| What Is Split Dollar Life Insurance
| Taking the Mystery Out of Split-Dollar Life Insurance
The mention of split-dollar life insurance sends many estate planning professionals running for cover and looking for answers. Why use split-dollar? How does it work? And the most common question:
This article answers such questions, beginning with the last one. Split-dollar insurance is not a type of life insurance. Rather, it is an arrangement between two parties that involves "splitting" premiums, cash values, ownership, death benefits and dividends of a life insurance policy. The traditional split-dollar arrangement involves an employer and employee but, as will be discussed later in this article, "private" split-dollar arrangements (in which there is no employer/employee relationship) have become increasingly popular.
In general terms, split-dollar insurance is an ownership and premium payment arrangement that involves some type of permanent, cash-value life insurance such as whole life, universal life, variable universal life or a term/whole life blend.
Because the form which a split-dollar arrangement may take is limited in variation only by the creativity of planners, this article tackles the most common variations.
Life insurance has become an increasingly popular vehicle to use for estate planning because of its many advantages when used in combination with an irrevocable trust. For instance, if structured properly, life insurance can pass significant monies to family members free of estate and income tax, and also can provide the liquidity necessary to pay estate taxes for an estate otherwise comprised of illiquid assets.
To avoid having life insurance proceeds taxable in an insured-decedent's estate, the insured must not have any "incidents of ownership" with respect to the life insurance policy. This often is accomplished by having an irrevocable trust be the applicant, owner and beneficiary of a new insurance policy.
If an existing policy is assigned from the insured to an irrevocable trust, the insured must survive for three years following the transfer to avoid having the proceeds included in his or her estate for federal estate tax purposes. The assignment by an insured of an existing life insurance policy to an irrevocable trust is a gift for federal gift tax purposes.
After a trust owns an insurance policy, in each year the insured would make cash gifts to the trust to enable it to pay the premiums. If the transaction is structured properly, these gifts (both of the policy itself, in the case of a pre-existing policy, and the annual amounts to fund premiums, whether pre-existing or new policies) will be gifts of "present interests" qualifying for the $10,000 gift tax annual exclusion. The tax advantages of using life insurance and irrevocable trusts in estate planning become even more beneficial in the context of split-dollar arrangements.
Second-to-die life insurance (a type of insurance that pays a death benefit on the death of the survivor of a husband and wife) has become a popular estate planning tool because it is less expensive to purchase than single life insurance (because the life expectancy is measured over two lives) and it provides liquidity at the time when it is needed most (very often there are no significant death taxes due until the second death of a husband and wife).
For insurance policies (whether single-life or second-to-die policies) owned by an irrevocable trust with large premiums, it can be more difficult to structure the transaction so that the entire premium is covered by annual exclusion gifts to the trust beneficiaries, thus creating the possibility that a portion of the transfers to a trust to cover premium payments will be taxable gifts or at least reduces the amount of such taxable gifts. As will be explained below, in such instances, a split-dollar arrangement may be a viable method to insure that the gifts to an irrevocable trust (to cover premium payments) are not taxable gifts.
In its traditional form, a split-dollar arrangement uses an employer's funds to reduce significantly an employee's cost of purchasing permanent life insurance. Without such assistance, it otherwise might have been impossible for the employee to purchase the desired amount of life insurance. This provides an important fringe benefit to the employee which may help an employer retain the employee.
Finally, an insurance policy with substantial cash value that was acquired through a split-dollar arrangement can be used by an employee as a source to supplement his or her retirement income.
The seminal Internal Revenue Service (IRS) rulings that sanction the use, and explain the taxation, of traditional split-dollar insurance arrangements are Rev. Rul. 64-328, Rev. Rul. 66-110 and Rev. Rul. 78-420. Rev. Rul. 64-328 involved the purchase of an insurance policy on an employee's life under an arrangement designated as split-dollar in which the employer provided the funds to pay the portion of the premiums equal to the increases in the cash surrender value of the policy. The employee paid the balance of the premiums. The death benefit was to be split, with the employer receiving an amount equal to the cash surrender value and the employee's beneficiary receiving the balance.
The IRS ruled that the employee had income equal to the value of the insurance protection in excess of the portions of the premiums provided by him. The IRS authorized the use of tables reflecting the one-year term cost of insurance in Rev. Rul. 55-757, commonly known as the "P.S. 58 cost," to calculate the value of the employee's income (known as the "economic benefit" to the employee).
The ruling also provided that the same income tax consequences would result "if the transaction is cast in some other form resulting in a similar benefit to the employee."
In Rev. Rul. 66-110, the IRS ruled that the economic benefit in measuring income to an employee could be determined by the lower of the P.S. 58 cost or the insurance company's individual one-year term cost on policies "available to all standard risks." In most instances, the one year term cost will be lower than the P.S. 58 cost.
In the context of second-to-die insurance, there is little guidance to determine the economic benefit in a split-dollar plan when both insureds are living. The guidance most commonly relied upon is known as the "Greenberg-to-Greenberg letter," which provides that the one year term cost for a second-to-die policy is based on Table 38, U.S. Life Tables and Actuarial Tables (commonly known as the "P.S. 38 cost" or the "U.S. 38 cost"), which is lower than the P.S. 58 cost.
Once the first of the insureds dies in the context of a second-to-die policy, the economic benefit reverts from the P.S. 38 cost to the more expensive P.S. 58 cost.
Rev. Rul. 78-420 was the first ruling providing that the payment of premiums in a third party split-dollar arrangement is a gift (e.g., a split dollar arrangement entered into by an employee's spouse and his employer). In this ruling, an employee, in addition to realizing income on premium payments made by the employer, was deemed to have made a gift to the policy owner (the spouse) in an amount equal to the economic benefit of the insurance protection provided by the employer.
These three rulings set the playing field for the numerous variations of split-dollar arrangements and private letter rulings that have been issued by the IRS.
How Split-Dollar Works
In the traditional employer/employee split-dollar arrangement, the employee has a need for some type of permanent life insurance but lacks the funds to pay the premiums. The employer has available funds and wants to assist the employee in obtaining the insurance. In a more modern context, an insured desires to purchase, through an irrevocable trust, a large single-life or second-to-die insurance policy, and desires to structure the transaction so that the premiums, which may be very large, qualify for the gift tax annual exclusion. In both instances, it may be advantageous for the parties to enter into a split-dollar arrangement.
As to splitting premiums, the arrangement either will be contributory or noncontributory to the employee (or his or her transferee, such as an irrevocable trust). Under a contributory plan, the employee and the employer each pays a portion of the premium, while in a noncontributory plan, only the employer pays premiums.
A contributory plan can be structured in many ways. Under the classic split-dollar arrangement, the employer agrees to pay that portion of the premium equal to the increase in the policy's cash value for the year and the employee pays the balance.
A more common split-dollar arrangement today is known as P.S. 58 offset split-dollar, where the employee (or his or her irrevocable trust) pays an amount equal to the P.S. 58 cost or the lower one-year term cost for the insurance coverage (the economic benefit). Any balance is paid by the employer. This arrangement is beneficial to the employee because usually the P.S. 58 cost or one-year term cost is small as compared to the amount of the premium itself. If an irrevocable trust is used, this P.S. 58 cost or one-year term cost is the amount the employee must transfer to the trust to cover his or her portion of the premiums (if the arrangement involves second-to-die insurance, the amount is the P.S. 38 cost). These transfers, because they are relatively small, may be sheltered from gift taxation as a result of the $10,000 annual gift tax exclusion.
There are various ways of splitting a death benefit. In its most common form, upon the death of the insured-employee, the employer will receive an amount equal to the total premiums it paid, and the beneficiaries designated either by the employee or his or her irrevocable trust will receive the remaining death benefit (such beneficiaries usually will be the irrevocable trust or family members of the insured). The amount that the employee (or irrevocable trust) designates for his, her or its beneficiaries is commonly called the "at risk" portion of the policy.
The two most common methods of policy ownership in a split dollar arrangement are the collateral assignment method and the endorsement method. In a collateral assignment split-dollar arrangement, the employee (or his or her irrevocable trust) applies for and owns the policy. In most cases today the employer pays all premiums, or such portion of the premiums that exceed the P.S. 58 or P.S. 38 costs.
At such time as the split-dollar arrangement is terminated (i.e., at the death of the insured-employee or when the policy is cashed in), the employer is reimbursed the amount of premiums that it has paid. A portion of the value of the insurance policy is collaterally assigned by the irrevocable trust to the employer to secure the employer's rights to be repaid for the premiums it advanced because the employer does not own any part of the policy itself.
By contrast, under the endorsement method, traditionally the employer is the purchaser and owner of the insurance policy and there is a separate agreement between the employer and employee spelling out the employee's rights in the insurance policy. The employer typically names itself as the beneficiary of an amount of the proceeds equal to the cash value of the policy at the time of the insured's death, and by endorsement, provides that the insured-employee (or his or her assignee) has the right to name and to change the beneficiary of the portion of the proceeds in excess of the cash value (the "at risk" portion). The insured then names a beneficiary to receive that portion. In the endorsement method, it is as if both the employer and the employee own a "slice" of the policy.
A third method of ownership is known as the split-ownership method. Under this method, the insured-employee is the original owner of the policy, names a beneficiary and then, by absolute assignment, transfers to the employer a portion of the policy values equal to the aggregate of premiums the employer has paid. The insured-employee retains all other ownership rights.
A fourth method of ownership is known as the sole ownership method. The employer and a third party, such as an irrevocable trust, enter into a split-dollar arrangement with an "outside" agreement and the employer has no interest in the policy. This method creates some degree of risk to the employer because it has no security and only has a contractual promise of the third party owner (i.e., the employee's irrevocable trust) for the return of its premium.
In a reverse split-dollar arrangement the roles of employer and employee/third party are reversed.
Generally, in a reverse split-dollar arrangement, the insured-employee (or his or her irrevocable trust, spouse or child) owns and controls the policy's cash value and the employer is the beneficiary of the "at risk" portion. When the plan is terminated, the employer would transfer the "at risk" portion to the insured-employee (or his or her irrevocable trust, spouse or child) who then would own the entire policy.
Typically this type of arrangement is kept in force until the dividends thrown off by the cash value in the policy are sufficient to pay the premiums. A reverse split-dollar arrangement is attractive because the employer generally pays the majority of the premiums and may eliminate the employee/third party's cost to terminate the split-dollar arrangement on a roll-out.
An objective of many reverse split-dollar arrangements is to build a substantial cash fund for the employee's retirement. In such a case, the employer should pay the P.S. 58 cost as its contribution to the premium rather than the lower one-year term rate so that the cash value grows more quickly.
If a third party or trust owns the cash value, the payment by the employer of the P.S. 58 cost will be a transfer subject to the gift tax, discussed in greater detail below. Moreover, with respect to estate taxes, if the insured holds any incidents of ownership, the proceeds of the policy will be includable in his or her gross estate for federal estate tax purposes, even though the employer owns the "at risk" portion of the death benefit.
"Private" split-dollar, which is also known as "family" split-dollar, is an arrangement that is unrelated to employment, and differs from traditional split-dollar in two primary ways. First, a third-party individual or a trust (not the insured) plays the role of the corporation and supplies the funds for the insurance program.
Second, the economic benefit is a gift (where in a business split-dollar arrangement it is taxable compensation to the insured). Such an arrangement may be useful to provide gift tax leverage for large policy premiums when the insured has no connection to an active business.
The most common form of a private split-dollar arrangement is between an irrevocable trust and the insured's spouse, an arrangement which was the subject of Private Letter Ruling 9636033. This ruling is the first issued by the IRS that dealt with gift and estate tax issues relating to private split-dollar arrangements.
Under the facts of the ruling, the couple lived in a community property state. The insured established the trust and funded it with separate funds. The initial beneficiaries of the trust are the insured's children. The trust purchased an insurance policy on the insured's life and entered into a collateral assignment agreement with the insured's wife. The trustee also executed and delivered a promissory note to the wife evidencing the trust's debt for the premiums that the spouse was advancing. The trustee paid the portion of the premium equal to the lower of the P.S. 58 cost or the one-year term cost, and the insured's wife paid the balance of the premium with her separate funds.
The collateral assignment provided that if the arrangement was terminated, the insured's wife would receive the greater of the premiums paid or the cash value. Following the death of the insured and the collection of the proceeds of the policy, the beneficiaries of the trust were the insured's wife and children.
The IRS ruled (i) that the insured made a taxable transfer to the trust only when he provided the initial funding on its creation, (ii) that the insured had not made a transfer to his wife, (iii) that the insured's wife was not making taxable transfers to the trust because of the trust's obligation to reimburse her for premium payments, and (iv) that the proceeds of the policy would not be included in the insured's estate under § 2042 because the insured did not possess any incidents of ownership over the policy.
In the context of second-to-die private split-dollar arrangements, the IRS recently issued Private Letter Ruling 9745019 ruling that private split-dollar life insurance arrangements between a husband and wife and an irrevocable trust will not result in the inclusion of policy proceeds in the estates of the insureds.
In Private Letter Ruling 9745019, a trust acquired a second-to-die life insurance policy on the lives of a husband and wife. The trust was named the owner and beneficiary of the policy. The insureds and the trustee were to enter into a collateral assignment split-dollar agreement with respect to any policies held by the trust.
During the joint lives of the taxpayers, the trustee was to pay that portion of the annual policy premiums equal to the insurer's current published premium rate for annually renewable term insurance generally available for standard risks. After the death of the first taxpayer to die, the trustee will pay that portion of the annual policy premiums equal to the lesser of the P.S. 58 cost or the insurer's current premium rate for annually renewable term insurance generally available for standard risks.
The insureds will pay the remaining portion of the annual premium.
The IRS concluded that the payment by the couple of the portion of the premiums for which they were responsible under the split-dollar agreement will not be a gift to the trust under § 2511 because the couple or the estate of the last to die will be reimbursed by the trust for the portion of the premiums paid by the couple.
The IRS further concluded that the insurance proceeds payable to the trust will not be includable in the gross estate of the last to die of the husband and wife under § 2042 because they did not retain any incidents of ownership. This is an important ruling because it presents a valuable estate planning opportunity for people contemplating a purchase of significant second-to-die insurance policies.
Income Tax. In a traditional employer/employee split-dollar arrangement, the employee must include in his or her gross income the value of the economic benefit accruing to him or her (resulting from the employer paying all or a portion of the premium) that exceeds the amount, if any, contributed by the insured-employee or the third-party owner of the policy. As discussed above, the amount taxable to the employee is the lesser of the P.S. 58 cost or the one-year term policy premium rates "available to all standard risks" if published by the insurance company issuing the policy (if the arrangement involves second-to-die insurance, the amount taxable is the P.S. 38 cost).
The employee (or his or her trust) can avoid having any taxable income if he or she pays the P.S. 58 cost (or lower one-year term cost). Note that the employee must report the P.S. 58 cost as income (or contribute such amount to the trust) whether or not a premium is actually due on the policy (i.e., even if the policy premium has vanished because there is sufficient cash value in the policy to support future premium payments without making any further contributions to the policy).
The employer and the employee may not deduct their respective premium payments.
After the insured's death, the proceeds will not be includible in the beneficiary's gross income.
The receipt by the employer of its portion of the proceeds will constitute a recovery of its cost basis in the policy.
The IRS stated in Rev. Rul. 64-328 that if the split-dollar arrangement is something other than traditional, "[t]he same income tax results obtain if the transaction is cast in some other form resulting in a similar benefit to the employee." Many practitioners have relied on this statement when devising some of the more modern and creative split-dollar arrangements.
Under an arrangement known as an "equity split-dollar plan," the employer's interest in the policy (cash value and proceeds) is limited to the return of the premiums it pays and the balance of the cash value belongs to the employee or third party owner (e.g., his or her irrevocable trust). At such time as the cash value of the policy grows and begins to exceed the aggregate amount of the premiums paid by the employer (which can occur between seven and nine years after the policy is issued), the employee/third party owner begins to develop equity in the policy. The IRS ruled on such a split-dollar arrangement in TAM 9604001.
Under the facts of this TAM, an employer entered into a split-dollar arrangement with a trust that was established by the employee. The employer paid two single premiums to fully fund two insurance contracts on the employee's life. The employer had an unqualified right to recover from the death benefits an amount equal to the employer's premium contributions and, upon termination of the split-dollar arrangement prior to the employee's death, the employer was to be repaid its cumulative contributions.
During the arrangement, each policy's cash value, in an amount no greater than the employer's premium advances, was assigned to the employer in order to protect its right to a return of those advances. The IRS ruled that in addition to receiving taxable income each year equal to the P.S. 58 cost of the insurance protection, the insured also received taxable income under § 83 beginning in the year in which the cash surrender value of the policies at issue exceeded the amount returnable to the corporation equal to the excess attributable to the year in question.
The TAM generated an outcry from the insurance industry as being in direct contravention of existing law. The insurance industry has requested that the TAM be revoked or amended, but to date, no action has been taken by the IRS.
Given that, if and until the TAM is revoked or amended, its ruling may reflect the IRS's current thinking, practitioners have offered the following suggestions when structuring split-dollar arrangements: (1) consider using an insurance policy designed to keep the cash value as low as possible (e.g., universal life or variable universal life policies), (2) consider setting up the agreement so that all the cash value passes to the employer, similar to the facts in Rev. Rul. 64-328, and (3) make the employee's access to the cash value a right that is subject to a risk of forfeiture for section 83 purposes.
Gift Tax. In most split-dollar arrangements today, ownership of the portion of the split-dollar insurance payable to the personal beneficiary (i.e., the "at risk" portion) is placed in an irrevocable trust. Thus, a constructive gift from the insured-employee to the trust will be deemed to take place each year the policy is in force, whether or not premiums are actually due in that year (i.e., even if the premium has "vanished"). The amount of the gift to the trust is equal to the income that the employee realizes as a result of the split-dollar arrangement (i.e., the economic benefit to the employee).
In addition, if the insured-employee is the original owner of the at risk portion of the proceeds and transfers such interest to an irrevocable trust, the transfer is a taxable gift.
If structured properly as present interests, both the transfer of the policy to the trust, if originally owned by the employee, and the constructive gifts to the trust equal to the economic benefit of the premium payments, will qualify for the $10,000 gift tax annual exclusion. This is because, as noted above, the amount of the gift usually is very small as compared with the actual premium payment. The gift tax results may be the single most important benefit of split-dollar arrangements for wealthy individuals.
Estate Tax. As discussed above, the usual estate tax rules applicable to life insurance will apply to split-dollar arrangements, including §§ 2035 and 2042. Pursuant to § 2042, life insurance proceeds will be included in the gross estate of the insured if the insured possesses any "incidents of ownership" in the policy, or the policy is payable to the insured's estate.
Under § 2035, if the insured transfers any incidents of ownership less than three years prior to his or her death, the proceeds of the policy will be includible in the insured's gross estate for estate tax purposes. If a split-dollar arrangement is structured properly, an irrevocable trust will have all of the incidents of ownership and the employee will have none. In this fashion, the proceeds should not be includable in the employee's estate for federal estate tax purposes.
It is also important to note that if the insured is a majority shareholder in a corporation, the corporation must not own any incidents of ownership. Otherwise, all or a portion of the death proceeds will be includable in the insured's gross estate for federal estate tax purposes. To avoid estate inclusion, it is important that the split-dollar arrangement provides that the corporation is prohibited from borrowing against the policy.
There are many reasons to terminate a split-dollar arrangement prior to the insured's death. For example, the employee retires, the economic benefit cost to the employee becomes too expensive as the employee increases in age, or the employee is concerned about taxation of equity, discussed above, and wants to terminate the split-dollar arrangement before the cash value exceeds the employer's cumulative premium outlay.
Upon termination of a split-dollar arrangement by reason other than the insured's death, the employer's interest in the policy is "rolled-out" (i.e., transferred) to the owner of the policy.
If a roll-out is contemplated, the collateral assignment, split-ownership or sole ownership methods of ownership should be used instead of the endorsement method because, under the former methods, the employee or a third party is the basic owner of the policy at the time the split-dollar arrangement is terminated.
The mechanics of a roll-out generally involve two steps. First, the employee pays the employer the total amount of the employer's premium contributions under the split-dollar arrangement. Second, any "outside" split-dollar agreement and the insurance policy documents (i.e., collateral assignment, assignment or split-owner endorsement) involved in the split-dollar arrangement must be terminated.
A roll-out does not have to take place at one time. It can happen over a number of years (often referred to as a "crawl-out"). An example of a crawl-out would be a situation where premiums are no longer payable on a policy because the internal value is sufficient to cover future premiums without any additions to the policy, but, in order to avoid income taxation, the employee continues to make payments to his or her trust equal to the P.S. 58 costs, which are then paid out to the employer. The payments would continue until such time as the employer is repaid in full. Hence, the split-dollar arrangement "crawls" out of existence.
A roll-out may have financial and tax implications to both parties depending on the terms of the split-dollar arrangement.
In conclusion, life insurance has become a popular and useful estate planning tool. Split-dollar life insurance is an arrangement that can further enhance the use of life insurance for estate planning. Although a split-dollar arrangement may be complicated, once the basic rules are understood, the mystery is gone, and it becomes another viable alternative for an estate planner to offer his or her clients.
If the policy is owned by an irrevocable trust, the trust beneficiaries must have "Crummey" withdrawal powers in order for transfers to the trust to satisfy the present interest requirement and thus qualify for the gift tax annual exclusion.
The "Greenberg-to-Greenberg letter" is a general information letter dated August 10, 1983 from Norman Greenberg, Chief, General Actuarial Branch, Department of the Treasury, to Morton Greenberg, Advanced Underwriting Director and Counsel, The Manufacturers Life Insurance Company.
Transferring the "at risk" portion to a third party may have transfer-for-value implications. Rev. Rul. 66-110 stated that either the P.S. 58 or the lower published term rates may be used in a regular split-dollar plan. Most practitioners believe that the reversal of the employer/employee roles should not render a different result. However, there is no published ruling on this point.
All references to Code or section refer to the Internal Revenue Code of 1986, as amended. However, under the transfer for value rules, if the insurance contract is transferred for valuable consideration, by assignment or otherwise, the amount of the death proceeds that are excluded from gross income is limited to the sum of the actual consideration and the premiums or other amounts subsequently paid by the transferee.
In order for the gifts to the trust to qualify for the $10,000 annual exclusion, the trust beneficiaries must have "Crummey" withdrawal powers.
The P.S. 58 cost increases over time as the insured gets older and there eventually may come a time when the P.S. 58 cost exceeds the cost of the premiums.
Perhaps the most notable tax implications involve the transfer-for-value rules. A good resource for an in-depth analysis of roll-out and split-dollar life insurance in general is Wynn, The Insurance Counselor, Split-Dollar Life Insurance (Section of Real Property, Probate and Trust Law, American Bar Association).
This article is reprinted with permission from the September 8, 1998 issue of New York Law Journal.
© 1998 NLP IP Company