What Is a Split-Dollar Agreement and How Does It Work?

A split-dollar agreement is a contractual arrangement where two or more parties share the costs and benefits of a life insurance policy. This structure allows distinct entities to participate in funding premiums while allocating portions of the policy’s cash value and death benefit. The primary goal is to provide life insurance coverage with shared financial responsibilities, effectively separating the ownership and benefit streams of a single contract.

Fundamental Structure and Participants

A split-dollar agreement typically involves a life insurance policy and a formal written contract outlining the roles and responsibilities of each party. Commonly, these arrangements are established between an employer and an employee, or a corporation and a shareholder. The agreement specifies which party pays the premiums, how the policy’s cash value is treated, and how the death benefit will be divided. For instance, an employer might pay the majority or all of the premiums for a policy on a key employee’s life.

The agreement also dictates who holds specific rights within the policy, such as the right to access cash value or designate beneficiaries for a portion of the death benefit. In an endorsement method, the employer owns the policy and endorses a portion of the death benefit to the employee’s chosen beneficiary. Conversely, under a collateral assignment method, the employee or a trust owns the policy, and the employer secures its interest through a collateral assignment. This assignment grants the employer rights to recover premium outlays, typically from the policy’s cash value or death benefit.

Regulatory Classifications of Agreements

The Internal Revenue Service (IRS) classifies split-dollar agreements into two primary categories: the “Loan Regime” and the “Economic Benefit Regime.” These classifications determine the tax treatment of the arrangement. The ownership of the life insurance contract is the determining factor for which regime applies.

Under the Loan Regime, premium payments made by one party on behalf of another are treated as loans. For example, if an employer pays premiums for a policy owned by an employee, these payments are considered loans to the employee. These loans must carry an adequate interest rate, typically based on the Applicable Federal Rate (AFR), to avoid imputed income. This regime generally applies to collateral assignment arrangements where the non-payer owns the policy and the payer is entitled to repayment from the policy’s cash value or death benefit.

Conversely, the Economic Benefit Regime applies when the policy owner provides a benefit to a non-owner that is not structured as a loan. This typically occurs in endorsement arrangements where the employer owns the policy and provides the employee with current life insurance protection and potential access to cash value. In this regime, the non-owner is taxed annually on the value of the economic benefits received.

Tax Treatment of Agreements

The tax implications of split-dollar agreements depend on whether they fall under the Loan Regime or the Economic Benefit Regime. Under the Economic Benefit Regime, the non-owner, typically the employee, is taxed annually on the economic benefit received. This benefit primarily represents the value of the current life insurance protection provided. The employer’s premium payments are generally not tax-deductible as they are viewed as compensation to the employee. However, the death benefit received by the employee’s beneficiaries is typically income tax-free.

For the employer in an Economic Benefit Regime arrangement, the policy’s cash value can be an asset on the balance sheet, and its growth is generally tax-deferred. Upon the employee’s death or termination of the agreement, the employer is typically reimbursed for premiums paid, and this reimbursement is usually treated as a return of capital, not taxable income. Any distributions or loans from the policy’s cash value to the non-owner are generally taxable to the extent they exceed the non-owner’s basis in the policy.

Under the Loan Regime, premium payments made by the employer are treated as loans to the employee. The employee, as the policy owner, may owe interest on these loans. If the interest rate charged is below the Applicable Federal Rate (AFR), the difference is treated as taxable imputed income to the employee. The employee cannot deduct the interest on these loans.

For the employer under the Loan Regime, the premium payments are considered receivables, and they are generally not tax-deductible as business expenses. The employer typically recovers the loan principal, and any accrued interest, from the policy’s cash value or death benefit upon termination of the agreement or the insured’s death. This repayment is generally not taxable income to the employer, as it represents a return of the loan. The death benefit paid to the employee’s beneficiaries under a loan regime policy can also be received income tax-free.

Calculating the Taxable Benefit

Under the Economic Benefit Regime, calculating the annual taxable benefit for the non-owner involves determining the value of the current life insurance protection. While older PS 58 rates existed, these were largely replaced by Table 2001, which reflects more current life expectancies and generally results in lower taxable benefits. Table 2001 rates are applied to the net death benefit protection provided to the non-owner.

Taxpayers may also use the insurer’s alternative one-year term rates if these rates are lower than Table 2001 and meet specific IRS guidelines. These guidelines require the insurer’s rates to be published and generally available to all standard risks for one-year term insurance. The taxable amount is calculated by multiplying the applicable rate (Table 2001 or insurer’s term rate) by the net death benefit per $1,000 of coverage. Any contributions made by the non-owner toward the cost of the coverage reduce the taxable amount.

Ending a Split-Dollar Agreement

A split-dollar agreement can terminate in several ways, each with distinct tax consequences. Common termination events include the employee’s death, retirement, or a mutual agreement between the parties to end the arrangement. The agreement typically specifies how the policy’s cash value and death benefit will be distributed upon termination, ensuring the party who advanced premiums is repaid.

Upon termination, the employer usually recovers their invested premiums, often from the policy’s cash value or death benefit. If the policy’s cash value exceeds the amount owed to the employer, this “policy equity” can have tax implications for the employee, potentially resulting in taxable income. For example, if an employee receives the policy or its cash value that exceeds their basis (premiums paid by them), the excess could be taxable as ordinary income.

In a Loan Regime arrangement, termination often involves the repayment of the outstanding loan balance to the employer. This repayment can come from the policy’s cash value, external funds, or the death benefit if the termination is due to death. If the employer forgives any part of the outstanding loan or accrued interest, that forgiven amount becomes taxable income to the employee. Transferring the policy to the employee upon termination might trigger income recognition if the policy’s cash value exceeds the employee’s investment in the contract.