Split-Dollar Insurance Can Help Fund an Estate Plan

By William G. Kistner Courtesy Healthcare Financial Management

Split-dollar insurance is a method of paying for an insurance policy by splitting the ownership of the policy the rights to the proceeds, and the responsibility for premium payments. A split-dollar plan usually exists in an employer/employee context, but recent rulings by the IRS have created opportunities to use a split-dollar plan among family members.

Split-dollar plans can be used to address financial and estate-planning needs, such as helping to supplement an executive's retirement plan benefits while providing more enduring and economical insurance than group term, and creating liquidity for estate taxes at substantially reduced gift-tax cost.

Highly compensated employees look for "nonqualified" ways to increase after-tax income and create wealth. One reason is that the maximum compensation that can be considered when calculating contributions to a qualified retirement plan is only $160,000.

A split-dollar plan offers executives "permanent" life insurance coverage at term insurance rates, provides executives with asset build-up and investment returns on a tax-deferred basis, and allows employers to be reimbursed for the premiums they pay toward the plan.

Under one popular split-dollar approach, the collateral assignment method, the employee owns the policy. Premium payments can be divided between both parties or borne entirely by the employer. If the employer pays all or part of the premium, the employee is charged with income each year equal to the economic benefit of the pure insurance coverage, less the amount that he or she contributes toward the premium.

The economic benefit is measured using the lower of either the IRS's Table 58, U.S. Life Tables and Actuarial Tables (commonly known as P.S. 58 cost) or the insurance company's actual rates for the yearly renewable term insurance. The insurance companies' one-year term rates generally are well below the PS. 58 cost.

Since the economic benefit recognizable as income by the employee will be reduced to the extent that the employee contributes to the premium payment, the employer often will pay most of the premium while the employee contributes the "economic benefit." Premiums paid by the employer are not deductible, but the employer's subsequent reimbursement for premiums paid is tax-free. Since there is no real tax impact on the employer, the real cost ends up being the loss of earnings on its contributions until it is reimbursed at the employee's death or earlier termination of the plan.

Typically, the plan will terminate upon the earliest of three events: retirement, separation from service, or death. If the plan terminates for reasons other than death, the employer's interest in the policy often is transferred to the employee. The employer recovers its investment from the cash value by seeking payment from the employee or by giving the cash value to the employee in lieu of other compensation. If the employee dies while the policy is in effect, the proceeds are shared by the employer and the employee's beneficiaries on an income-tax-free basis.

However, the tax implications upon termination of the plan are unclear. The IRS has argued that the employee should be taxed on the excess of the cash surrender value over the amount due back to the employer under the plan. There also are valid arguments to support the position that the employee should not be taxed on the excess cash value at all.

The split-dollar approach, often used to finance the purchase of life insurance owned by an irrevocable life insurance trust, is one of today's most popular estate-planning techniques. A well-drafted trust will keep the proceeds of the insurance out of the insured's taxable estate. Meanwhile, the split-dollar plan creates gift and generation-skipping transfer (GST) tax leverage because the amount of the taxable gift or GST transfer is limited to the economic benefit rather than the actual premium. Typically, the collateral assignment method is used, and the trust is both owner and beneficiary of the policy. The trust gives the collateral assignment to the employer, which pays the premium.

The executive can make annual gifts to the trust equal to the P.S. 58 amount for the year. The trust, in turn, contributes each year's gift to the employer, thereby eliminating the income tax impact of the split-dollar plan on the executive. At the executive's death, the proceeds are split between the trust and the employer based on the collateral assignment. The trust then can use the proceeds to buy assets from the estate or lend money to the estate so that it will have liquidity to pay estate taxes.

Two recent IRS rulings (Private Letter Ruling 9848011 and IRS Notice 99-36) suggest ways to use a split-dollar plan outside of the employer-employee context. For example, the insured creates an irrevocable trust, funds it with cash, and names a third party as the trustee. The insured retains no powers over the trust, and neither the insured nor the spouse can ever be trustee. The trust will benefit the insured's children during their life and then the insured's spouse and children after the insured dies. The trustee uses the initial contribution toward the purchase of a life insurance policy on the insured's life.

The trustee then enters into a collateral assignment split-dollar agreement with the insured's spouse. Under the agreement, the insured's spouse will pay the full premium less the lower of the P.S. 58 cost or the one-year renewable term cost, which would be paid by the trust. Presumably, the trustee would use the insured's initial, and then annual, contributions to the trust to pay the P.S. 58 (or lower term) costs.

If the agreement is terminated before the insured's death, the insured's spouse would be entitled to the net cash surrender value of the policy. After the insured's death, the insured's spouse would be entitled to the greater of the net cash current value or the premiums paid. The balance of the death benefit would be payable to the trust.

The insured's spouse has the exclusive right to borrow on the policy. After a few years, the insured's spouse can begin to take cash from the policy by way of nontaxable policy withdrawals and loans. When the insured dies, the spouse will receive the greater of the cash value or premiums paid, and the net death benefit will be paid to the trust. If the insured's spouse dies first, the cash value or premiums paid will be included in the estate, a result that calls for advance planning. Divorce is another potential event that calls for planning.

According to an IRS ruling in a similar transaction, the premiums paid by the insured's spouse under the split-dollar agreement will not be gifts to the trust because the insured's spouse will be repaid those premium advances (or the cash value, if greater). Also, the death benefit would not be includable in the insured's gross estate, since the insured retains no incidents of ownership in the policy.

An exit strategy for a private split-dollar arrangement requires careful planning. As with any split-dollar arrangement, the key concern is how it will be terminated. In either type of plan, all the cash value is to be repaid by the trust, so there will be nothing in the policy to fund that repayment and still leave anything for the trust. Therefore, the arrangement will have to continue until the insured dies, with the ever-increasing P.S. 58 costs as an ongoing obligation of the trust. One may decide to overfund the trust in the early years to build a "bank" from which the trust can pay ongoing P.S. 58 costs. Or, if the trust ever has enough funds, it can repay the insured in full and terminate the plan.

Private split-dollar arrangements can provide a large tax benefit in the right circumstances.

William G. Kistner, MM, CPA, is a tax partner, Ernst & Young LLP, Chicago, Illinois, and a member of HFMA's First Illinois chapter.