Split dollar plans have historically been based on an arrangement in which two parties, typically an employer and an employee, share the premiums, cash value, and death benefit of a life insurance policy. The employer tended to pay the bulk of the premium, and in return was assigned an interest in the cash value and death benefit, generally equal to the cumulative premiums paid. This type of arrangement is known as “equity” split dollar because the owner of the policy was obligated to repay only the cumulative premiums, while retaining any equity or gain in the policy.

It is no longer possible to enter into a new equity split dollar arrangement, due to the Final Split Dollar Regulations, which went into effect on September 18, 2003. Split dollar arrangements entered into prior to September 18, 2003, however, can remain intact unless they are materially modified.

IRS Notice 2002-8, which governs equity split dollar arrangements entered into prior to the Final Split Dollar Regulations, essentially provides two major “safe harbor” rules:

1. As long as the parties to the arrangement continue to annually account for the economic benefit costs, the IRS will not attempt to tax the equity buildup. Due to this safe harbor rule, “equity” may never be taxable as long as the equity split dollar arrangement remains in place until the death of the insured(s).
2. As long as the equity split dollar arrangement was terminated prior to January 1, 2004, the IRS will not attempt to tax any equity that may have existed at the time of termination. This safe harbor rule implies that if an arrangement was not terminated by that date, then the IRS may assert that any equity is taxable in the event the arrangement is terminated during the lifetime of the insured(s), subsequent to December 31, 2003.

Although the latter safe harbor rule implies that equity will be taxed upon termination, the Notice stipulates that “no inference should be drawn from this notice regarding the appropriate Federal income, employment and gift tax treatment of split dollar life insurance arrangements entered into before the date of publication of final regulations.”

Assessing the Options

Clients who did not take advantage of the expired safe harbor date for terminating their arrangements basically have three options:

1. Continue the arrangement until the death of the insured(s) and continue to account for the annual economic benefit costs.
2. Terminate the arrangement and pay income and/or gift tax on any equity. If there is currently no equity, one strategy would be to defer terminating the arrangement until just before the first dollar of equity accrues.
3. Terminate the arrangement based on the “no inference” language above and assert that the laws governing split dollar prior to Notice 2002-8 do not permit the equity to be taxed upon termination of the arrangement. This strategy subjects the client to the risk of an IRS audit and the potential that it will attempt to tax the equity.

A Split-Dollar Case Study

The following case study serves as an analysis of the relative advantages for clients to continue with their equity split dollar arrangements or terminate them and pay any taxes due.

Mr. and Mrs. Wealth, both age 60, have an equity split dollar arrangement that was entered into 11 years ago between Mr. Wealth’s company and their irrevocable life insurance trust (ILIT). The ILIT is the owner of an $8 million survivorship policy on the Wealths with an annual premium of $75,000, which is projected to be no longer payable. Cumulative premiums paid by the Company for the policy are $825,000 and the current cash value is $1.1 million. That means that the arrangement has $275,000 ($1,100,000 - $825,000) of equity.

The Wealths did not take advantage of the December 31, 2003 safe harbor date. They are now in the process of trying to determine whether to terminate the split dollar arrangement or continue it as is. The Wealths have already used up their lifetime exemptions, and would prefer not to have $275,000 of additional taxable income and gifts if they terminate the split dollar arrangement this year. However, they are willing to incur those costs if it is in their best interest to do so.

In order to properly advise the Wealths, it is important to ascertain the consequences of keeping the current split dollar arrangement in place. The Wealths will continue to incur income and gift taxes from the annual economic benefit costs, which will increase each year. Table A shows the possible economic benefit costs in five-year increments. Column [1] shows the costs based on their insurer’s current joint term rates. Because it is possible that guidance could be issued disallowing the continued use of the insurer’s rates, column [2] shows the joint Table 2001 rates. 

Table A
Annual Joint and Survivor Economic Benefit Costs

Assuming that an insurer’s alternative term rates will continue to be allowed for purposes of economic benefit reporting, one could conclude that keeping the arrangement in place until the death of the second insured is a viable strategy. The economic benefit costs do not appear to become problematic, if at all, until the clients are in their mid-90s.

However, these joint rates can only be used so long as both insureds remain alive. What is more likely to happen is that one insured will die before the other, at which time single life rates must be used for economic reporting purposes. To further the analysis, let’s assume that Mr. Wealth dies at age 75.

Table B
Annual Economic Benefit Costs (Assumes Mr. Wealth Dies at Age 75)

IF ONLY THE AGE 75 Line is supposed to be shaded, try shading the entire row to make it stand out…

Clearly, the economic benefit costs increase dramatically upon the death of the first insured (Table B, Columns [3] and [4]) and potentially become problematic as early as the surviving insured’s early 70s. The costs would be even higher if Mrs. Wealth died before Mr. Wealth, as the male rates are even higher.

So what is likely to happen if the above costs were to become reality? In all likelihood, Mrs. Wealth would call her advisor to ask how to get out of the arrangement in order to avoid onerous economic benefit costs. If the arrangement is terminated in the future, when the economic benefit costs become prohibitive, the equity in the arrangement at that time becomes income and/or gift taxable, and the equity is likely to be considerably larger than it is today.

As the case study illustrates, the risk of keeping an existing equity split dollar arrangement in place is that the longer an insured lives, the greater the economic benefit costs become, and the costs can eventually become prohibitive. The tax consequences of terminating the arrangement at the point that the economic benefit costs become prohibitive may be extremely harsh from an income and/or gift tax standpoint. In many cases, it might be more advantageous for clients to terminate their arrangements now and accept the tax consequences, even though they missed the safe harbor date.

Although there are exceptions, such as clients who do not have a family history of longevity or who are not in good health, it is essential that clients fully understand the risks involved with continuing their existing split dollar arrangements so that they can make an informed decision as to what to do today.

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Keith Buck, JD, LLM, CLU, FLMI , National Financial Partners, is vice president, Strategy Research & Development. Buck holds the Chartered Life Underwriter designation from The American College and the Fellow, Life Management Institute designation. He has had several articles published in various industry publications and is a frequent speaker on a variety of estate and business planning topics.