Split Dollar Life Insurance: A Guide For Businesses And Employees

 

Life insurance is a valuable financial tool that can protect your loved ones in case of your untimely death. But did you know that there are different ways to share the costs and benefits of a life insurance policy with another party? One of them is called split dollar life insurance, and it is designed for businesses and employees who want to secure their financial future.

Split dollar life insurance is a contract in which two parties agree to split the costs and benefits of a permanent life insurance policy. The parties can be an employer and an employee, a corporation and a shareholder, or two individuals. The contract outlines how the premium payments, cash value, and death benefit of the policy will be divided between the parties.

There are two types of split dollar arrangements: economic benefit and loan. In an economic benefit arrangement, one party owns the policy and pays the premiums, while the other party receives a portion of the death benefit as an economic benefit. In a loan arrangement, one party lends money to the other party to pay the premiums, while both parties have an interest in the policy.

Split dollar life insurance has several benefits and drawbacks for businesses and employees, depending on their situation and objectives. Some of the benefits include tax advantages, estate planning, employee retention, etc. Some of the drawbacks include complexity, compliance, reduced coverage, etc.

In this article, we will explain what split dollar life insurance is, how it works, who should consider it, what are the alternatives to it, and how to choose the best policy for your needs and goals.

How Does Split Dollar Life Insurance Work?

Split dollar life insurance works similarly to a regular life insurance policy, but with some differences. Here are some of the basic features and mechanics of split dollar life insurance:

• Policy ownership: The policy owner is the party who has control over the policy and can make changes to it. The policy owner can be either one of the parties involved in the split dollar arrangement or a third party such as a trust.
• Premium payments: The premium payments are the amounts that are paid to keep the policy active. The premium payments can be paid by either one or both parties involved in the split dollar arrangement or by a third party such as a trust.
• Death benefit distribution: The death benefit is the amount that is paid to the beneficiaries of the policy when the insured person dies. The death benefit can be divided between the parties involved in the split dollar arrangement or between other beneficiaries according to the contract.
• Collateral assignment: The collateral assignment is a legal document that assigns a portion of the policy’s benefits to one party as collateral for a loan or an economic benefit provided by that party. The collateral assignment can be revoked or modified by mutual agreement of both parties.

The way split dollar life insurance is taxed depends on who owns the policy and how the benefits are divided . Generally speaking:

• If one party owns the policy and pays all or most of the premiums, while the other party receives an economic benefit from a portion of the death benefit, the economic benefit arrangement applies. In this case, the party receiving the economic benefit has to report the value of the benefit as taxable income each year. The value of the benefit is determined by IRS tables based on the age and health of the insured person and the amount of the death benefit. The party paying the premiums may be able to deduct them as a business expense if certain conditions are met.

• If one party lends money to the other party to pay the premiums, while both parties have an interest in the policy, the loan arrangement applies. In this case, the party lending the money has to charge interest on the loan at or above the applicable federal rate (AFR) to avoid tax consequences. The party borrowing the money has to pay interest on the loan and report it as taxable income. The interest payments may be deductible as a business expense or as an investment expense if certain conditions are met.

Some of the factors that affect the cost and availability of split dollar life insurance are:

• Interest rates: The interest rates affect the cost of borrowing money to pay the premiums and the value of the economic benefit. The lower the interest rates, the lower the cost of borrowing and the higher the value of the economic benefit.
• IRS regulations: The IRS regulations affect how split dollar life insurance is taxed and reported. The IRS issued new regulations in 2003 that changed some of the rules and requirements for split dollar arrangements. The parties involved in split dollar life insurance should comply with these regulations to avoid penalties and audits.
• Sarbanes-Oxley Act: The Sarbanes-Oxley Act is a federal law that regulates corporate governance and accountability. The act prohibits publicly traded companies from lending money to their executive officers or directors. This means that these companies cannot use loan arrangements for split dollar life insurance with their executives or directors.

Who Should Consider Split Dollar Life Insurance?

Split dollar life insurance may be a suitable option for businesses and employees who want to share the costs and benefits of a permanent life insurance policy. However, not all businesses and employees may need or benefit from this type of policy. Here are some of the scenarios and situations where split dollar life insurance may be a good fit:

• Businesses that want to provide supplemental benefits for key executives or shareholders: Split dollar life insurance can help businesses attract, retain, and reward key executives or shareholders who are vital to their success. Split dollar life insurance can provide these individuals with valuable life insurance coverage at a low cost, while also allowing them to access cash value or death benefit for their personal or business needs.

• Employees that want to access affordable and flexible life insurance coverage: Split dollar life insurance can help employees obtain life insurance coverage that they may not be able to afford or qualify for on their own. Split dollar life insurance can also provide employees with more flexibility and control over their coverage than group term life insurance, which is usually limited and temporary.

• Businesses and employees that want to leverage tax advantages and estate planning opportunities: Split dollar life insurance can help businesses and employees reduce their tax liabilities and enhance their estate planning strategies. Split dollar life insurance can provide tax-free death benefits, tax-deferred cash value growth, tax-deductible interest payments, etc. Split dollar life insurance can also help businesses and employees transfer wealth to their heirs or charities in a tax-efficient manner.

• Businesses and employees that have a long-term and mutually beneficial relationship: Split dollar life insurance works best when both parties involved have a long-term and mutually beneficial relationship. Split dollar life insurance requires trust, cooperation, and commitment from both parties, as they have to share the costs and benefits of a permanent life insurance policy. Split dollar life insurance also requires ongoing communication, documentation, and reporting from both parties, as they have to comply with tax and legal requirements.

For example, let’s say ABC Inc. is a privately held company that wants to provide a supplemental benefit for its CEO, Bob. Bob is 50 years old and has been with ABC Inc. for 15 years. He earns $500,000 per year and has a net worth of $10 million. He wants to buy a permanent life insurance policy with a $5 million death benefit and a $1 million cash value.

ABC Inc. decides to use a split dollar life insurance arrangement with Bob. ABC Inc. owns the policy and pays the premiums, while Bob receives an economic benefit from a portion of the death benefit. ABC Inc. and Bob sign a collateral assignment agreement that assigns $2 million of the death benefit to Bob as collateral for the economic benefit. ABC Inc. also agrees to forgive the economic benefit if Bob stays with the company until retirement or dies while employed.

The split dollar life insurance arrangement benefits both ABC Inc. and Bob. ABC Inc. can provide a valuable benefit for Bob at a low cost, while also retaining an interest in the policy. ABC Inc. can also deduct the premiums as a business expense and receive $3 million of the death benefit tax-free if Bob dies. Bob can access affordable and flexible life insurance coverage without paying any premiums or interest. Bob can also receive $2 million of the death benefit tax-free if he dies, or access the cash value of the policy if he retires or leaves the company.

What Are The Alternatives To Split Dollar Life Insurance?

Split dollar life insurance is not the only option for businesses and employees who want to buy life insurance. There are other types of business or individual life insurance policies that may suit their needs and goals better. Here are some of the alternatives to split dollar life insurance:

• Group term life insurance: This is a type of life insurance that provides temporary and basic coverage for employees at a low cost. The employer pays the premiums and provides a fixed amount of death benefit for each employee, usually based on their salary or position. The employees do not own the policy and cannot customize their coverage. The coverage ends when the employee leaves the job or reaches a certain age.
• Executive bonus plans: These are plans that allow employers to pay for individual life insurance policies for employees as a bonus. The employer pays the premiums and reports them as taxable income to the employee. The employee owns the policy and can choose their coverage amount, beneficiary, etc. The employee can also access the cash value or death benefit of the policy for their personal or business needs.
• Nonqualified deferred compensation plans: These are plans that allow employers to defer part of an employee’s compensation until a future date, such as retirement, death, disability, etc. The employer sets aside money in a trust or an account for the employee, while also buying a life insurance policy on the employee’s life. The employer owns the policy and pays the premiums, while also receiving tax deductions and tax-deferred growth. The employee receives the deferred compensation plus interest at a future date, while also receiving tax deferral and protection from creditors.
• Individual term or permanent life insurance policies: These are policies that provide personal and customized coverage for individuals at their own cost. The individual buys the policy and pays the premiums, while also choosing their coverage amount, beneficiary, etc. The individual can also access the cash value or death benefit of the policy for their personal or business needs.

Each alternative has its own advantages and disadvantages, such as cost, coverage, tax implications, eligibility, etc. Therefore, businesses and employees should compare and contrast different options before deciding which one is best for them.

How To Choose The Best Split Dollar Life Insurance Policy?

Choosing the best split dollar life insurance policy for your needs and goals can be challenging, as there are many factors to consider and options to choose from. Here are some tips and guidelines on how to find and select the best policy for you:

• Determine how much coverage you need and how long you need it for: You should calculate how much money you or your partner would need to pay off your debts, cover your living expenses, fund your future goals, etc., after your death. You should also estimate how long you or your partner would need this financial support. This will help you decide how much death benefit you need and how long your policy term or duration should be.
• Compare quotes and rates from different insurers and agents: You should shop around and compare quotes and rates from different insurers and agents who offer split dollar life insurance policies. You should look for the best value for your money, not just the cheapest price. You should also check the reputation and ratings of the insurers and agents you are considering.
• Review the policy terms and conditions carefully: You should read and understand the policy terms and conditions carefully before signing anything. You should pay attention to details such as the premium payments, death benefit amount, policy term or duration, exclusions, limitations, riders, endorsements, etc. You should also ask questions if anything is unclear or confusing.
• Consider adding riders or endorsements to enhance your coverage or benefits: Riders or endorsements are optional features that you can add to your policy for an extra cost. They can enhance your coverage or benefits by providing additional protection or flexibility. For example, you can add a waiver of premium rider that waives your premium payments if you become disabled; or an accelerated death benefit rider that allows you to access part of your death benefit if you become terminally ill.
• Consult a financial planner or an insurance expert if you have any questions or doubts: Buying a split dollar life insurance policy can be a complex and important decision that affects your financial future and your partner’s. Therefore, you should consult a financial planner or an insurance expert if you have any questions or doubts about your options, needs, goals, etc. They can help you assess your situation, compare different policies, and choose the best one for you.

Conclusion

Split dollar life insurance is a contract in which two parties agree to split the costs and benefits of a permanent life insurance policy. It can be a suitable option for businesses and employees who want to secure their financial future. However, it is not the only option, and it may not suit everyone’s needs and goals.

Split dollar life insurance has several benefits and drawbacks, depending on the situation and objectives of the parties. Some of the benefits include tax advantages, estate planning, employee retention, etc. Some of the drawbacks include complexity, compliance, reduced coverage, etc.

There are also alternatives to split dollar life insurance, such as group term life insurance, executive bonus plans, nonqualified deferred compensation plans, or individual term or permanent life insurance policies. Each alternative has its own advantages and disadvantages, such as cost, coverage, tax implications, eligibility, etc.

To choose the best split dollar life insurance policy for your needs and goals, you should determine how much coverage you need and how long you need it for, compare quotes and rates from different insurers and agents, review the policy terms and conditions carefully, consider adding riders or endorsements to enhance your coverage or benefits, and consult a financial planner or an insurance expert if you have any questions or doubts.

Split dollar life insurance can be a valuable financial tool that can help you share the costs and benefits of a permanent life insurance policy with another party. If you are interested in buying a split dollar life insurance policy, you should start by contacting an independent insurance agent who can help you find and compare different options and guide you through the process.