented plan is advised, but it is not needed, because it helps to avoid the employer’s deduction being disallowed on the basis that the incentive is unjustified.
- While there are no contribution limits or minimums, certain premium amounts may be required to ensure that the life insurance policy achieves its goals.
Executive Bonus Plan with a Restrictive Executive Bonus Arrangement under Section 162 (REBA)
How does supplemental life insurance work?
- Supplemental life insurance is a type of coverage that you can add to your existing whole or term life insurance policy.
- If you work full-time, your employer might provide additional life insurance for free or at a reasonable fee.
- It may pay for burial expenses or accidental death and dismemberment.
- Check out these Policygenius offers to see what life insurance choices are available to you right now.
When it comes to various sorts of insurance, you’re probably well aware of the significance of things like health, car, and homeowner’s insurance.
In general, these insurance policies provide protection in the event that something goes wrong in those specific areas of your life. They provide financial support and, to some extent, emotional support against the ups and downs that life may hurl at you.
Supplemental life insurance is another sort of insurance that you may not have considered but that is worth investigating. Your employer may provide this form of insurance for free or at a minimal cost, depending on where you work. It is also available for purchase through private companies.
What is a collateral assignment split dollar plan?
When your small business clients hire the appropriate individuals, they want to reward them with incentives that make them feel appreciated. A collateral assignment split dollar arrangement is one alternative.
How this plan works
In a collateral assignment split dollar agreement, the company lends money to a key employee to cover the cost of a life insurance policy premium. The insurance is pledged as security for the loan by the employee. He or she owns the policy and can choose the beneficiary, and the interest-free portion of the loan is taxed.
Are buy sell agreements tax deductible?
Premiums paid for life insurance to fund a buy-sell arrangement are not tax deductible; but, when the notice and consent requirements are completed, the death proceeds are normally exempt from federal income tax.
