The Triple Win Of Endorsement Split Dollar As An Executive Benefit Planning Tool
Endorsement split dollar has long been used as a planning tool to provide executives with an affordable option to obtain additional insurance coverage.
Typically, a companys group life plan that provides all employees with a small death benefitusually no more than $50,000has little impact upon highly compensated executives. Such small sums will do virtually nothing to replace the substantial income unexpectedly lost to the family of a deceased executive or to provide estate liquidity for that executive after retirement.
Likewise, the employer sees advantages in utilizing endorsement split dollar for recruiting and retaining key employees by offering this benefit and growing it over time.
Endorsement split dollar works like this: The employer purchases and owns an insurance policy on the life of an executive. Then, the employer endorses part or all of the death benefit to the personal beneficiary of the executive. This executive, in turn, “splits” the premium with the employer by paying his economic benefit for the death benefit endorsed to the executive using a measurement of the annual renewable term cost of the life insurance. (See chart.)
This portion of the premium is usually quite small and is based, somewhat loosely, on what the cost of term insurance would be for that executive to obtain the same amount of coverage.
In most circumstances, the employer pays the entire premium with the executives portion being imputed to him as income. The executive is then responsible for the income tax on the employers payment of his portion of the premium.
While employed, the executive has substantially greater life insurance protection than provided by a group life plan. At retirement, the employer has a number options of what to do with the policy. The employer could elect to continue owning the policy and, if the executive wishes to have his beneficiary receive the death benefit, the executive would still contribute his portion of the premium in terms of the economic benefit calculation.
Normally, however, the employer and executive desire to sever their relationship at retirement with the employer “bonusing” the policy to the executive. The employer transfers ownership of the policy to the executive pursuant to an exception of the transfer for value rule. The policys cash value is treated as compensation to the executive who is responsible for the income tax.
If transferring ownership of the policy to the executive at retirement is the intent at the beginning of the endorsement split dollar plan, the executives future tax liability can be addressed more creatively. The employer throughout the executives employment can build the cash value so that, at retirement, when the policy is transferred, there may be enough cash in the policy for the executive to withdraw to meet his tax liability and to continue the policy in-force without further premium contributions.
Used in this way, the endorsement split dollar plan is a powerful retention tool for the employer. The increasing value of this “retirement benefit” decreases the likelihood of the executive prematurely leaving employment.
Once in the hands of the insured, the executive can maintain personal ownership of the policy or transfer it to the executor of his irrevocable life insurance trust for placement into the trust. The cash value in the policy would then apply against the executives lifetime exemption.
As the title of this article indicates, the traditional application for estate liquidity is not the only use for endorsement split dollar. Two others–key person coverage and retirement income–can be integrated into the same plan using a single policy. Those familiar with how deferred compensation works can easily pick out the similarities of a deferred compensation arrangement to that of an endorsement split dollar plan.
Deferred compensation arises where a promise of a future benefit is made to an executive by his employer. The employer then purchases a life insurance policy to fund that promise. When the promised benefit is due to the executive, the employer simply taps the life insurance policy to provide the cash flow to meet that promise. This can be accomplished with the policy owned by the employer in an endorsement split dollar arrangement.
While employed, the policy can be used to provide the executive additional death benefit coverage as discussed above. However, instead of transferring ownership of the policy to the executive at his retirement, the employer maintains ownership, using the policys cash values to fund a promised retirement benefit to the executive.
In this scenario, it is important for a number of reasons that a properly drafted deferred compensation agreement exist between the executive and the employer.
First, an agreement satisfies the executives need to have a contractual arrangement regarding any promised future benefit. More importantly, a well-crafted agreement will make a promise to the executive without mention of the use of the policy as the funding vehicle.
Directly tying the funding vehicle to the promise to pay in a nonqualified deferred compensation arrangement results in constructive receipt for such plans and would cause the employers portion of the premium payments to be immediately taxable as income to the executive when the premiums are paid.
At retirement or at another agreed upon date, the executive relinquishes the right for his personal beneficiary to receive part or all of the death benefit by ceasing his payment of the economic benefit. The employer then has not only the cash value of the policy from which to pull money to meet the benefit promise, but also will receive the death benefit for use to meet any unfulfilled payments if the executive dies during the benefit period.
In addition, the employer can use the death benefit as a cost recovery mechanism to potentially recover outlays involved with both the endorsement split dollar and deferred compensation plans.
A third application of endorsement split dollar is for key person coverage. The employer may elect to allow the executive to select a personal beneficiary for part of the death benefit while reserving the rest for use by the employer. In this approach, the executive would only split the premium and pay for the economic benefit associated with the death benefit assigned to his personal beneficiary and not the portion retained by the employer. The employer would use his portion of the death benefit to provide for the absence of the executives talents and labor and to recruit a replacement.
Taking advantage of the unique planning applications permitted by endorsement split dollar allows an employer to more easily attract, retain, and motivate its executives.
The executive realizes the immeasurable benefit of having substantially greater life insurance coverage and either a tool for future estate liquidity or retirement income.
At the same time, the employer has a method to protect itself in the event of the executives early death and a financing vehicle for a deferred compensation liability. The most appealing aspect of all these applications is that they can be accomplished with a single life insurance policy.
, J.D., is an advanced sales consultant for Nationwide Financial Services, Columbus, Ohio. He can be reached via e-mail at JUDASJ@nationwide.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.