What Is Split-Dollar Life Insurance?

Split-dollar life insurance is a contractual agreement that allows two parties to share the costs and benefits of a permanent life insurance policy. This arrangement outlines how premiums, cash value, and death benefits are allocated between the involved parties. It establishes a formal framework for cooperation, typically involving a written contract that details each party’s rights and responsibilities.

The primary purpose of split-dollar life insurance is to enable one party to provide financial assistance for the acquisition of life insurance coverage on another party’s life. This can be useful when one party desires coverage but lacks the immediate means to fully fund the premiums. A split-dollar plan facilitates the purchase and management of a cash-value life insurance policy.

Understanding Split-Dollar Life Insurance

Split-dollar life insurance divides the components of a permanent life insurance policy between two parties. These components include premium payments, the policy’s accumulating cash value, and the eventual death benefit. The agreement formalizes this division, ensuring clarity on contributions and benefits received.

Commonly, split-dollar arrangements involve an employer and an employee, a corporation and a shareholder, or individuals within a family or an individual and a trust. In an employer-employee context, the employer often assists the employee in obtaining life insurance coverage, which can serve as a benefit. This arrangement can offer the employee coverage with reduced out-of-pocket expenses.

One party, often the employer, pays all or a portion of the premiums for a life insurance policy on the life of the other party, the insured. In return for these premium contributions, the contributing party typically holds an interest in the policy’s cash value and/or death benefit. This interest usually ensures the contributing party can recover their outlay when the arrangement terminates, either upon the insured’s death or at a predetermined date.

For instance, if an employer pays premiums for an employee’s policy, the agreement might stipulate that the employer recovers the premiums paid, the policy’s cash value, or a specified amount from the death benefit. The remaining portion of the death benefit then goes to the employee’s designated beneficiaries.

Methods of Structuring

Split-dollar arrangements are structured using two primary methods: the endorsement method and the collateral assignment method. Each method defines the legal ownership of the policy and how rights and responsibilities are documented. The choice of structuring method impacts how the arrangement is treated for tax purposes.

Under the endorsement method, the employer typically owns the life insurance policy. The employer then assigns certain rights to the employee, such as the right to name a beneficiary for a portion of the death benefit. The employer usually pays the premiums and retains ownership of the policy’s cash value. This method ensures the employer maintains control over the policy’s assets.

Conversely, the collateral assignment method typically designates the employee as the owner of the life insurance policy. Here, the employer advances funds for premiums, which are treated as loans to the employee. The employee then grants the employer a security interest in the policy’s cash value and death benefit through a collateral assignment. This assignment secures the employer’s right to recover the advanced premiums, usually upon the employee’s death or termination of the agreement.

Split-dollar arrangements are categorized into two tax regimes: the economic benefit regime and the loan regime. The specific tax regime that applies depends on the policy’s ownership and the nature of the financial exchange. These regimes dictate how the benefits are valued for tax purposes.

The economic benefit regime generally applies when the employer owns the policy, as seen in endorsement method arrangements. In this regime, the employee is considered to receive a taxable economic benefit each year, representing the value of the life insurance protection provided by the employer. This benefit is typically measured by the cost of one-year term life insurance.

The loan regime applies when the employee owns the policy, commonly in collateral assignment arrangements. Under this regime, the employer’s premium payments are treated as loans to the employee. These loans are typically secured by the policy’s cash value and death benefit. Tax implications in the loan regime revolve around the interest on these deemed loans.

Taxation of Split-Dollar Arrangements

The tax treatment of split-dollar arrangements varies depending on whether the economic benefit regime or the loan regime applies. These tax implications affect income tax and, in some cases, gift and estate taxes for all parties involved.

Under the economic benefit regime, the employee is taxed annually on the economic value of the benefit received from the life insurance coverage. This taxable amount is calculated based on the cost of one-year term life insurance. The Internal Revenue Service (IRS) provides methods for determining this cost, such as the PS 58 rates, Table 2001 rates, or the insurer’s generally published one-year term rates. This value is typically reported as taxable income to the employee on their Form W-2.

In the loan regime, the employer’s premium payments are treated as loans to the employee, and tax implications center on the interest on these loans. If the interest charged on the loan is below the Applicable Federal Rate (AFR), published monthly by the IRS, then Internal Revenue Code Section 7872 applies. Section 7872 treats the foregone interest as taxable income to the employee, and potentially as a gift in private arrangements.

Gift tax considerations arise, particularly in private split-dollar arrangements, such as those between an individual and an irrevocable life insurance trust (ILIT). If the value transferred to the trust exceeds the annual gift tax exclusion amount, a taxable gift may occur. In the economic benefit regime, the annual economic benefit can be considered a gift to the trust, which may consume a portion of the grantor’s lifetime gift tax exemption. Under the loan regime, if the interest on the loan to the trust is forgiven or below the AFR, it can be treated as a taxable gift.

Estate tax implications also exist. If the insured individual retains “incidents of ownership” in the policy, such as the right to change beneficiaries or borrow against the cash value, the entire death benefit may be included in their taxable estate upon death. To avoid estate taxation of the death benefit, policies are often structured to be owned by an ILIT, which can remove the policy proceeds from the insured’s gross estate.

Applications and Considerations

Split-dollar life insurance arrangements serve various purposes, offering financial flexibility and wealth transfer opportunities for both parties.

A common application is in executive compensation and retention strategies. Employers use split-dollar plans to attract, reward, and retain key employees by providing life insurance coverage with shared costs. This arrangement incentivizes employees to remain with the company long-term, as benefits may be tied to continued employment. For the employee, it offers access to life insurance protection with lower upfront costs.

Split-dollar arrangements are also used in business succession planning. They can provide liquidity to a business upon the death of a key owner or executive, helping to fund buy-sell agreements or compensate for the loss of an individual. The arrangement ensures the company can recover its premium contributions, while also providing a benefit to the deceased’s family.

In estate planning, private split-dollar arrangements are employed to facilitate wealth transfer and minimize estate taxes. These often involve an individual and an Irrevocable Life Insurance Trust (ILIT). By structuring the policy through an ILIT with a split-dollar agreement, the life insurance proceeds can be excluded from the insured’s taxable estate. This strategy helps ensure a death benefit can be passed to heirs with reduced estate tax liability.