The Dangers And Opportunities Of The New Split-Dollar Regulations

The Chinese have a symbol, pronounced jitsui, which means both danger and opportunity.

Jitsui is a perfect descriptor for the new market for split-dollar life insurance plans. Final regulations issued by the Internal Revenue Service and U.S. Treasury aimed at curbing the abuses created by some split-dollar life insurance plans were published in the Federal Register on Sept. 17, 2003.

Since then, substantial commentary has been published about “rescuing” pre-Sept. 17 split-dollar plans, if indeed they needed to be rescued. Much of the commentary also has detailed the potential pitfalls for split-dollar plans going forward.

The good news is that the marketing opportunities for split-dollar plans are substantial, despite the new regulations. Tax law changes often provide new creative planning opportunities.

Split dollar may still be one of the most effective solutions to minimize individual income and gift tax consequences for dynasty trust-owned life insurance. It is still one of the better ways to preclude a double tax on corporate accumulated earnings when those earnings are used to fund a split-dollar welfare benefit. Split dollar also can be used to fund a salary continuation benefit for select employees and it can provide the means to execute a group term carve-out strategy. It is an effective way to use the corporate pocketbook to fund a cross-purchase buyout obligation between business owners. The applications are limited only by ones creativity.

Endorsement Split-Dollar Applications:

SERPAn endorsement split-dollar (ESD) plan can informally fund a supplemental employee retirement plan (SERP) while simultaneously providing for an income-tax-free spousal benefit should the employee die before retirement. This application can avoid the double income in respect of a decedent (IRD) tax applicable to standard deferred compensation plans.

Since endorsement split-dollar constitutes an employer-owned asset, it continues, as always, to be subject to taxation as an economic benefit. Double-tax benefits are available to the corporation in the form of tax-free withdrawals up to cost basis for non-modified endowment contracts or policy loans followed by tax deductible distributions to the insured at retirement.

Deferred CompensationAnother application for ESD is to simulate a deferred compensation asset transfer plan. The ESD agreement can link a future transfer of policy ownership from the corporation to the key person after a specific number of years of service, or when certain performance requirements have been met. Employee tax consequences upon the transfer of the life insurance policy to the insured can be minimized or neutralized with a bonus at rollout time. A new employees cost basis in the life insurance is generated by the taxes incurred, which can permit greater tax-free income withdrawals followed by tax-free loans to supplement retirement income needs.

Stock Redemption Purchase ESD can fund a discounted stock redemption purchase plan to transfer a business to an unrelated business owner. When the insured dies, the deceased owners spouse receives a tax-free fringe benefit. Simultaneously the corporation can use its interest in the policy cash values to initiate an installment purchase stock buyout from the deceased owners estate. ESD employer premium payments may effectively reduce the corporate accumulated earnings threshold to $250,000 to avoid an additional 15% tax on excess earnings.

Non-Equity Collateral Assignment Plan Applications:

Cross-Purchase BuyoutA non-equity collateral assignment (NECA) plan can use corporate dollars, preferably those subject to accumulated earnings taxation, to fund a cross-purchase buyout between two business owners. The buyout agreement can be made more tax efficient than a standard or trusteed cross purchase plan by having each owner create his or her own family business disposition trust, which would then own the buyout insurance on his or her partner. The irrevocable trust and not the surviving owner is then obligated to purchase the deceased owners stock for the ultimate benefit of family member trust beneficiaries.

This removes the purchased stock from the surviving owners estate and may make him eligible for a minority interest discount if the trust ends up owning 50% or more of the business. The designated trust purchases an increasing death benefit insurance plan and uses the corporate assignee under a non-equity collateral assignment split-dollar plan to pay the premiums. The surviving owner could continue to maintain fiduciary control over the business by being the trustee of his or her respective trust.

Gift tax leveraging occurs since the gift becomes the economic benefit charged as compensation to each owner and not the premium paid by the corporation. If using an increasing death benefit option, the trustee may eventually have sufficient tax-free funds to both fulfill its stock purchase obligation as well as to reimburse the corporation for its assigned collateral, the policy cash surrender values. Non-equity split-dollar plans continue to be taxed only as an economic benefit. The corporation could recycle its interest back to the deceased owners estate as a taxable spousal death benefit.

Another advantage of trust ownership of the deceased owners stock is that the surviving owner retains only a discounted minority interest of 50% or less for estate planning purposes.

Dynasty TrustNECA can create a multimillion-dollar family dynasty trust using corporate accumulated earnings in a way that precludes gift and estate tax consequences.

For example, a $50 million second-to-die legacy life insurance plan for a 50-year-old closely held corporate owner and his 50-year-old spouse could be owned by an irrevocable trust. The trustee may assign the life insurance policys cash values as collateral to the owners corporation. Annual corporate premiums of approximately $316,434 may avoid any accrued accumulated earnings taxation and the premium payments are not taxable income to the insured owner.

Instead, an economic benefit of $270 as calculated using IRS Notice 2001-10 single life mortality tables is charged as W-2 income to the corporate owner. Also, the $270 is the only gift transfer that the insured makes to the family dynasty trust for gift and generation skipping exemption purposes. The insured owner can insulate the trust from any future generation skipping tax (GST) consequences by allocating a portion of his 2004 $1.5 million GST exemption to each years realized economic benefit on a 709 gift tax return.

There is still a lot of life in properly designed split-dollar applications that have not been affected by tax law changes. Problem solving is the name of the gameits the value you provide your clients. Under the new split-dollar regulations, you can best help your clients by steering them clear of the dangers and pointing out the opportunities.

John S. Budihas, CLU, ChFC, CFP, is a business, estate and trust planning consultant for Hartford Life in Sarasota, Fla. He can be reached at: john.budihas@hartfordlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 13, 2004. Copyright 2004 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.