What is Split Dollar Life Insurance
Split dollar life insurance is not an insurance product or a reason to buy life insurance. Split dollar is a strategy that allows the costs and benefits of permanent life insurance to be shared. Any type of permanent life insurance that creates a cash value can be used. (See also: Understanding Different Types of Life Insurance)
What is split dollar?
Most split dollar plans are used in a business setting between an employer and an employee (or a corporation and a shareholder). However, plans can also be created between private individuals (sometimes referred to as private split dollars) or through an Irrevocable Life Insurance Trust (ILIT). This article deals mainly with agreements between employers and employees; However, many rules are similar for all plans.
In a split dollar plan, the employer and employee execute a written agreement that specifies how they share the premium cost, cash value, and death benefit of a permanent life insurance policy. Split dollar plans are often used by employers to provide additional benefits to executives and / or to retain key employees. The agreement outlines what the employee must do, how long the plan will remain in place, and how the plan will end. It also contains provisions that limit or terminate benefits if the employee decides to terminate an employment relationship or fails to meet agreed performance metrics.
Since shared dollar plans are not subject to ERISA rules, there is quite a bit of leeway in how an agreement can be written. (See also: Employee Retirement Income Security Act) However, agreements must meet certain tax and legal requirements. A qualified lawyer and / or tax advisor should therefore be consulted when preparing the legal documents. Shared dollar plans also require record keeping and annual tax reporting. Generally, with a few exceptions, the policy owner is also the owner for tax purposes. There are also limitations on the usefulness of shared dollar plans depending on how the business is structured (for example, as S Corporation, C Corporation, etc.) and whether plan participants also own the business.
History and regulation
Split dollar plans have been around for many years. In 2003 the IRS published a number of new regulations governing all split dollar plans. The ordinances put forward two different acceptable dollar split agreements: economic benefits and loans. The new regulations also cut some of the previous tax breaks, but split dollar plans still offer some benefits, including:
A life insurance policy based on the rates in Table 2001 that may result in a lower cost than the actual cost of coverage, especially if the employee has health problems or is being assessed.
The ability to use corporate dollars to pay for personal life insurance that can reap the benefits, especially when the company is in a lower tax bracket than the employee.
Low interest rates if the applicable federal interest rate (AFR) is below current market rates when the plan is implemented. Loans can keep the interest rate when the plan is introduced, even if interest rates rise in the future.
The ability to minimize gift and inheritance taxes.
Economic performance agreement
Under the Benefit Agreement, the employer owns the policy, pays the premium, and approves or assigns certain rights and / or benefits to the employee. For example, the employee can name beneficiaries who would receive part of the policy cancellation. The value of the economic benefit received by the employee is calculated every year. Term insurance is valued using the 2001 table annual renewal rates, and the policy present value is an increase that has occurred during the year. The employee must record the value of the economic benefit as taxable income annually. However, if the employee pays a premium equal to the value of the life insurance term and / or the cash value received, no income tax is incurred.
A non-equity arrangement is when an employee's only benefit is part of term life insurance. With a dividend dollar plan, the employee receives the term life insurance coverage and also has a share of the policy's present value. Plans can allow the employee to borrow or withdraw a portion of the cash value.
The loan agreement is far more complicated than the economic benefit plan. Under the loan agreement, the employee owns the policy and the employer pays the premium. The employee participates in the policy by transferring ownership to the employer by way of security. A collateral assignment puts a restriction on the policy that limits what the employee can do without the consent of the employer. A typical assignment of collateral would be for the employer to reclaim the loans made in the event of death or termination of the agreement.
The employer's premium payments are treated as a loan to the employee. Technically, the premium payment is treated as a separate loan every year. Loans can be structured as term or demand and must have a reasonable interest rate based on the AFR. But the rate can be below current market rates. The interest rate on the loan depends on how the agreement is drawn up and how long it will stay in place.
Abandon split dollar plans
Split dollar plans are terminated either upon the employee's death or on a future date (often retirement) included in the agreement.
In the event of the premature death of the employee, the employer will receive either the premiums paid, the cash value or the loan amount back, depending on the agreement. When the repayment has been made, the employer releases any restrictions on the policy, and the employee's designated beneficiaries to which an ILIT can receive the remainder as a tax-free death benefit.
If the employee complies with the term and requirements of the contract, then all restrictions under the loan agreement are lifted or ownership of the policy is transferred to the employee under the economic benefit agreement. Depending on how the agreement was drawn up, the employer may claim back all or part of the premiums paid or the cash value. The employee now has the insurance policy. The value of the policy is taxed to the employee as compensation and is deductible for the employer.
The bottom line
Like many unqualified plans, split dollar agreements can be a very useful tool for employers looking to add extra perks to their key employees. (See also: How Unqualified Deferred Compensation Plans Work)
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