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Ask About Split Dollar Life Insurance

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By | May 25, 2012

Dear Toolkit,

Since I'm a new Dad I think I need some life insurance, and one of my colleagues suggested I hit my employer up for a split-dollar policy (whatever that is) as that'd be the only way I could afford sufficient coverage, or so he says. Can you clue me in?

Thanks,

Perplexed Parent

Dear Perplexed,

I must say your question is quite timely inasmuch as the IRS has issued some post-Enron rules on split-dollar policies. But, with all due respect to your colleague, I think there are many other insurance options you should investigate in addition to split-dollar. Once you've waded through this treatise on split-dollar arrangements, check out my previous column on life insurance and you'll find many more choices.

Individual, permanent life insurance is a luxury few can afford to buy with after-tax dollars. Split-dollar life insurance was developed as a way to fill this gap. The term split-dollar comes from the fact that the premiums for the life insurance policy on an employee are split between the insured employee and his or her employer. In the most traditional form of split-dollar, the employer pays the portion of the premium that relates to the yearly build-up in the cash value, while the employee pays the portion that relates to the term (pure insurance) protection.

Split-dollar insurance, prior to September 17, 2003, was an important benefit for the employee and, ultimately, it cost the employer nothing. The premium costs paid by the employer were recouped by sharing the death benefit with the insured's beneficiary or by the employee's purchase of the employer's premium costs (and hence the policy) at retirement. This type of policy required no IRS approval and an employer could select for (or exclude from) participation anyone it chose. Thus, it was a good way to cover owners and any co-owners or key employees.

The advantages included:

  • low-cost insurance protection
  • a way to get money out of your business since life insurance proceeds are tax-exempt
  • a way to prevent un-insurability in later years due to illness
  • the ability to extend coverage after retirement, paying the employer the total of its contributions over the years by getting a loan using the policy as collateral
  • a way to base the premium cost on your age at date of issue rather than on age at the date the policy would be purchased from the employer.

If the employer paid the employee's part of the premiums and called it a bonus to the employee, the cost could be deducted by the business, but it was taxable compensation for the employee.

As of September 17, 2003, no doubt another result of the Enron debacle, new regulations were issued for split-dollar arrangements going forward. The final regulations provide that the tax treatment of split-dollar life insurance arrangements will be determined under one of two sets of rules, depending on who owns the policy.

If the employee owns the policy, the employer's premium payments are treated as loans to the employee. Consequently, unless the employee is required to pay the employer market-rate interest on the loan, the employee will be taxed on the difference between market-rate interest and the actual interest.

If the employer is the owner, the employer's premium payments are treated as providing taxable economic benefits to the employee. The economic benefits include the employee's interest in the policy cash value and current life insurance protection.

An IRS guidance bulletin was issued early in 2008 regarding modifications to split dollar arrangements that basically indicates a post 2003 modification of the arrangement that doesn't modify the underlying insurance will not be treated as a material change.

I'm confident this is more than you or anyone else wants to know about split-dollar arrangements, but it could prove to be critically important information to some folks due to the recent changes mentioned above. Be sure to check out my previous column outlining some simpler options.

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