Split dollar life insurance plans have been around a long time and many owners of closely-held and family-owned business owners have heard about them, but what are they and how can they be beneficial to closely-held and family-owned businesses as well as their owners and key employees?
A split dollar life insurance plan is an arrangement whereby the cost of premiums of a permanent life insurance policy and the economic benefits of the policy are allocated among a closely-held and family-owned corporation, LLC, LP, or other entity (the “business”) and a key employee, owner, director, officer, or other person (the “key person”) of such business so as to maximize tax advantages for both parties. These plans are attractive to closely-held and family-owned businesses as well as their owners and key persons for several reasons. For instance, many of these businesses are owned by a family and it may be the intent of the founders and the current owners that the business continue to be owned only by family members and not other persons (no matter how loyal and essential to the business such other persons may be). Additionally, ownership in a closely-held or family-owned business although potentially valuable, is highly illiquid and may not provide any other economic benefits (such as the payment of dividends) for a key person who is no longer being compensated by the business. Finally, the existence of an insurance policy provides a level of security for a key person who wants to ensure their family and dependents have resources in the event of the key person’s death.
Although a split dollar insurance plan may be used in many contexts, there are many reasons why a split dollar life insurance plan is particularly well-suited for a closely-held or family-owned business. Such reasons, although varied, stem from the lack of marketability of an ownership interest in a closely-held or family-owned business (and, therefore, a lack of liquidity for the owner of such an interest) and an almost universal desire of every owner of a closely-held or family-owned business is that the ownership of the ongoing business continue to be restricted to a specific group of persons. The reasons may include a need to fix a funding source for a financial incentive granted to a key person, the need to fund buyout arrangements entered into among the key person and/or owners, or a need to provide liquidity for the success of a key person’s or an owner’s estate and business succession planning.
The structure of a split dollar insurance plan is driven largely by both the specific economic goals and objectives of the business and the key employee as well as the tax consequences resulting to each party.
An initial structuring consideration is the proper classification of the individual who is involved in ownership of the business and who is benefiting from the policy – the individual receiving such benefits as an owner of the closely-held or family-owned business or as an employee of such business. For instance, a key person who receives a policy benefit as an employee is treated as having received regular income and is taxed accordingly at current ordinary income tax rates. In contrast, a key person who receives a benefit as an owner may be treated as having received a dividend or a return of capital and accordingly may be taxed at more favorable rates. Another initial structuring consideration is determining the federal tax classification of the business which is a party to the arrangement – such as a C corporation, an S corporation, or a partnership. For an owner of a business classified as a C corporation, a policy benefit is taxed as a distribution to the extent the corporation has earnings. The same is true for the owner of a business classified as an S corporation, but because an S corporation is a “pass through” entity for deferral tax purposes, earnings are passed-through to the owner and realized as after tax income. The tax treatment of a policy benefit for an owner of a business classified as a partnership is not clear because an owner in a partnership (a partner) cannot be an employee of the business.
As stated above, in a split dollar life insurance plan the costs and the benefits of the permanent life insurance policy are allocated among the parties to the arrangement as specified in the plan. The plan will state who (the business or the key employee) will pay the policy premiums. The plan may provide that the business pay the policy premiums and the key person pay nothing. Alternatively, the plan may provide that the key person pay a specified portion of the policy premiums which relate to the portion of the benefits received by the key person. For instance, if the policy subject to the plan is a whole life policy, the plan may specify that the key person pay the cost of term insurance – which would likely be far less than the cost paid by the business on the whole life policy subject to the plan. In this way, the business retains the cash value building in the policy and may also be allocated some portion of the death benefit to reimburse the business for the policy premiums paid by the business. Further, if the policy subject to the plan is a whole life policy, the plan will also state who will have access to the cash value which builds in the policy. For example, the plan may specify that the business will receive an amount equal to the total policy premiums paid and the key person will receive the policy’s cash value in excess of such amount. Additionally, the plan will specify who will receive the death benefit. In this connection, the plan may specify that upon the full vesting of the benefit (perhaps a specified number of years of continuous employment with the business) the key person will be entitled to receive the death benefit. The plan will also specify who will make various policy related decisions. As you can see, these plans provide a great deal of flexibility and therefore can be adapted to a wide-range of desired outcomes.
A split dollar life insurance plan must also address the ownership of the policy made by the subject of the plan. This issue is typically dealt with using one of two accepted structures. Under the first, the business may retain the ownership of the policy and pay the policy premiums, but endorse to the key person the portion of the death benefit that is in excess of the greater of the premiums paid or cash value of the policy. This plan structure requires that the value of the “economic benefit” retained by the business must be determined so that the economic benefit to each party (the business and the key person) and the resulting tax consequences are properly allocated. Currently, there are two methods for determining such value; however, a discussion of those methods is beyond the scope of this article. The second accepted structure involves the “collateral assignment” of the policy to the key person. Using this structure, the business would pay the policy premiums, but the key person or an irrevocable trust established for the benefit of such key employee (providing a potential asset protection benefit) would own the policy (although the business would retain a security interest in the policy until the “loan” of the total amount of the policy premiums is repaid to the business).
For more information about how a split-dollar insurance plan can work for your business, please contact Frank L. Leffingwell a tax attorney in the firm’s Tax Planning & Controversy, Estate Planning, Probate & Trusts, and Real Estate sections.