Not a type of insurance policy, per se, a business split-dollar life insurance plan is used by a business when an arrangement allocates that a life insurance policy benefits and premium costs are made between an employer and a valued employee.
Typically, an employer assists certain employees in purchasing a business split-dollar life insurance plan. The employer pays all or a portion of the premiums. In the event of an untimely death of the employee, the employer ultimately receives the benefits from the policy. If the policy is not used during the premium and benefit sharing arrangement, the employee has received life insurance at a reduced out-of-pocket cost, while the employer recovers his share of the premium costs from the policy’s cash value or death benefit.
The Two Different Types of Split-Dollar Life Insurance Plans
Under this type of life insurance plan, an employer and employee agree to split the premiums and benefits of a life insurance policy. The type of split-dollar arrangement determines how the policy benefits are allocated.
- Equity Split-Dollar Plan – Under this plan, the employee receives an interest in the policy’s cash value that is not equal to the employee’s share of the premium payments. However, the employer pays more of the premium cost.
- Non-Equity Split-Dollar Plan – Under this plan, the employer typically provides the employee with current life insurance protection, but the employee has no claim to any of the policy’s cash value.
The tax treatment of the split-dollar arrangement is taken into account, since the goal of a business-split dollar life insurance plan is to provide a key employee with life insurance policy benefits at a reduced out-of-pocket cost.
Tax Treatment of Split-Dollar Life Insurance Plans
The ownership of the life insurance policy on the employee’s life is the main determinate as to which tax regimes will apply to the split-dollar plan. There are two different regimes of a split-dollar life insurance plan:
Economic Benefit Regime (Endorsement Split-Dollar Plan)
Under this plan, the employer owns the life insurance contract. He then advances the money to pay the premiums. The employee then is allowed to name a beneficiary for the policy’s death benefit through means of an endorsement to the life insurance contract. The employee is taxed on the value of the economic benefits received in each taxable year.
Loan Regime (Collateral Assignment Split-Dollar Plan)
Instead of the employer owning the life insurance contract, the employee is the owner. He then names a personal beneficiary and assigns the policy as collateral to the employer. In return, the employer pays the premium payments.
In the event of the employee’s death, the employer receives a portion of the death benefit and the remainder is given to the beneficiary. If the policy is surrendered, the employer receives the total premiums paid, up to the policy’s cash surrender value and the employee receives any remaining cash surrender value.
When the payment of premiums paid by the employer for the life insurance contract owned by the employee, it is treated as a series of loans to the employee. Unless the employee pays the employer the current market-rate interest on the loans, the employee is taxed each year on the difference between the market-rate interest and the actual interest paid.
Federal and state law should be verified to determine if there are any restrictions on corporate loans to employees, shareholders, or officers, before implementing a collateral assignment split-dollar plan. This is due to the employer’s premium contributions being considered a loan to the employee. Publicly-held corporations should consult their securities counsel on the impact of collateral assignment split-dollar plans under the Sarbanes-Oxley Act of 2002.
Due to the complexity to a split-dollar life insurance plan, a professional tax advisor should be consulted in the administration and design in order to avoid any unintended tax consequences.
Traditional Split-Dollar Life Insurance Plan
In a basic version of the split-dollar life insurance plan, the employer agrees to pay a portion of the annual premium equal to the annual increase in the policy’s cash value, while the employee pays the remainder of the premium. The employee’s portion of the annual premium payment will gradually lessen over time due to the annual increase of the life insurance policy’s cash value becoming larger each year. For example:
- At year 1, the annual premium is $2,000 and the annual increase in cash value is $250. The employer pays $250 and the employee pays $1,750.
- At year 2, the annual premium remains $2,000, while the annual increase in cash value increases to $1,000. The employer pays $1,000 and the employee pays $1,000.
- At year 3, the annual premium remains $2,000, while the annual increase in cash value increases to $1,400. The employer pays $1,400 and the employee pays $600.
- At year 4, the annual premium remains $2,000, while the annual increase in cash value increases to $1,450. The employer pays $1,450 and the employee pays $550.
- At year 5, the annual premium remains $2,000, while the annual increase in cash value increases to $1,500. The employer pays $1,500 and the employee pays $500.
Depending on who owns the policy, the employee will either report the value of the economic benefits received each taxable year as income.
In the event that the employee dies or surrenders the policy, the employer recovers the total premiums paid with the balance of the proceeds going to the chosen beneficiary at death or to the employee when the policy is surrendered.
Any premiums that are contributed to an endorsement split-dollar plan by the employee must be recorded as income to the employer.
Variations to Premium Sharing
In addition to the complexity of split-dollar plans, there are variations in premium sharing. Some of these variations include:
- Employer pay all split-dollar
- Level outlay split-dollar
- Economic benefit split-dollar (Endorsement plan only)
- Bonus split-dollar (Endorsement plan only)
- Bonus split-dollar (Collateral assignment plan only)
Due to the complexity of split-dollar plans, any employer interested in providing life insurance for their employees should seek the advice of a qualified financial planner or tax professional.