Split-Dollar And Deferred Comp A Dynamic Combination

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Despite the changing environment in the executive benefit marketplace, attracting and retaining talented professionals remains an important part of a business plan. Businesses need to continue to provide benefits that attract and retain key executives.

The merger of split-dollar and nonqualified deferred compensation can offer a dynamic benefit package to the employee and can offer a measure of control and flexibility to the business. The combination of these tools into one plan could make the difference between getting and keeping the people who are key to the success of the business or not.

But the split-dollar landscape is changing. What we once knew as “endorsement split-dollar” will now be known as “economic benefit regime split-dollar.” The split-dollar proposed regulations issued in July 2002, when finalized, will change the rules for split-dollar.

The type of split-dollar plan will be defined by who owns the life insurance contract. If a life insurance policy is owned by an employer and is part of a split-dollar plan designed to benefit an employees beneficiary, it will likely fall under the economic benefit regime type of split-dollar plan. In this case, the value of the annual economic benefit, as currently measured by Table 2001, will be additional taxable income to the employee.

Separately, there has been some recent scrutiny given to deferred compensation plans. The Jobs and Growth Reconciliation Tax Act of 2003, as reported out of the Senate Finance Committee, contained a set of proposals that would have negatively impacted the use of deferred compensation plans. The proposals would have eliminated the use of rabbi trusts to hold deferred compensation assets and would have restricted the choice of investment options, making a deferred compensation plan much less attractive to the executive.

The final bill, as signed into law, did not contain any provisions that would have been adverse to deferred comp plans or to corporate-owned life insurance (COLI) policies.

To illustrate how split-dollar can be combined with a deferred comp plan, consider the following example. ABC Inc. would like to offer an incentive to its key salesman, Joe, to stay with the company. ABC and Joe agree that a nonqualified salary continuation plan with a pre-retirement death benefit would be an acceptable incentive. ABC and Joe enter into a split-dollar arrangement in which a life insurance policy on Joe, owned by ABC, is used as the funding vehicle. ABC pays the premium on the policy, and Joe is given the right to designate his own beneficiary of that part of the death benefit in excess of the cash value.

If Joe dies prior to retirement, a lump-sum death benefit will be paid to his beneficiaryincome tax free. If Joe leaves ABC Inc. prior to retirement, he receives nothing. Joe will be taxed on the annual economic benefit as measured by Table 2001. Joe will have no right to any portion of the policys cash value.

Simultaneous with the execution of the split-dollar agreement, Joe and ABC enter into a traditional nonqualified salary continuation agreement. The terms of the plan require Joe to continue employment with ABC Inc. until retirement at age 65. Upon Joes retirement, ABC promises to pay him a specific annual income for his lifetime. ABC also promises to pay the same income stream to his wife for her lifetime if she survives Joe. The same policy used to fund the split-dollar portion of this executive benefit can be used to fund the salary continuation portion of the benefit.

If Joe dies prior to retirement, a lump-sum death benefit will be paid out to his beneficiary. It will be equal to the excess death benefit payable over the cash value amount in the policy and it will not be subject to federal income tax to the beneficiary. If his beneficiary is his wife, this amount will not be included in his taxable estate because it is marital deduction property and, in any case, the benefit will avoid probate. The balance of the death benefit, equal in amount to the policys cash value, will be paid to ABC Inc. It is, likewise, part of a death benefit distribution and not subject to federal income tax.

If Joe lives until retirement, the split-dollar plan will be terminated, the nonqualified salary continuation plan will take effect and he will receive a specific annual income stream, as agreed upon. The income stream will be taxable to Joe and deductible to ABC.

At Joes death, ABC will continue the income stream to Joes wife. The commuted value of the income stream payable to his wife would be included in his gross estate. However, this would be considered to be marital deduction property and not subject to estate tax. The result is that Joes wife would not be entitled to an IRD (income in respect to a decedent) deduction because no estate tax is attributable to the remaining income. If the income recipient was a nonspouse, an IRD deduction against taxable income would likely be available unless Joes death occurs in a year in which the estate tax is repealed (currently 2010).

The successful conclusion of this plan depends, in part, on the continued existence of ABC. If it goes into bankruptcy or is bought by a competitor, Joe will likely receive nothing. There are no triggers or safety measures to protect the integrity of the plan. Joe is no better than a general creditor of ABC.

This type of benefit arrangement is a very cost-effective way of providing a benefit to a valued employee. Premium payments for the life insurance policy are not deductible to the company. The annual value of the economic benefit is taxable as income to the employee for as long as the split-dollar plan is in effect. However, if the employee lives to retirement, the income stream is deductible to the company and taxable as income to the employee.

Upon the death of the employee, the company will receive some part of the death benefit that can be used to reimburse itself for out-of-pocket costs of the plan. And, if this benefit has been effective, the employee will have stayed active in the business and helped to generate greater profits.

Despite the changing environment, the combination of split-dollar and deferred compensation remains a dynamic and potent tool to attract and retain key executives.

JD, CLU, is leader, advanced sales for GE Financial in Richmond, Va. She can be reached at Dianne.Ritz@gecapital.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 2003. Copyright 2003 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.