What Is Split-Dollar Insurance & How Does It Work?

Understanding the Core Structure

A split-dollar arrangement involves at least two parties who acquire and benefit from a life insurance policy. Commonly, these are an employer and a key employee, but can also be a company and a shareholder, or individuals and trusts. The agreement defines their respective roles and financial interests in the policy.

At the heart of every split-dollar arrangement is a permanent life insurance policy, such as whole life or universal life. These policies are distinct from term insurance because they include a cash value component that grows over time on a tax-deferred basis. This accumulated cash value can be accessed during the insured’s lifetime, offering a flexible financial resource within the arrangement.

The defining characteristic, and the origin of the term “split-dollar,” lies in how the policy’s costs and benefits are divided between the parties. This division extends to the premium payments, the accumulating cash value, and the eventual death benefit. The specific allocation of these elements is defined to align with each party’s objectives.

For instance, one party might contribute to premiums, while the other gains access to a portion of the death benefit or cash value. Neither party bears the full cost nor receives the entire benefit. This shared approach distinguishes split-dollar plans from traditional life insurance ownership.

A formal agreement is necessary for establishing a split-dollar arrangement. This legally binding document outlines the rights and obligations of each party, detailing how premiums will be paid, who owns the policy, and how the cash value and death benefit will be distributed. It also specifies the duration of the arrangement and the conditions under which it can be terminated. Such an agreement ensures clarity and provides a framework for managing the policy throughout its lifecycle, mitigating potential disputes.

Different Forms of Split-Dollar Arrangements

Split-dollar arrangements are implemented through one of two primary structural methods: the collateral assignment method or the endorsement method. Each method dictates a different approach to policy ownership, premium payment responsibilities, and how the interests of the parties are secured within the life insurance policy.

Collateral Assignment Method

Under the collateral assignment method, the employee or the insured individual holds formal ownership of the life insurance policy. This means the policy is issued in their name, and they possess the primary rights associated with policy ownership, such as the ability to designate beneficiaries or access the cash value. This ownership structure places the policy directly within the employee’s control.

The other party, commonly the employer, provides funds for all or a portion of the policy premiums. To secure the employer’s investment, the employee assigns a portion of the policy’s cash value and/or death benefit to the employer as collateral. This assignment is a legal claim against the policy, ensuring that the employer can recover the premiums paid or a specified amount upon the termination of the arrangement or the insured’s death.

The collateral assignment is formalized through a written agreement and filed with the insurance company, legally establishing the employer’s interest. Should the arrangement terminate, or the employer’s advances need to be repaid, the collateral assignment provides a mechanism for the employer to recoup their funds from the policy’s cash value or death benefit. Upon full repayment, the collateral assignment is released, and the employee regains full, unencumbered ownership of the policy.

Endorsement Method

Conversely, the endorsement method involves the employer or the premium-paying entity retaining ownership of the life insurance policy. In this structure, the policy is issued to and owned by the employer, who also pays all the premiums directly to the insurer. The employer, as the owner, controls the policy’s cash value and retains the primary rights.

To provide a benefit to the employee, the employer “endorses” or assigns a specified portion of the policy’s death benefit to the employee’s designated beneficiaries. This endorsement is a contractual right granted to the employee, allowing their beneficiaries to receive a predetermined share of the death benefit upon the insured’s passing. The employer’s share of the death benefit is equal to the premiums paid or a greater amount, depending on the agreement.

The endorsement method ensures that the employer maintains control over the policy, which can be advantageous for corporate accounting and risk management. The employee’s interest is limited to the endorsed death benefit, and they generally do not have direct access to the policy’s cash value. This structure clearly delineates the employer’s financial interest and the employee’s benefit.

The key distinctions between these two methods lie in policy ownership and the mechanism for securing the non-owner party’s interest. Collateral assignment places ownership with the employee, with the employer’s interest secured by a lien. The endorsement method places ownership with the employer, with the employee’s benefit secured by a contractual right to a portion of the death benefit.

Taxation of Split-Dollar Arrangements

The taxation of split-dollar arrangements is governed by two distinct tax regimes: the economic benefit regime and the loan regime. The applicable regime depends on the specific structure of the arrangement and whether premium payments are considered loans.

Applicable Tax Regimes

If premium payments made by one party on behalf of another are required to be repaid from the policy’s cash value or death benefit, the arrangement is treated as a loan for tax purposes, falling under the loan regime. If there is no repayment obligation, or if the arrangement is structured such that one party provides a benefit to the other without expectation of repayment, it falls under the economic benefit regime. Internal Revenue Service (IRS) guidance, particularly Treasury Regulations Section 1.7872, provides the framework for distinguishing between these two.

Economic Benefit Regime

Under the economic benefit regime, the non-owner party, typically the employee, receives a taxable economic benefit each year. This benefit represents the value of the current life insurance protection provided by the policy owned by the other party, usually the employer. The value of this benefit is determined using the IRS’s Table 2001 rates, which provide the cost of one-year term life insurance per $1,000 of death benefit. Alternatively, an insurer’s generally available, published one-year term rates for standard risks may be used if they are lower than the Table 2001 rates.

The economic benefit is treated as taxable income to the employee. For example, if the employer owns the policy and provides the employee with $1,000,000 of death benefit coverage, the employee recognizes income based on the Table 2001 rate for their age multiplied by 1,000. The employer cannot deduct the premium payments, but may deduct any bonus paid to the employee to cover the tax liability of the economic benefit. Cash value growth within the policy owned by the employer is tax-deferred, and the death benefit received by the employer is income tax-free. The portion of the death benefit received by the employee’s beneficiaries is also income tax-free.

Loan Regime

When a split-dollar arrangement is structured as a loan, premium payments made by one party for the benefit of another are treated as genuine loans. This occurs in collateral assignment arrangements where the employee owns the policy and the employer advances premiums with an expectation of repayment. The tax implications revolve around the interest on these loans.

If the loan is interest-free or charges an interest rate below the applicable federal rate (AFR), it falls under the rules for below-market loans, specifically Section 7872. Under these rules, the foregone interest (the difference between the AFR and the interest, if any, charged on the loan) is imputed as taxable income to the borrower, which is the employee in this scenario. This imputed interest is also treated as a deductible expense for the borrower and as taxable income for the lender, the employer, though the employer may also have an offsetting deduction for compensation.

Repayments of these loans are treated as principal repayments and are not taxable events for either party. The cash value growth within the policy owned by the employee remains tax-deferred, and the death benefit received by the employee’s beneficiaries is income tax-free. The employer’s repayment from the policy’s cash value or death benefit is also tax-free as a return of capital.

Ending a Split-Dollar Arrangement

Terminating a split-dollar arrangement involves several pathways, each with distinct financial and tax implications for the involved parties. The method of termination is predetermined within the initial split-dollar agreement, outlining how the policy’s value and benefits will be settled.

Methods of Termination

One common method for ending a split-dollar arrangement is a “rollout.” In a rollout, the employee, or the non-owner party, acquires full ownership of the life insurance policy from the employer. This is often achieved by the employee buying out the employer’s interest, frequently using the policy’s accumulated cash value to repay the premiums or advances made by the employer. The rollout effectively transfers the policy entirely to the employee, allowing them to continue the coverage independently.

Another definitive termination event is the death of the insured. Upon the insured’s passing, the death benefit is distributed according to the pre-established terms of the split-dollar agreement. The employer recovers their investment, such as the premiums paid or a specified portion of the cash value, from the death benefit, with the remaining balance paid to the employee’s designated beneficiaries. The death benefit received by both the employer and the beneficiaries is income tax-free.

A policy can also be terminated through its surrender. If the policy is surrendered, its cash value is distributed between the parties as outlined in the agreement. The employer would recover their investment, and any remaining cash value might be distributed to the employee. Surrendering a policy can trigger taxable income if the cash value received exceeds the premiums paid, for either party.

Some arrangements terminate with the repayment of premiums. This occurs when the non-owner party repays the full amount of premiums advanced by the other party, effectively settling the financial obligation. Once the repayment is complete, the split-dollar agreement is dissolved, and the policy’s ownership and future benefits revert entirely to the party that made the repayment.

Beyond these primary methods, split-dollar agreements may include other triggers for termination, such as the employee’s retirement, termination of employment, or the achievement of a specific financial milestone. The agreement details how the policy will be handled upon these events, which often involve a buyout or transfer of the policy to the employee.

Financial and Tax Consequences

The financial consequences of termination depend on the specific method chosen. In a rollout, the employee gains full control of the policy but must account for the repayment to the employer. This repayment can sometimes lead to a “transfer for value” issue if the policy is transferred for valuable consideration, potentially making the death benefit taxable in the future. However, there are exceptions to this rule, such as transfers to the insured.

For arrangements under the economic benefit regime, termination might involve the employee taking over the policy. If the policy’s value exceeds the employee’s basis (the amount they have recognized as income over the years), the employee could recognize taxable income upon transfer. Under the loan regime, the repayment of the loan closes the arrangement without further tax implications related to the loan itself, as long as the interest was properly accounted for.

Surrendering a policy can lead to taxable gain for the party receiving the cash value if the amount received exceeds their investment in the contract. For instance, if the employee receives cash value that surpasses their cumulative recognized economic benefit or premiums paid, that excess would be taxable as ordinary income.