Protect Your Business with a Split-Dollar Life Insurance Plan

Certain employees are extremely valuable to a business due to their knowledge, skill set, or investment in the company.  Therefore, arming these employees with life insurance can protect a business that may suffer financial loss if the employee becomes unable to work due to disability or death.

The Mechanics of a Business Split-Dollar Life Insurance Plan

A business may choose to assist certain employees in purchasing personal life insurance with dollars that the business can ultimately recover.

  • First, the business enters into an agreement with selected employees that spells out the rights and responsibilities of all parties involved.
  • The business and employee contributes an agreed upon portion of the premium payments.
  • Based on the ownership and beneficiary arrangements of the life insurance policy, the selection of the collateral assignment or endorsement method is chosen.
  • At this point, the employee may have to pay income tax on the economic benefit received or on the interest from the employer’s premium loans.
  • If the employee dies, the business is entitled to receive the total of the premiums paid, from the death benefit.  The beneficiary named by the employee receives the balance of the death benefit.
  • The business is normally entitled to the cash surrender value from the policy if it is surrendered prior to the employee’s death.

Tax Results of an Endorsement Split-Dollar Life Insurance Plan

For business owners, the tax implications may be a bit perplexing.  However, this often-confusing area can be explained in detail by a qualified financial advisor.  Some of the points covered include:

  • The premium paid by the business or employee is considered tax deductible.  However, if a bonus is paid to the employee by the business to the employee that is connected with an endorsement split-dollar insurance plan, the business may use that expense as a tax deduction.  
  • Because the employee receives an economic benefit from the business contribution in the plan, it is taxable to the employee.  However, this amount may be reduced considerably or eliminated entirely from the premium payment from the employee.
  • Any premiums that are made to an endorsed split-dollar plan by the employee are considered income to any employer.
  • In the case of a corporation, there are corporate alternative minimum tax implications on the policy’s cash values.
  • Generally, any proceeds from the life insurance policy received by the beneficiary and the business are not subject to federal income tax.  
  • If the employee has not paid for any portion of the life insurance protection, the death benefit proceeds are paid to the employer and are taxed when paid to the beneficiary.
  • Any death benefits paid to the beneficiary is then included in the deceased employee’s estate.  However, due to nuances in third-party transfer rules, the proceeds may be removed from the deceased employee’s estate.

A Reportable Economic Benefit Worksheet

For income tax purposes, any employee who receives an annual economic benefit from an endorsement split-dollar life insurance arrangement must include it as part of their gross income.

To determine the value of the economic benefit that is reported as income to the employee:

  • First, take the total death benefit and subtract the total amount payable to the policy owner/employer including any outstanding loans on the policy that offsets amounts that are otherwise payable to the owner.
  • Next, subtract the portion of the cash value to which the employee has current access.
  • The difference is equal to the current life insurance protection that is provided to the employee.
  • This amount is then added to the value of any other benefits that were provided to the employee.
  • The sum is equivalent to the total value of the economic benefits on which the employee must pay income tax.

Summary of Tax Results of a Collateral Assignment Split-Dollar Plan

Consulting a professional tax advisor when considering a split-dollar plan in the administration and design process in order to avoided any unintended tax consequences.  It is important to remember:  

  • No portion of the premium on the split-dollar plan is tax deductible by either the business or employee.  However, if there are any bonuses paid to the employee that are in connection with the split-dollar insurance plan, the business may use them as a tax deduction.  The employee, then, has to report the bonus as income.
  • If the loan’s interest rate is below-market, the loan is characterized as a loan with interest and the employee must report the loan as taxable income.
  • Interest on a split-dollar loan paid by the employee to the employer is not deductible by the employee.
  • Generally, life insurance proceeds received by the employer and the beneficiary of the life insurance proceeds are not subject to federal income tax.
  • The deceased employee’s estate includes any death benefit paid to the employee’s beneficiary if the employee held any incidents of ownership.  Once the three-year rule is satisfied, if the policy ownership is transferred to a third party, the proceeds may be removed from the estate of the decedent.  

A Checklist for a Business Split-Dollar Life Insurance Plan

First, decide which employees are going to participate in the plan.  Determine the insurance amounts and the premium sharing methods, in addition to the ownership arrangements.  Next, select the type of life insurance funding vehicle.  Then, establish the insurability of each participating employee.  Finally, arrange for the premiums to be paid.

In the short-term, draft and execute a split-dollar agreement along with the resolution that authorizes the plan.  Be sure to review the policies that have been issued.  Verify the ownership and beneficiary designations.  Then, set up a system to pay insurance premiums when they become due and how taxes or interest payments will be reported.

In the long-term, review that plans remain current with an annual review.  The final step is to consider and evaluate other employee benefit planning needs.

Once these steps are in place, a business is more financially stable in the event that a key employee needs to be replaced due to death or disability.

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