What Is an Endorsement Split Dollar Arrangement?
Learn about endorsement split dollar, an arrangement where an employer owns and pays for a life insurance policy, creating a taxable benefit for the employee.
Split-dollar life insurance is a method where two parties, often an employer and an employee, share the costs and benefits of a permanent life insurance policy. This arrangement allows a business to provide a substantial benefit to a key employee, helping with retention and succession planning. The structure is governed by specific tax regulations that define how these plans operate.
There are two primary ways to structure these arrangements: the endorsement method and the collateral assignment method. Each approach has different implications for policy ownership and taxation. This article focuses on the endorsement method, where the employer owns the policy and provides a portion of the benefits to the employee.
How Endorsement Split Dollar Works
In an endorsement split-dollar arrangement, the employer applies for, owns, and controls the life insurance policy on a key employee. The company pays the policy premiums, making it a corporate asset. Through a formal agreement, the employer then “endorses” a portion of the policy’s death benefit to a beneficiary designated by the employee. This structure is often used to retain valuable employees, as the benefit is tied to their continued service.
For example, a company might purchase a $3 million life insurance policy on its chief financial officer. The company pays all the premiums and is the policy’s legal owner. The agreement stipulates that upon the employee’s death, the company will be reimbursed for all the premiums it has paid. The remaining death benefit is then paid to the CFO’s designated beneficiaries.
This division ensures the company recovers its costs, while the employee receives significant life insurance coverage for their family at a much lower personal cost than if they had purchased the policy themselves. Some arrangements are structured as “equity” split-dollar plans. In these cases, the employer’s interest is limited to the premiums it paid, and any cash value growth in the policy beyond that amount belongs to the employee.
Annual Tax Consequences for the Employee
Since the employer pays for the employee’s life insurance benefit, the Internal Revenue Service (IRS) considers it a form of compensation. The employee must recognize this “economic benefit” as taxable income each year, and it is often included on their Form W-2.
The value of this economic benefit is determined under rules in Treasury Regulation § 1.61-22. This regulation provides two methods for calculating the taxable amount. The default method uses an IRS table, Table 2001, which provides standardized one-year term insurance rates based on the insured’s age.
Alternatively, the employee may use the insurance carrier’s own one-year term rates if they are lower than the IRS table rates. To qualify, these alternative rates must be available to all standard-risk individuals. Using the lower of the two rates minimizes the employee’s annual income tax liability. This annual taxation only covers the value of the current year’s life insurance protection and does not pertain to the policy’s cash value growth or the ultimate death benefit.
Taxation at Policy Termination or Death
The tax treatment of an endorsement split-dollar arrangement changes when the plan ends. When the insured employee dies while the arrangement is active, the policy pays out the death benefit according to the agreement. Under Internal Revenue Code Section 101, the death benefit proceeds received by the employee’s beneficiary are generally free from federal income tax. For the employer to maintain this favorable tax treatment, it must comply with specific notice and consent requirements.
A different set of tax rules applies if the arrangement is terminated before the employee’s death, an event often called a “rollout.” This can occur when the employee retires or leaves the company. At this point, the employee often has the option to purchase the policy from the employer for a price equal to the total premiums the company has paid.
If the policy’s cash surrender value at the time of the transfer is greater than the amount the employee pays for it, the difference may be considered taxable income to the employee in that year. This is a consideration in equity split-dollar arrangements where the employee has a growing interest in the policy’s cash value. The tax liability from this policy equity can be substantial, and some employers may offer a bonus to help the employee cover the associated taxes.
The Split Dollar Agreement
A formal, written agreement is the foundation of any endorsement split-dollar arrangement. This document is required to establish the rights and obligations of both the employer and the employee and to ensure the intended tax treatment is respected by the IRS.
The document must define the conditions that would cause the arrangement to terminate. These triggers include the employee’s death, retirement, termination of employment, or reaching a specific date outlined in the contract. The agreement also details the employee’s right to acquire the policy during a “rollout,” including the purchase price.
Without a comprehensive written agreement, the arrangement could be reclassified by tax authorities, leading to unintended and adverse tax consequences for both parties. The document serves as the controlling guide for the plan’s administration, from the annual calculation of economic benefit to the final distribution of policy value.