What is Split-Dollar Life Insurance?

How does a split-dollar life insurance plan work?

Split-dollar life insurance is a contract under which the premium payments and death benefit of a permanent insurance policy with a cash value is shared, usually between an employee and their employer.  In business contexts, split-dollar life insurance is often a form of company-owned life insurance that benefits both the company and its employee.

Every split-dollar policy must involve two or more parties and share the costs and benefits of a cash value life insurance policy. However, split-dollar contracts can be customized and differ in the following respects:

• Which party pays the premiums.
• Which party owns the policy.
• Which party designates the beneficiaries.
• How the death benefit and cash value are split.
• When and under what circumstances the agreement terminates.

All of these details (among other items) should be laid out in the contract establishing the split-dollar policy arrangement.

Who owns a split-dollar life insurance policy?

The ownership of a split-dollar life insurance policy is determined by contract. The various ownership models each have advantages and disadvantages. The following are the primary ownership models:

• Employee-owned: The employee owns the life insurance policy while another party makes part or all of the payments
• Employer-owned: Similar to key person insurance, the employer owns the policy and uses its portion of the payout to recoup business expenses related to the employee’s death.
• Business partner-owned: Small business partners or closely held businesses may include a split-dollar contract in their buy-sell agreement, which dictates what happens if one owner exits the business.
• Trust-owned: Placing a life insurance policy in an irrevocable life insurance trust prevents the assets from being counted in the value of an estate.

What are the two main types of ownership contracts between companies and employees?

The two main types of ownership agreements between businesses and employees are (1) the economic benefit/endorsement agreement; and (2) the collateral assignment/loan regime.

Economic benefit/endorsement agreement

When the company owns and pays the premiums on the life insurance policy in a split-dollar contract, but the employee executive and his or her beneficiaries obtain some of the benefits, such benefits are assigned to the employee through an endorsement agreement.

The term “economic benefit’ refers to the way that the Internal Revenue Service (“IRS”) taxes the split-dollar policy. The policy is taxed as employee pay — and calculated annually based on the benefits in the policy and the premiums paid by the company.

Collateral assignment and loan regime

When the employee executive owns the life insurance policy under the contract, but the company pays the premiums and obtains a portion of the policy benefits, the employee assigns such benefits to the company under a collateral assignment agreement.

The IRS treats the premiums paid by the company as an annual, interest-free loan to the employee (i.e., a loan regime). The company’s share of the policy benefits is treated as repayment for the loan. The employee pays tax on the interest that would have been charged if the contract was a traditional loan arrangement (known as the applicable federal rate or “AFR”).

Loan regime contracts are more complex to establish but potentially have greater tax benefits for the employee because the employee is not taxed on the value of the split-dollar policy benefits.

What is the bottom line?

IRS regulations governing split-dollar policies have become fairly strict. However, split-dollar life insurance contracts can still be very beneficial in many circumstances.

Additionally, even if a split-dollar policy is not the best arrangement for a company, other nonqualified deferred compensation plans, or executive benefit plans may best meet its current and future goals.