The New Split Dollar Loan Regime: Who Will Do This?

In order to implement a loan regime arrangement the loan interest, imputed income and loan payoff issues have to be addressed. Loan interest and imputed income will be determined based on the type of loan chosen. Premium loans may be structured as either term or demand loans. The rules regarding both types of loans can be extremely complex and difficult to administer.

In the past, most split-dollar arrangements have utilized a demand loan structure. The employer could call the loan at any time. Term loans, however, bring a level of certainty to the arrangement since the loan rate can be set at the time the premium is paid. To the extent that the policy could be financed with just a few term loans, the taxpayer may escape the fluctuations in future published interest rates. The demand loans, on the other hand, have interest based on the blended annual Applicable Federal Rate (AFR), a rate that fluctuates each year but is based on short-term rates. Initially, these rates will be more attractive than the long-term rates associated with the initial term loan premiums.

Ultimately, the choice of loan structure will depend upon overall cost projections, taking into account the number of expected premium payments, the desire to pay back the loan at a specific point, and the means through which the insured will make the payments.

Since many split-dollar loan regime plans will involve closely held business owners, its reasonable to assume that some plans will be meant to last until death. Careful planning is in order to ensure that policy death benefits will increase enough over the years to support the employer reimbursement and still have sufficient proceeds to satisfy the insureds original need for liquidity. Most insurance companies provide Return Of Premium riders that can be used to pay back the loan principal. Not all riders, however, last past life expectancy.

For those loan regime arrangements where employer or donor payback is anticipated, we may see some creative reimbursement plans besides the crawl-out. The fact that many of these policies will be in irrevocable grantor trusts will help with the planning.

One approach will be to have the grantor provide other appreciated and income producing assets to the trust that can be used for both interest payments and employer loan reimbursement. These other assets could be sold to the trust on an installment basis. Valuation discounts may be achieved on the sale, and the installment payments may be made from income generated by the asset. Installment interest payments will not be taxable to the grantor under this arrangement. Any excess income generated by the assets may be used to cover the interest due on the premium loans. The assets purchased by the trust will be a source for employer reimbursement. To the extent that insurance policies may have extremely large premiums, these types of asset transfers become even more important.

Another means to provide the trust with additional assets is the use of a grantor-retained annuity trust (GRAT). The initial transfer of assets to the GRAT can, once again, achieve valuation discounts. By naming the ILIT the remainder beneficiary of the GRAT, the ILIT receives the assets it needs to pay back the premium loans at the end of the GRAT term.

While many commentators have touted split-dollar alternatives such as premium financing (premium loans through commercial lenders) and the use of FLPs and other partnerships to own and pay for life insurance policies, many clients will continue to turn to split-dollar plans with third-party owners. While not as straightforward as they once were, these plans continue to make economic sense. Insurance cash value increases currently outpace the AFR rates. If that trend continues, borrowing premiums will remain attractive. However, split-dollar plans under the new regulations will require more decision-making and more detailed planning in regard to exit strategies. Planners and tax advisors will become more involved in these aspects of the split-dollar arrangement than ever before.

Ted A. Kirchner, J.D., CLU, is director of advanced sales at Penn Mutual Life Insurance Company, Horsham, Pa. He can be reached via e-mail at [email protected].

Reproduced from National Underwriter Edition, June 11, 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.