Using Premium Financing To Rescue Split-Dollar Plans
Between now and December 31 of this year a key theme among many financial advisors will involve how to handle existing client split-dollar arrangements. Planners have a wide range of options to consider with these clients.
Among the many options are:
Terminating the split-dollar arrangements and avoiding taxation on any equity buildup;
Maintaining the split-dollar program until the life insurance policy can better support itself–even though it may result in some taxation on equity buildup;
Never terminating the split-dollar arrangement, instead keeping the program in place until death;
Switching from a collateral assignment to an endorsement program; and
Maintaining an existing plan until just prior to the equity crossover point, then terminating with a note rollout.
Many variations of these choices exist, and other choices are available. Not every choice will work with all split-dollar arrangements. Some may not work numerically; some may carry financial or tax risks.
A key concern of advisors centers on those split-dollar plans where the life insurance cash values are insufficient to reimburse the premium payor and maintain the viability of the underlying life insurance contract. Where this is an issue, clients might wish to consider handling their split-dollar rollout through a premium financing arrangement.
Under this approach a new, independent lender essentially substitutes for the original assignor in a collateral assignment split-dollar arrangement.
Typically, the lender will advance sufficient funds to reimburse the original premium payor. This allows for the split-dollar plan to be unwound without raiding life insurance values. Once the loan is received from the new lender, the former employer can be paid off and exit the arrangement. This can allow for the rollout of a split-dollar arrangement before Dec. 31, 2003, without triggering any equity taxation.
Publicly traded corporations can eliminate their concerns under the Sarbanes-Oxley Act as employers are removed from the split-dollar arrangement and an outside, independent, lender steps into their shoes.
Where new, or ongoing, premium payments are required they can be handled via corporate bonuses, or through additional loans under a premium financing arrangement. Each year new advances can cover premium payments.
Some premium financing arrangements have steep minimums for each loan advance; this is to limit their costs associated with the loan underwriting in relation to the funds advanced. If the original arrangement called for smaller premium amounts, it is possible that the lenders minimums can still be met by restructuring the premium payment pattern. Often, fewer, but larger, payments might meet a clients objectives while meeting the minimum amounts for premium financing arrangements.
An example can be seen with Charlie and Stella, both 72 years old. They own a good-sized, closely held business. They determined some time ago, as part of an overall planning process, that they had a need for $5 million of death benefit to cover their estate taxes. They did all the right planning for the time; they set up estate documents that deferred estate taxes until the second death. They set up an irrevocable life insurance trust. The trustee purchased a survivorship policy on their lives and then set up an equity collateral assignment split-dollar plan with the business.
The split-dollar plan was set up in a way to handle a controlling shareholder and Charlie regularly has been reporting the economic benefit from the split-dollar plan in his income each year. That was seven years ago. The policy was a variable universal life survivorship, illustrated at 10%–an approach normal for the time.
Now, seven years into the program the business is owed $430,000 and the plan is just shy of having any equity. In other words, there are insufficient funds in the insurance policy to pay off the employer and maintain the life insurance death benefit.
The trustee has several choices–none of which are particularly attractive:
They can terminate the plan by giving the policy to the corporation;
The couple can continue the existing plan and rollout in about seven more years, based on the original illustration. Based on that illustration the couple would now face income taxation of about $500,000 equity, and they may also have gift tax consequences at termination;
The corporation can distribute its current interest to Charlie. He will be taxed on the income and will need to make a gift of the policy to the trust–an expensive approach. Future premiums will need to be handled by bonuses or other after-tax dollars gifted into the trust–adding to the expense;
Charlie and Stella can gift $430,000 into the trust and have the trustee pay off the corporation to end the split dollar; or
Adopt a rollout technique with a suppressed cash value product.
However, there is another choice and as the couple looks at the numbers, it becomes very attractive. This choice involves using premium financing, with an outside lender as a substitute for the business handling the premium payments.
The couple decides to move ahead with the premium financing approach. An outside lender advances $430,000 to the trust to repay the business. The split-dollar arrangement can now end, and the couple will not be taxed on any equity. Now, rather than pay several more years of moderate premiums, the lender structures a series of loans that allow for the policy to be fully funded in three more years, through a small number of larger payments. This escalated, and higher, premium payment structure also allows Charlie and Stella to meet the minimum loan requirements required by the lender.
The couple also adopts a new policy as part of the premium financing arrangements. This new policy allows for stronger guarantees and lower COIs than existed seven years ago. Moreover, the new policy has a feature known as a return of premium rider that increases the death benefit equal to the premium payments into the contract. At the couples second death, the lender is reimbursed, through the return of premium rider, and the trust receives their $5 million, which has not been eroded away by the loan repayment.
As with any concept, any number of issues must be watched. Among the key issues when using premium financing for split-dollar rollouts are:
The need to work this change through with all the parties, insured, trustees, employers and other family members. The split-dollar agreement controls and if it does not allow for such a rollout, it may need to be amended;
Interest and principal repayments; and
Some premium financing arrangements require a new policy–and this may raise issues related to insurability, increased costs due to older ages, etc.
Regarding the first item, it is critical that all parties involved in the original split-dollar plan agree to the change. It is best that all convene and determine that a change in the agreement is necessary. This is true of any split-dollar rollout, but particularly true with premium financing. Why? The business must agree to be paid back and may need to release their assignment, even briefly, so as to allow for a new lender to step into their place. The insured must agree to new insurance. The trustee must also agree, and all must cooperate with the new lender. It may be necessary to watch how the original assignor is paid off and how the collateral assignment is released and, if necessary, re-established with the new lender.
The second two may often work in tandem to facilitate the overall planning, and a few comments are in order here. Interest can be a substantial issue that is neglected until too late. Just as split-dollar plans need to be paid off, so do the loans. If anything, commercial lenders will enforce these principal repayments and interest payments to a degree that employer/employee split-dollar premium advances rarely did.
A central issue is how to repay the premium payor without eroding the death benefit. After all, the issue of softening the repayment impact often drove clients to the equity split-dollar arrangements that are now being re-examined. Clearly, a well-planned rollout strategy is required.
Every lender may treat this issue differently. Some financing arrangements will allow for interest to accumulate and compound. This can be tempting but needs to be planned for. Compounded interest on large loans severely can erode a needed death benefit. Other financing arrangements may require interest to be paid periodically. While this will keep the compounding in check, clients need to plan for the source of interest payments and in many cases will lose the use of funds through the payment of interest.
Fortunately, in recent years several life insurers have developed return of premium riders. This can be a very attractive solution for premium financing. First, the return of premium rider (sometimes called death benefit option three) allows for a death benefit on a policy to be increased over and above the initial death benefit. This allows for a source of funds to repay the principal, without eroding the death benefit needed for planning.
Where interest is compounded, many return of premium riders also allow for that additional death benefit to be increased. The increase is often designed to mirror, or nearly mirror, the compounding on a loan. This can be an attractive feature even where interest is paid periodically to the lender, as it can refund a family a source of cash for their lost use of funds due to paying interest.
Combining the return of premium rider, with the often lower cost of insurance available on newer policies and the newly popular secondary guarantees, often takes away the sting of needing to change the split-dollar agreement.
Finally, all premium financing arrangements are different and clients need to be aware of all the risks, as well as the advantages, of each. Clients need to understand the risks associated with fluctuations in interest rates and, with some arrangements, there may be additional concerns with currency exchange rates. Clients need also to be aware of when loans will be reviewed and have a plan to handle any loans that might be called. Some lenders will never call a loan, even when financials change, except in the case of a default. Where ongoing premium payments are required, clients need to be aware if the lender will willingly cover these future needs.
In many cases premium financing may offer another avenue for split-dollar rescue. In the right situation, it can offer an ability to substitute one premium payor with another, as well as a means by which a client can terminate a split-dollar plan. Keep in mind, however, that this approach will not be appropriate or even work with every client. But for some cases–particularly estate planning cases–this may be one approach worth looking at.
The clock is ticking on equity split-dollar arrangements and the IRS-offered window will soon be closing. It is important to begin reviewing these arrangements as soon as possible.
Mark A. Teitelbaum, JD, LL.M., CLU, ChFC, is second vice president, advanced sales at Travelers Life & Annuity, Hartford, Conn. He can be reached at email@example.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.