Split-dollar life insurance is a grand plan that enables the exchange of premium expenses and additional benefits to offer benefits for employers and workers. It is an executive compensation package used frequently to help employers lure and obtain key personnel.
In addition, it offers personal financial protection for anyone within the policy by enabling them to establish their own cash value or aiding them to easily afford life insurance protection. As it provides positive ways of effectiveness for businesses and people, it can be developed to plan financially for the future.
What is Split-Dollar Life Insurance?
Split-dollar life insurance is a negotiation between an employer and an employee, commonly found in executive compensation packages. The employer covers the life insurance premium, either entirely or partially, for a cash-value life insurance policy held on the employee’s life.
Typically, the employer has control over the cash value and the death benefit, limited to the premiums paid by the employer. Occasionally, the employer sets aside an amount greater than the actual premiums.
Some split-dollar setups grant the employee rights to any cash surrender value exceeding the employer’s contribution. If the employee contributes to the plan, their beneficiaries may be entitled to a portion corresponding to the employee’s premium payments.
Lastly, it can be eliminated in two different ways. This includes the employee’s death or the conclusion of the agreement. While the predominant application of split-dollar life insurance plans occurs in business scenarios involving employers and employees or corporations and shareholders, there are alternative setups.
These plans can extend to arrangements between individuals, referred to as private split-dollar, or between an individual and an irrevocable life insurance trust (ILIT).
How Split-Dollar Life Insurance Works
As stated, split-dollar life insurance begins with a contract or agreement between an employer and employees. However, these steps concern mainly a company or group split-dollar agreement instead of a private split-dollar agreement.
In a company split-dollar agreement, both the employer and the employee agree to outline the distribution of the death benefit between the employer and the employee. This method describes the procedures for accessing cash (if applicable) and specifies the exit mechanisms for each party involved.
Types of Split-Dollar Life Insurance
However, these regulations lead to the offering of two types of split-dollar life insurance agreements. These types include economic benefit arrangement and loan arrangement.
• Economic Benefit Arrangement
In an economic benefit arrangement, the employer is considered the owner of the policy. It covers the premium and shares rights and benefits with the employee.
In this arrangement, the employee is enabled to choose beneficiaries to receive a share of the policy’s death benefit. The annual calculation determines the value of the economic benefit extended to the employee.
• Loan Arrangement
The loan arrangement presents a more complex structure compared to the economic benefit plan. In addition, the employee is regarded as the owner of the policy, while the employer covers the premium expenses.
The employee presents an interest to the employer in executing a collateral assignment. Furthermore, collateral assignment sets a restriction to limit certain actions of the employee without the employer’s approval.
Additionally, the collateral assignment is assigned to the employer to recover the loans upon the employee’s death or termination of the agreement. Premium payments made by the employer are regarded as loans to the employee.
Each year, these payments are regarded as separate loans. These loans can be structured as term or demand loans. And they are obligated to carry an appropriate interest rate in accordance with the Applicable Federal Rate (AFR).
Benefits of Split-Dollar Life Insurance
Split-dollar life insurance has been around for years. However, the IRS issued new laws that highlighted two various split-dollar life insurance arrangements. Nevertheless, split-dollar still offers benefits for both employer and employee, which include:
• Employer Benefits
Initially, the employer authorizes flexibility in the agreement for each covered person, and the business obtains the cash value and death benefit for its contribution. In addition, it reduces the overall cost and also offers insurance benefits to the employee.
• Employee Benefits
Additionally, the employee achieves a discount for death benefits or a cash value increase depending on the employer contribution.
• Tax Benefits
Generally, a corporation can’t obtain a tax deduction for premium payments associated with a split-dollar agreement. Nevertheless, if the employer opts to furnish cash value to the employee in the future, the employer can claim a deduction to deduct the compensation provided.
In the economic benefit regime, the employee pays a tax for the benefit they can control. Conversely, the premiums paid by the employer are regarded as a loan to the employee. Lastly, the employee will cover taxes on the interest associated with this loan.
• Low Interest Rates
Within the loan regime for split-dollar agreements, it is requested that the employer pay interest on the loan granted to the employee. Frequently, the calculation of interest for these loans involves the use of the applicable federal rate (AFR).
The AFR represents the minimum rate at which the employer can apply for a genuine loan. It typically falls below prevailing market interest rates.
How Split-Dollar Life Insurance Plans Are Terminated
Split-dollar plans are eliminated at the earlier of either the employee’s demise or the specified elimination date highlighted in the agreement. The elimination of these plans typically occurs through three common methods:
• The Employees Death
If the death of an employee happens while the agreement is in effect, the employer either reclaims the premium payment, cash value, or debt. However, the employee recipient obtains the remains of the tax death benefit.
• The Agreement Terms End
Within the loan regime agreement, the employee accomplishes the terms of the agreement by releasing all collateral as stated in the agreement. Moreover, within an economic benefit plan, the employee assumes ownership of the policy as an additional benefit.
Furthermore, these situations could create an income tax for the employee, which can be deductible by the employer.
• One Party Chooses to Terminate
By choosing to quit the plan at the end of the agreement, the employer could decide to reclaim all shares of the premium payment or cash value. In addition, the insurance policy will assume ownership by the employee.
The employee sustains income tax on the value of the policy, while the employer has the potential to claim a deduction for this amount.
A well-planned split-dollar plan is a valuable, non-qualified arrangement offering notable advantages to all involved parties. Additionally, employees can receive additional benefits and, in turn, benefit from the employer’s contributions to premium payments.
To ensure proper performance, it is advisable to collaborate with a knowledgeable insurance agent and a financial advisor when establishing these plans.