SPLIT DOLLAR LIFE INSURANCE: TEN WAYS TO SOLVE PROBLEMS AND SAVE TAXES

By J. Craig Sullivan, JD, Sullivan Associates, Inc.

Life insurance is a financial vehicle that enjoys three tax benefits not available with most alternate investmentsÑan income tax free death benefit, income tax free cash value buildup, and income tax free cash distributions. If properly structured, its proceeds can also be excludable from the insured's estate.

Financial services professionals should not treat life insurance as a commodity, just another financial instrument. Life insurance is a problem solver. Planners should identify needs and use this financial vehicle to address business, estate, and retirement planning problems. For the problem solving planner, split dollar is also the most flexible and multifaceted concept currently available to obtain large amounts of life insurance on a tax favored basis.

Split Dollar Concept

The split dollar concept employs a series of techniques for sharing the costs and benefits of a life insurance contract. It is typically used by employers to join with selected employees in obtaining personal life insurance protection. In its simplest form, the insured executive owns the policy. The employer advances some or all of the annual premium. Those premium advances are not includable in the executive's income. Instead, the economic benefit of the life insurance protection is included on the executive's W-2, based on the insurance carrier's one-year term insurance rates for standard risks (Rev. Ruls. 64-328; 66-110). The policy's cash value is collaterally assigned to the employer to secure its cumulative contributions. Upon the executive's death or upon surrender of the policy, the employer recovers its advances; all other benefits inure to the executive or to the insured's personal beneficiary.

Total Account Split Dollar

This technique solves multiple problems for both the business and the executive in one comprehensive split dollar solution. It provides the business with full cost recovery for its after tax premium outlay and also generates annually increasing tax deductions for the employer. At the same time, it creates a substantial key person indemnification plan to protect the business against loss of that executive. That same coverage provides funding for a regular or an IRC Sec. 303 stock redemption or death-benefit-only deferred-compensation agreement. The plan is fully secured with a cash value account available to the business for emergencies or opportunities.

The executive is rewarded with a large income tax free death benefit at no after tax cost. This same plan can be used to provide tax free retirement income indexed against the ravages of inflation by withdrawing and/or borrowing against the growing cash value. These multiple benefits are obtained via a bonus of the executive's preretirement plan outlay, coupled with the favorable IRC Sec. 72(e) treatment of policy cash value growth, which accommodates distributions up to basis and borrowing thereafter. IRC Sec. 101(a) then excludes both the employer's and executive's respective death benefits from income tax.

Gift Tax Free Split Dollar

Large amounts of income, estate, and gift tax free survivorship ("second-to-die") insurance can be funded with full cost recovery to the business. This technique works well not just for C corporations, but for S corporations and partnerships as well. The driving force is the gift tax benefit. It is structured to provide substantial estate liquidity without ever having to pay gift tax on the transfer of policy premiums to a third party policy owner. This is due to the favorable income and gift tax treatment afforded under Rev. Rul. 78-420 to third party ownership split dollar arrangements.

Once the planned premium paying period is complete, the "crawl-out" technique reimburses the business for its premium advances. The third-party owner remits the annual economic benefit amount, not to the insurer as a premium contribution, but to the employer as a partial repayment of its premium advances. Each payment made by the third-party owner to the business can offset any ongoing economic benefit that might otherwise attract income and gift taxation, while simultaneously reimbursing the corporation for its premium advances. This permits the gradual unwinding of the plan calibrated to stay within the annual gift tax exclusion. As a result, split dollar is chosen by executives who need substantial estate liquidity and estate tax shelter.

Business Owner's Split Dollar

This concept is geared specifically toward the business owner who desires to take money out of the corporation in order to supplement retirement income. Using the "capital transfer" split dollar method, it generates a growing personal cash asset account at no after tax cost. The employer contributes amounts substantially in excess of the policy's annual premium, up to the "seven pay test" modified endowment contract limit of IRC Sec. 7702A. This generates cash value growth which is retained by the executive. A substantial income tax free death benefit is created while generating a tax free retirement income stream. All this is done by transferring money through the "corporate veil" on a tax efficient basis, permitting significant corporate tax deductions.

Unlike other plans, business owner's split dollar terminates at retirement without stripping the policy's cash value in order to pay back the business. A "cash value bonus" rollout, whereby the company releases the accumulated value subject only to income tax payment by the owner, gives the owner access to dollars that had been secured by a collateral assignment. It also generates a substantial income tax deduction to the business. Any income tax payable by the owner on the rollout is funded solely with tax free dollars by borrowing against the policy. These tax benefits can be achieved through a combination of IRC Secs. 162, 83, and 72.

Switch Dollar

When the need is to obtain substantial amounts of personal life insurance, which is betterÑan executive bonus or split dollar? The answer generally depends on three factors:

* The relative tax bracket differential between the executive and the business,

* Deductibility to the business versus taxation to the executive, and

* Control over the policy and its values.

Since these factors will change over time, switch dollar allows the client to change from executive bonus to split dollar and back again. When the corporate bracket exceeds the personal bracket, executive bonus generally makes tax sense, while giving the executive full control over policy values. If, in later years, the personal bracket exceeds the corporate bracket, a "late start split dollar" plan can be introduced. The business advances the nondeductible premium, secured by a collateral assignment. Because the executive's income is now measured not by the full premium but, instead, by the insurance carriers' one-year term P.S. 58 alternative, the executive's outlay drops despite the hefty tax bracket increase. Later, at retirement, the plan is gradually unwound. Increments of cash value, tax deductible to the business, are bonused out to the executive, who may enjoy lower retirement income tax rates.

Private Split Dollar

Does split dollar require an employer-employee relationship? The IRS has never said so; neither has any court. For split dollar to work, there are only two essentials: one person who has a need and another person who has the money. By bringing these two parties together, the planner has a private split dollar opportunity.

The most common application is family split dollar. A grandchild is the owner and beneficiary of a policy insuring the life of a grandparent. If the grandparent paid the annual premium without a split dollar agreement, it could generate a total transfer tax which exceeds 140%Ñin addition to the policy premium. This is due to the combined effect of the generation skipping transfer tax and the gift tax.

Private split dollar may provide the ideal solution. In return for the grandparent's contractual agreement to advance the annual premium, a collateral assignment is placed on the policy securing the grandparent's contributions. The balance of each premium is paid by the grandchild, who obtains the funds through tax free gifts from the grandparent. Therefore, even though the grandparent supplies all of the premium dollars, no taxable gift occurs because the joint spousal gift tax exclusion can be used to shelter the arrangement from gift tax exposure. Nor is there a transfer for generation skipping transfer tax purposes. Once the premium payment period expires, the grandparents release $20,000 per year in tax free assignment gifts until the equity rolls over fully to the grandchild. At that point, the collateral assignment is released and the grandchild owns all policy values.

Any risk that the death benefit will be included in the insured grandparent's estate can be minimized by the use of a "bare bones," Rev. Rul. 82-145, collateral assignment. It confers no right to borrow, only the right to be reimbursed for premium advances. Or, estate tax risk can be eliminated by using an "unsecured" split dollar format. Alternatively, the split dollar plan can be set up directly between the grandparent's noninsured spouse and the grandchild. Private split dollar also works well when the child or the child's parent is the insured.

The potential for intergenerational family wealth transfer using private split dollar is attractive. It can transform a potential 140% transfer tax problem into a solution free of income tax, gift tax, estate tax, and generation skipping transfer tax.

Stock Redemption Split Dollar

Thousands of closely held businesses will change hands over the next decade and beyond. While many business continuation plans will be set up as stock redemptions, there are several drawbacks to the typical corporate owned life insurance approach:

* Alternative minimum tax exposure on corporate cash values and death benefits,

* Potential accumulated earnings tax as cash values boost retained earnings,

* Corporate cash values subject to attack by business creditors, and

* Stockholder cannot gain personal access to those cash values.

Stock redemption split dollar provides an alternative which creates numerous benefits for stock candidates:

* Extended term insurance to fund the corporate buyout,

* Significant amounts of cash value develop outside of the business and personal benefits free from corporate creditors,

* Growing tax free personal death benefits and cash values with no personal outlay,

* Term coverage reverts to permanent insurance, becoming available for personal planning purposes, and

* Income tax free capital transfer to stockholder supplements retirement income or permits "wait and see" cross-purchase funding.

The technique uses reverse split dollar with a prepaid premium account to solve each problem encountered by the stock redemption candidate while maximizing the business contributions. The corporation pays each annual premium in its entirety to the insurance company. For accounting purposes, an increasing part of each premium represents the corporation's current term insurance expense. The balance of each premium is booked on the financial records as a prepayment of future term costs for future corporate death benefits provided under the reverse split dollar agreement.

The executive owns the policy and assigns the death benefit to the corporation. The policy's cash value is also assigned to the business in an amount equal to the unapplied balance of its prepayments. Any remaining death benefit and cash value is retained by the executive. This technique allows the business to contribute the entire policy premium without generating current income taxation to the executive, since "overpayment" by the corporation in the early policy years is fully secured by a collateral assignment of the contract's cash value. If the insured executive survives to the end of the mutually agreed upon term period, the policy death benefit that had been temporarily assigned to the corporation reverts at that point to the insured-policy owner, who can use it to fund a "wait and see" cross purchase agreement, or for personal planning purposes.

Cross Purchase Split Dollar

While stock redemptions remain a viable option for business continuation arrangements, many stockholders prefer the cross purchase approach.

* Surviving shareholders achieve a step-up in the purchased stock's cost basis,

* Corporate surplus is not required,

* Corporate alternative minimum tax is avoided,

* There are no IRC Sec. 318 family attribution problems, and

* The insurance is sheltered from corporate creditors.

The problem with funding a cross-purchase agreement is that shareholders must pay life insurance premiums personally with after tax dollars. This is particularly difficult for younger generation owners, who must pay large premiums on policies insuring their older co-shareholders.

Cross purchase split dollar may provide the answer. It supplies full funding for the buyout at no after tax cost to the policy owner. It also creates a sinking fund to satisfy lifetime buyout needs on a tax favored basis.

Using this technique, a younger shareholder can purchase full buy-sell coverage on an older shareholder's life, then implement a lifetime buyout with tax free dollars by withdrawing basis out first and then switching to loans. This is accomplished at little after tax cost and without impairing the policy's viability, because an interest free demand note is used to terminate the split dollar arrangement. Tax is payable on imputed interest only, pursuant to IRC Sec. 7872.

Impaired Risk Split Dollar

The more impaired the risk, the more split dollar makes sense. No matter how large the premium, it is never taxed to the insured. The executive's only cost is tax on the "P.A. 58" term alternative.

Using an endorsement split dollar format in which the business owns the policy and provides protection to the executive via an endorsement of the policy's death benefit, the corporation achieves immediate and full cost recovery of its entire premium advance at death. It also owns all of the policy's cash valueÑeven when that amount exceeds the company's cumulative premium outlay. The IRC Sec. 72(e) tax free values remain available to the company at all times for business emergencies or opportunities. By owning all the cash value under this plan, the corporation's higher premium contributions created by the executive's medical impairment will be offset. The executive receives term insurance protection at standard rates regardless of health impairment, because the rates used to measure the executive's economic benefit are the insurance carrier's one-year-term insurance charges used for P.S. 58 substitute purposes.

Group Carve Out Split Dollar

When it comes to providing substantial death benefit protection for business owners and key executives, group term life insurance has several drawbacks:

* IRC Sec. 79 nondiscrimination restrictions preclude targeted benefits based on needs,

* Protection disappears at retirement or is convertible at the carrier's highest rates,

* Term costs generally increase based on the group's overall age and medical history,

* Executives develop no equity, and

* Benefits are perceived as passive and are unappreciated.

Planners who counsel business owners should become familiar with group carve out split dollar. Carving out the management team, which is usually an older and, therefore, higher cost group of participants, from the group life plan can reduce employer term costs for the rank and file. These savings are then redirected to fund permanent protection for the management group. The result is as follows:

* Any additional employer costs are fully recovered, usually with a significant overall gain, and

* Executive costs drop dramatically, yet the plan creates permanent protection with substantial equity.

A collateral assignment plan giving the insured current protection with growing tax free equity will help attract and retain the most talented executives. For those employees who show promise but whose best contributions are yet to be made, the endorsement plan makes great sense, since this method permits the business to own the policy and its cash values, even when those values exceed the corporation's cumulative premium advances. Either way, split dollar is the key dimension which makes it an affordable proposition to the firm to carve out the key executive group.

S Corporation Split Dollar

There is a common misconception among some professional advisors that split dollar doesn't work in an S corporation. Yet, in the right circumstances, split dollar can provide numerous benefits, not just to the shareholders, but to the S corporation itself: When an S corporation enters into a split dollar agreement with one of its shareholders, the entity enjoys cash value buildup and death benefit cost-recovery withÑ

* no alternative minimum tax,

* no accumulated earnings tax, and

* no flow-through taxation to the shareholders.

Split dollar can also provide gift tax leverage for insured shareholders. This is because third party owned split dollar plans entered into with S corporations benefit from the same Rev. Rul. 78-420 gift tax treatment described earlier. Accordingly, even if the corporate paid premiums are income taxed to the insured shareholder, the gift tax benefits can still provide substantial transfer tax leverage. This is because the shareholder does not gift entire policy premium to the third party policy owner. Instead, the shareholder gifts only the one-year term insurance amount used to measure the economic benefit provided under the split dollar arrangement.

Since the TRA '86, it has become more and more difficult for taxpayers to shift income to lower bracket tax pockets. When S corporations make premium advances under a split dollar agreement, the income applied flows through and is taxed to the shareholders pursuant to their respective stock ownership percentages. Therefore, in family owned companies, a significant portion of each split dollar premium payment made by the S corporation is income taxed to lower generation family members. This is completely consistent with the estate planning objectives of senior members. Furthermore, to the extent that the S corporation borrows policy cash values, whether to pay premiums or otherwise, the policy loan interest payments generate income tax deductions which also flow through to the personal benefit of the shareholders. Many observers believe that the $50,000 per insured policy loan interest deduction limitation provided under IRC Sec. 264 can be increased to $100,000 when loans are taken against a survivorship (second-to-die) policy. Considerable tax efficiency can result particularly when there are several insured shareholders. And, of course, split dollar works very well in the traditional manner with respect to nonowner key executives' personal insurance needs. *

Editor:
Milton Miller, CPA
Consultant

Contributing Editors:
Andrew B. Blackman, CFP, CPA/PFS
Shapiro & Lobel LLP

David R. Marcus, CPA
Paneth Haber & Zimmerman

SEPTEMBER 1995 / THE CPA JOURNAL