It's not often that a complex IRS ruling actually clears the air, but in the case of split-dollar arrangements, that's exactly what happened. It's been five years since the Internal Revenue Service rocked split-dollar's boat by issuing Notice 2002-8--revoking the previous year's Notice 2001-10. Many life insurance practitioners liked the new ruling because it eliminated a lot of uncertainty--some caused by Notice 2001-10, some that had been hanging around since the first split-dollar life insurance purchasing arrangement hit the books.
Finally, insurance practitioners could see clearly. Direct from the IRS, it was two thumbs down--way down--on so-calledequity split-dollar, two thumbs up on private split-dollar, and two regimes for calculating the gift-tax consequences of splitting the dollar. "Although the rules are complex, at least we know what they are," says Jeffrey Tegeler of Minneapolis-based Garrity, Tegeler and Varley Wealth Strategies. "And 2002-8 legitimized some techniques that only had private letter rulings to support them, private split-dollar in particular."
In the simplest terms, split-dollar--a method of buying life insurance, not a type of insurance policy--contracts two or more parties to split one or more elements of a life insurance policy, including the death benefit, the cash value and the premium. In a business context, the split is typically between a corporation and an executive, generally to provide an employee benefit. In private split-dollar, the split is usually between the grantor/insured and a trust--most often for purposes of purchasing a large life insurance policy on a gift-tax-favored basis. At least in the private context, the driving force behind split-dollar is the idea of paying large premiums with little or no gift tax, according to Tegeler. "Since the gift tax exemption became disconnected from the estate tax exemption, we've had problems trying to push big things through little holes."
Split-dollar makes that push much easier because under the new regulations, the IRS figures the gift tax on a dollar figure that is generally much smaller than the actual insurance premium. For example, under the so-called economic benefit split-dollar regime, the grantor/insured might advance the premiums to an insurance trust which, in turn, pays the insurance company. However, the value of the transfer for gift tax purposes is based on Table 2001, which is essentially the equivalent of term insurance rates on an individual life. Rates on joint and survivor life insurance are also derived from that table and are substantially lower than the individual rates, so long as both parties are alive. In fact, Tegeler is currently working on a joint and survivor case where the premium on a $10 million policy for a male age 64 and female age 60 is $130,000. Under Table 2001, however, the taxable gift to the trust in the first year is only $695 and in the tenth year, only $4,717. "The split-dollar plan is obviously freeing up a lot of gifting ability that otherwise would have been soaked up by that premium," he explains. "Of course, you have to plan for the possibility that one of the insured parties might die." At that point Tegeler would suggest switching to loan regime split-dollar among other options.
Under so-called loan regime split-dollar, the grantor/insured loans premiums to an insurance trust, which in turn pays premiums to the insurance company. In such cases, any gift tax is based on the annual loan interest on the premium loans rather than on the premiums themselves. According to Tegeler, loan regime split-dollar generally works best with single-life cases where the insured is older, because the Table 2001 rates are often too high in those situations. For example, the gift tax, if any, on a $200,000 annual premium loan would be imposed on just the interest at the applicable federal short-term rate of 4.93 percent (as of February 2007)--in this case, an amount less than $10,000 in the first year. "The interest rate on the loan is based on the short-term, mid-term, or long-term AFR, depending on how the loan is structured," Tegeler says.
Even better news is that using the loan regime, a private split-dollar arrangement can be structured so that there is no gift tax at all. For instance, assume an annual premium of $100,000 for nine years. Obviously, gifting that much money each year could present some transfer tax problems, especially if the insured already has other gifting programs in place. "And if that's the case, the cost of the premium in the client's mind has been increased by the gift tax," Tegeler says. "An arrangement that has no gift tax associated with it is obviously very attractive relative to that."
To achieve that result, the grantor/insured establishes an irrevocable life insurance trust [ILIT] that applies for and is the owner of an insurance policy on the insured's life. The grantor/insured then loans $900,000 to the trust in the first year to pay the premium. In turn, the trust agrees to accrue the interest for nine years. The lump-sum payment also allows the insured to lock in the mid-term AFR rather than being subject to the ever changing short-term rate.
To this point, the grantor/insured has effectively paid $900,000 in premiums with no gift tax. However, to maintain that status, the trust must eventually pay back the loan plus interest, and that requires additional planning. "Whether it's the economic benefit regime or the loan regime, it needs to be married to other estate planning strategies designed to get other money into the trust to pay off the premium loan as well as to pay any possible future premiums, on the policy," Tegeler explains.
In this case, a grantor retained annuity trust [GRAT] makes a wonderful marriage partner. For example, the grantor might fund a GRAT with $1 million in S corporation stock with a 30 percent minority interest discount, for a taxable gift of $700,000. According to Tegeler, the objective would be for the GRAT to zero out; that is, the GRAT would pay the grantor the gift-tax value of his gift plus interest over time. Assuming that the property generates $100,000 a year in income and a mid-term AFR of 5.8 percent, that would occur in about nine years. At the end of that period, whatever remained in the GRAT--something in excess of $1 million--would go to the remainderman, in this case the ILIT. "It's all designed to get some money into the ILIT so there are sufficient funds to pay off the premium loan plus interest and to pay future premiums on the policy," Tegeler says. "The grantor trust is particularly appealing because that would mean that the interest paid from the trust to the grantor would not be considered income to the grantor."
A grantor trust also plays an important role in what St. Louis attorney Larry Brody refers to as side-fund split dollar, a private split-dollar technique that combines the very low Table 2001 survivorship term rate with an intentionally defective grantor trust or IDGT to make it possible for a couple to purchase life insurance on a tax-favored basis. Unlike the loan regime, side-fund split dollar uses the non-equity collateral assignment approach. The IDGT owns both the life insurance and the side-fund. As owner of the policy, the IDGT collaterally assigns an interest in the policy's cash value and death benefit equal to the greater of the policy's cash value or premiums paid to secure the grantor's premium payments. "In order for this to work, it has to be clear from the beginning that the trust never can have--not even for a moment--any present or future interest in the cash value," Brody cautions.
Because of the trust's defective status, transactions between the grantor and the trust are income-tax free even though any assets in the trust are not part of the grantor's estate. Thus, the grantor can seed the side-fund by selling appreciated securities or a business interest to the trust in return for the trust's note and not be required to recognize any gain on the sale or income from the interest payments on the note. "The best side-fund is one that's funded on a leveraged basis," Brody says.
The purpose of the side-fund is to create a pool of assets that can be used at some future date to repay the grantor for life insurance premiums paid and to insure that from that point on, the trust can pay ongoing premiums. Split-dollar practitioners refer to this process as a rollout or exit strategy. "Under the new regulations, you can't use the policy's cash value for an exit strategy like we used to," Brody explains. "In fact, the trust cannot have any equity interest in the policy at all, so today you need a side-fund outside the policy to do the exit."For the exit to work, it is imperative to start the side fund early. "You can always start it later, but it is much more difficult," Brody explains. "If I wait 10 years to fund it, I'm going to wind up having to make much larger gifts than if I start early."
Brody suggests using a guaranteed no-lapse universal life (GUL) policy for the side-fund approach because of its low-premium, low-cash value characteristics. Remember that the grantor retains a security interest in the greater of the policy's cash value or total premiums paid to the point of rollout. "If you use a high-cash-value policy, you'd be pushing more money than necessary back into the grantor's estate," Brody continues. "With a low- cash-value or no-cash-value GUL, it's only the premiums, and they're lower as well."
If this sounds complicated, it's because it is. However, experts point out that the pain of not doing it is much greater than the pain of acting on it. Portland attorney Alan Jensen, a partner in the firm Holland & Knight, knows that pain can be insufferable. In one instance, he had clients looking for $60 million in coverage that would cost $16 million over time. "After exemptions, that's still a $14 million dollar taxable gift. In other words, they'd have to pay roughly $7 million worth of gift tax to buy the insurance."
Instead, the clients opted for private split-dollar and all the attendant complexities. Why? Because the measure of the gift under the split-dollar regulations--that is, the economic benefit--was only $8,000 in the first year. "Of course, there was no tax on that because it was covered by their annual exclusions," Jensen says.
Insurance consultant Mark Chandik of Irvine, Calif.-based Financial Diligence Partners has discovered another reason to propose private split-dollar, especially to younger, newly wealthy clients in need of large amounts of life insurance. They don't cotton to the idea of making irrevocable gifts yet, he says, especially when the intended beneficiaries may be currently self-absorbed teenagers. "They like the idea of loan-regime split-dollar because they can call back the loan if the kids tick them off," he explains. "Later on, once the kids have settled down, and love is in the air, they can forgive the loans and begin gifting the premium instead."
No, split-dollar is not for everyone; but in the right hands and for the right reasons, it is a powerful tax avoidance or deferral tool. "It's a good time for split-dollar if you understand its limitations," Brody says. "It ain't the golden age of split-dollar; that's behind us. But it's used all the time in big cases." To the chagrin of the taxman, he might add.
Gregory Taggart (email@example.com), a former practicing attorney who has worked in insurance and financial planning, teaches writing at Brigham Young University.