How Split-Dollar Life Insurance Works

Split-dollar life insurance is a strategy that allows the sharing of the cost of a premium for a permanent life insurance policy. They are often a key part of an executive compensation package and can provide a benefit to both the employer and employee.

What Is Split-Dollar Life Insurance?

In a split-dollar plan, an employer and employee execute a written agreement that outlines how they will share the premium cost, cash value, and death benefit of a life insurance policy. Split-dollar plans are frequently used by employers to provide supplemental benefits for executives and to help retain key employees.

The agreement lays out what the employee needs to accomplish, how long the plan will stay in effect, and how it will be terminated. It also includes provisions that restrict or end benefits if the employee leaves the job or fails to hit agreed-upon performance metrics.

Since split-dollar plans are not subject to Employee Retirement Income Security Act (ERISA) rules, there is more latitude in how agreements can be written. However, they must still adhere to specific tax and legal requirements.

Split-dollar plans also require record-keeping and annual tax reporting. Generally, the owner of the policy, with some exceptions, is also the owner for tax purposes. Premium payments made by the employer are considered taxable benefits paid to the executive. Limitations also exist on the usefulness of split-dollar plans depending on how the business is structured (for example as an S Corporation, C Corporation, etc.) and whether plan participants are also owners of the business.

Benefits of Split-Dollar Plans

Split-dollar plans have been around for years. In 2003, the IRS published new regulations which outlined two different acceptable split-dollar arrangements: economic benefit and loan. While some tax benefits were removed that year, split-dollar plans still offer advantages such as:

• Use of corporate dollars to pay for personal life insurance: Plans can leverage the benefit, especially if the corporation is in a lower tax bracket than the employee is.
• Low-interest rates: Low interest rates are available if the applicable federal rate (AFR) is below current market interest rates when the plan is implemented. Plans with loans can maintain the interest rate in effect when the plan was adopted, even if interest rates rise in the future.
• Tax benefits: Options to help minimize gift and estate taxes.

Economic Benefit Arrangement

Under the economic benefit arrangement, or economic benefit regime) the employer is the owner of the policy, pays the premium and endorses or assigns certain rights or benefits to the employee. The employee is allowed to designate beneficiaries who would receive a portion of the policy death benefit. The value of the economic benefit the employee receives is calculated each year.

Loan Arrangement

The loan arrangement, or loan regime, is more complicated than the economic benefit plan. Under the loan arrangement, the employee is the owner of the policy and the employer pays the premium.

The employee gives an interest in the policy back to the employer through a collateral assignment. A collateral assignment places a restriction on the policy that limits what the employee can do without the employer’s consent. A typical collateral assignment would be for the employer to recover the loans made upon the employee’s death or at the termination of the agreement.

The premium payments by the employer are treated as a loan to the employee. Technically each year, the premium payment is treated as a separate loan. Loans can be structured as term or demand and must have an adequate interest rate based on the AFR.

Terminating Split-Dollar Plans

Split-dollar plans are terminated at either the employee’s death or a future date included in the agreement (often retirement). 

At the premature death of the employee, depending on the arrangement, the employer recovers either the premiums paid, cash value, or the amount owed in loans. When the repayment is made, the employer releases any restrictions on the policy and the employee’s named beneficiaries, which can include an ILIT, receive the remainder as a tax-free death benefit. 

If the employee fulfills the term and requirements of the agreement, all restrictions are released under the loan arrangement, or ownership of the policy is transferred to the employee under the economic benefit arrangement.

Depending on how the agreement was drafted, the employer may recover all or a portion of the premiums paid or cash value. The employee then would own the insurance policy. The value of the policy and premiums payed by the employer are taxed to the employee as compensation.

The Bottom Line

Like many non-qualified plans, split-dollar arrangements can offer several benefits as a financial tool for employers looking to provide additional benefits to key employees. Employees can take advantage of an employer's assistance with the premium. Consider consulting an attorney or tax advisor when drawing up the documents.