Split-Dollar Life Insurance: What It Is and Isn’t
Knowing How This Arrangement Works
by Joseph Milano CHFC, CLU, CLTC
On the surface split-dollar life insurance is easy to understand. Digging into the legal and tax considerations of such a plan sheds light on the inherent complexities.
Splitting the Costs and Benefits
Split-dollar life insurance is NOT a policy, but an agreement between an individual and employer (or trust) using permanent life insurance. The employer pays all or most of the premiums while retaining an interest in the policy’s cash value and/or death benefit. The objective is to offer an employee high-quality life insurance while allowing the employer eventual reimbursement for premiums paid. A contract is drawn up spelling out the details of these main issues:
- Ownership of the policy
- How much of the premiums the employer pays (maybe all)
- How the cash value and/or death benefit will be shared
The agreement lends itself to customization based on the goal. Maybe the objective is to offer employees a plum benefit, that is, great life insurance at little or no cost. The employer could use split-dollar life insurance to attract talented people or retain a top executive. The company could even use the arrangement to protect against the financial impact felt by the early death of a key employee.
Two Main Arrangements
Policy ownership is a critical component of any split-dollar life insurance contract since it affects the way premiums are taxed and who has access to the policy’s cash value. Following are the two approaches:
Collateral Assignment Method: the employee owns and has control over the insurance policy and its cash value. However, the employee assigns a portion of the cash value and/or death benefit to the employee as collateral (often the amount of premiums paid). Employer-paid premiums are treated as loans to the employee with an adequate rate of interest attached. That interest is treated as taxable income to the employee. This approach cannot be used by publicly traded companies since the Sarbanes-Oxley Act disallows them from loaning to executives.
The split-dollar arrangement could allow the employee to borrow from the cash value, provided it exceeds the assigned collateral portion. Since the employee owns the policy, at retirement he/she can decide then whether to allow the policy to expire or take over the premium payments.
Endorsement Method: the employer owns and controls the permanent insurance policy while paying all or a portion of the premiums. It is written into the split-dollar contract that the employee can name a beneficiary for a share of the death benefit. The employee pays as taxable income his/her share of the economic benefit received. That amount is reflected on a W-2 form as imputed income. A clause is included in the contract detailing the exit strategy (roll out), i.e., how the policy will be managed on the employee’s retirement.
Customization Can Add Complexity
There are no templates to these arrangements; they are instead “made-to-order.” Financial advisors are schooled in the particulars of these agreements and should be consulted on how best to develop one. A lawyer and CPA will also need to be involved before signatures hit the dotted line.