When a client isn't inclined to bear the full premium of a life insurance policy, then you, as advisor, might do well to propose a time-honored tradition: sharing the cost with someone else. Many insurance and financial service professionals are doing just that.
Split-dollar life insurance, an arrangement in which the costs and benefits of a policy are shared among parties--typically between an employer and key employee within a business; and between a parent and child in estate planning scenarios--is alive and well.
And, sources tell National Underwriter, for good reason. The technique lends itself to multiple business and wealth transfer planning objectives, many of them involving business owners who are looking to attract, reward and retain management talent.
Split-dollar, for example, lets an employer provide an executive with a life insurance benefit at low cost and low outlay to the exec. The technique can be used as an alternative to an insurance-funded non-qualified deferred compensation plan. In the wealth planning arena, split-dollar life insurance often is an ideal vehicle with which to move assets out of an estate tax efficiently.
"Split-dollar is increasingly used in the estate planning arena for gifting purposes," says Stephen "Bo" Wilkins, a partner at Nease, Lagana, Eden & Culley, Inc., Atlanta, Ga. "You can squeeze the value of a policy premium gifted to a trust down to its pure economic benefit. That allows you to transfer the policy to the third party owner on a gift-tax friendly basis."
The Good and the Bad
Advantages aside, the regulatory landscape of the decade past has been a mixed blessing for the various split-dollar planning techniques, observers say. Whereas IRS regulations finalized in 2003 validated private split-dollar for estate planning, the regs also dampened enthusiasm for a once popular strategy, equity collateral assignment split-dollar, as a vehicle for funding non-qualified executive compensation.
For the uninitiated, the final regulations created two mutually exclusive tax regimes for split-dollar plans based on who is named the policy owner of the insurance contract: (1) an economic benefit regime for endorsement arrangements, wherein the employer of a business or the donor of an estate is the owner of the insurance policy; and (2) a loan regime for collateral assignment plans, wherein the employee or donee (such as a trust) is the policy owner.
When deciding on a regime, clients have to weigh the relative tax costs. Under an economic benefit regime, the taxable economic benefit is determined using premium tables governing term rates published by the IRS in Notice 2001-10.
Under the loan regime, premium payments are treated as a series of "loans" to the employee or donnee. Assuming (as is usually the case) the loan is governed by below market loan rules, then the loan is characterized as one bearing interest, subject to the applicable federal rate (AFR). And this "foregone interest" is taxable.
Key employees thus now must pay a tax on a previously tax-free fringe benefit: their share (or equity) of a policy's cash value. For this reason, sources say, the 2003 regs chilled businesses' interest in loan regime plans used in executive comp planning.
"The 2003 regulations changed the game," says Wilkins. "To do equity split-dollar now, you have to use the loan regime, which isn't as attractive as the more tax-efficient technique available previously."
Have the rules effectively eliminated loan regime plans in executive compensation planning? Some think not. Richard Landsberg, a director of advanced sales at Nationwide Financial, Columbus, Ohio, believes the impact of the 2003 regs has been overblown. While changing its tax treatment, the loan regime technique is still a good deal, he says, because of the plan's large benefit relative to its costs.
"The industry convinced itself that the end of civilization occurred [with the finalized regulations]," he says. "But when you crunch the numbers, it's still a highly leveraged transaction: The corporate dollars spent funding the plan are small compared to the benefit to be received. Whereas previously the technique was between 90% and 95% leveraged, now it's between 65% and 85%, depending on interest rates."
Point noted. But other regulations governing non-qualified deferred compensation plans and finalized in 2009, encapsulated in Internal Revenue Code Section 409A -- complicated matters for advisors seeking to use split-dollar in the corporate realm. The rules contain numerous provisions respecting the application of both grandfathered and non-grandfathered split-dollar arrangements.
Most significant for advisors, sources say, is IRS Notice 2007-34, which offers guidance on the application of 409A to split-dollar and was issued in tandem with the finalized regs. Among other things, the notice stipulates that loan regime split-dollar plans be treated as non-qualified deferred compensation -- and hence subject 409A's restrictions on the timing of deferrals, distribution elections and permitted distribution events, plus interest and tax penalties for running afoul of the regulations -- if amounts on a split-dollar loan are "waived, cancelled or forgiven."
Amid the regulatory minefield, some advisors have latched onto a version of the endorsement split-dollar technique as a deferred comp alternative, thereby escaping 409A's requirements. Steven Kroeger, a senior director for advance sales at Crump Life Insurance, Roseland, N.J., says the strategy lends itself to a short-term deferral exception to the rules --409A(1)(b)(4) -- which stipulates that compensation paid within 2 1/2 months of the close of the calendar year when the comp was earned (typically when the key employee reaches age 65) is not considered deferred compensation.
Under the endorsement arrangement, the employer owns the policy and is chiefly responsible for paying the premiums. When the insured (key employee) dies, the employer receives the greater of the premiums paid or accumulated cash value in the policy; the remaining death benefit is paid to the employee's beneficiaries.
The technique, says Kroeger, offers "golden handcuffs" with which to tie the key employee to the business. At the time of distribution, the business recovers the cost of the plan and receives an income tax deduction for the fair market value of the policy. Employees recognize income on the net death benefit, but they can also withdraw against the policy to pay the income tax.
"Since 2009, interest among our clients in this split-dollar plan has almost doubled," says Kroeger. "There is a strong desire among organizations to offer their key executives deferred comp. But because of the high compliance costs of 409A, people are increasingly looking to other options."
High compliance costs are not only a concern of business owners, he adds, but also of non-profits that (typically) don't have a lot of surplus cash to fund executives' retirement plans. Or they're not keen to comply with a separate set of complicated IRS rules--IRC Section 457(f)--that apply to non-profits and government employers.
Indeed, Crump Life counts many non-profits among its new-found clients for endorsement split-dollar, which often supplement the technique with other executive comp plans. Example: offering a life insurance-funded executive bonus plan to long-standing key executives; and, for recently hired execs, an endorsement plan that is better suited to the goal of retaining management talent for the long-term.
Split-Dollar for Gifting
Business owners, and high net worth individuals generally, often turn to split-dollar to make good on another objective: removing a large life insurance policy from their estate in the most tax-efficient manner. In the case of a family-run business, for example, the owner may wish to transition the company to one business-savvy child; and to equalize the estate for other children by designating them beneficiaries of a policy equal to the value of the company.
The policy proceeds can pass to the child beneficiaries income tax-free and, when the contract is owned by an irrevocable life insurance trust, estate tax-free. To avoid gift tax on premiums advanced to the trust, the business owner can set up a "private" split-dollar plan.
The most common of these in estate planning, market-watchers say, is the non-equity collateral assignment (economic benefit regime) arrangement. Lee Slavutin, a principal of Stern Slavutin 2, Inc., New York, says this private split-dollar technique is most tax-efficient when funded with a second-to-die insurance policy.
As an example, Slavutin cites two clients of his, a husband and wife, who purchased a $10 million second-to-die policy for which the annual premium is $70,000. In this split-dollar arrangement, the annual gift to the trust is equal to the policy's term insurance cost, which Slavutin says is about $300--as compared to thousands of dollars if the trust were funded with an individual life policy.
"The amount of the premium gift is dramatically reduced using a second-to-die policy," says Slavutin. "That means the client doesn't have to use up valuable annual gift exclusions of $13,000 or part of their lifetime gift tax exemption of $1 million."
But sources caution that the private split-dollar technique can become too costly without an exit strategy. When (using the above example) the first spouse dies, the "economic benefit" (premiums paid) to the trust will increase substantially, from a second-to-die term rate to an individual term rate. Upshot: a steep hike in the gift tax.
"With split-dollar, it's crucial to have an exit strategy laid out in advance," says Wilkins. "Whether you're using the carrier or Table 2001 term rates, they can get extremely onerous, especially if you have a second-to-die policy and the spouse dies. With one spouse living, the table for individual rates is much more onerous than for second-to-die rates."
What to do? Depending on the client's circumstances, says Slavutin, one of several exit strategies should be adopted when establishing the trust. Among them: making additional annual gifts of cash or stock to the trust from income-producing assets, the gifts used to pay the greater of the cash value or premiums paid to the trust donor/grantor.
Alternatively, the client can set up a grantor-retained annuity trust that terminates to the insurance trust. To that end, the grantor transfers an asset to the GRAT and retains an annuity payment for a term of years. At the term's expiration, any appreciation of the trust asset exceeding the IRC Section 7520 federal discount rate passes to the ILIT beneficiaries with little to no gift tax.
Or perhaps not. Too often, experts say, advisors recommend and implement a sound estate or business succession plan, but then fail to properly monitor and service it. In the worst cases, the plan can become unsustainable, as when the loan interest in a private equity split-dollar arrangement exceeds the trust's ability to make payments.
To avoid such outcomes, Wilkins says, the advisor should meet with the client at least annually to review the plan and ensure that plan objectives remain on target. The advisor should also aim, he adds, to affiliate with a group practice that can offer complementary expertise; and, should the split-dollar arrangement outlive his or her practice, avail the client of an additional advisor (such as a junior partner) to maintain servicing of the plan.
Slavutin agrees, adding that advisors also need to ensure that plans are properly documented. A common oversight, he notes, is for the advisor to set up a plan without a signed agreement or with forms that are inappropriate. Or the advisor overlooks provisions that undermine plan objectives. Case in point: allowing a client to borrow against a policy, which can create an "incidence of ownership" that places the policy in the client's taxable estate.
"The split-dollar policy has to be very carefully drafted to avoid having an estate inclusion problem," says Slavutin. "This is frequently an issue. But the most serious problem I've seen over the years is improper documentation. From time to time, someone drops the ball and the split-dollar agreement just isn't signed."