How Does Split-Dollar Life Insurance Work?

Split-dollar life insurance is a strategy used by businesses and individuals to share the costs and benefits of a life insurance policy. It can be advantageous in estate planning, executive compensation, or employee retention strategies. However, the arrangement involves complexities around premium payments, ownership, tax implications, and termination terms that require careful navigation.

Basic Structure

A split-dollar life insurance arrangement is an agreement between two parties, typically an employer and an employee, to share the costs and benefits of a life insurance policy. These agreements fall into two main categories: collateral assignment and endorsement. In a collateral assignment arrangement, the employee owns the policy and assigns a portion of the death benefit to the employer as collateral for premium payments made by the employer. In an endorsement arrangement, the employer owns the policy and allows the employee to designate beneficiaries for part of the death benefit.

These agreements must comply with IRS guidelines, particularly Revenue Ruling 64-328 and Revenue Ruling 66-110, which govern the tax treatment of such arrangements. The agreements should clearly define premium payment responsibilities, the division of the death benefit, and the conditions for termination or transfer of the policy.

Accounting for Premium Payments

Accounting for premium payments is a critical component of split-dollar life insurance arrangements. When the employer pays the premiums, the payment is often treated as a loan to the employee, requiring repayment at termination or upon the employee’s death. Accurate record-keeping is essential to ensure compliance with accounting standards and tax regulations.

For employers, premium payments are typically recorded as either a loan receivable or a compensation expense, depending on the agreement’s structure. If treated as a loan, the employer records payments as a receivable and may accrue interest income. Meanwhile, the employee must acknowledge the loan liability and report any imputed interest as taxable income. IRS rules govern the treatment of these transactions, particularly regarding imputed interest and the economic benefit regime.

Under the economic benefit regime, often used in endorsement arrangements, the employer must report the economic benefit provided to the employee as taxable income. This benefit is calculated based on the cost of current life insurance protection, using either the insurer’s published rates or IRS Table 2001 rates. Employees must include this economic benefit in their gross income, which may affect their tax liability. Employers must ensure proper tax reporting to avoid penalties for non-compliance.

Policy Ownership Arrangements

The ownership structure of a split-dollar life insurance policy significantly affects the financial and tax implications for both parties. Ownership arrangements generally fall into two categories: employer-owned and employee-owned policies.

In employer-owned arrangements, the employer controls the policy, while the employee has rights to part of the death benefit. This structure may require the employer to report the policy’s cash surrender value as an asset. In employee-owned arrangements, the employee controls the policy, while the employer retains rights, such as collateral assignment, to secure repayment of premiums. The choice of ownership structure depends on factors like tax treatment and financial reporting objectives.

Regulatory requirements further complicate ownership arrangements. The IRS and the Financial Accounting Standards Board (FASB) provide guidelines to ensure compliance with tax and accounting standards. For example, FASB’s ASC Topic 715 requires employers to account for the costs of these arrangements in their financial statements. Additionally, IRS regulations, particularly the split-dollar final regulations under Treasury Regulation 1.61-22, outline reporting and taxation requirements.

Tax Implications

The tax implications of split-dollar life insurance arrangements depend on their classification under the economic benefit or loan regimes. Under the economic benefit regime, the value of the life insurance protection provided to the employee is taxable. This value, considered additional compensation, is calculated using the insurer’s rates or IRS Table 2001 rates and must be accurately reported.

Under the loan regime, premium payments are treated as loans from the employer to the employee, with interest requirements governed by IRC Section 7872. The interest rates must align with the Applicable Federal Rates (AFR) to avoid classification as a below-market loan. Non-compliance can lead to reclassification of the arrangement or tax penalties.

Termination Terms

The termination of a split-dollar life insurance arrangement must be carefully planned to avoid financial or tax consequences. Termination may occur due to an employee leaving the company, the employer ending the arrangement, or the death of the insured. The initial agreement should specify how the policy’s cash value and death benefit will be distributed and how any outstanding obligations, such as premium repayments, will be resolved.

In a collateral assignment arrangement, the employer typically recovers the premiums paid from the policy’s cash value or death benefit, with any remaining value allocated to the employee or their beneficiaries. In an endorsement arrangement, the employer may transfer policy ownership to the employee, which is generally treated as a taxable event. The employee must report the fair market value of the policy as income.

If the employer forgives outstanding premium loans, this forgiveness is treated as taxable compensation to the employee under IRC Section 61. Additionally, the IRS may scrutinize the policy’s valuation to ensure it reflects its true economic value. Transfers to family members or trusts may also trigger gift tax implications. Proper documentation and adherence to the agreement are essential to mitigate risks and ensure compliance with tax and accounting standards.