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

Now that final split-dollar regulations have been published and the industry has had a chance to digest the new rules, we can now assess whether any of our clients should use this planning.

Its the new loan regime that seems to be the hardest to get our arms around. Already, some attorneys and accountants have declared the maintenance of split-dollar loans to be more trouble than theyre worth. We need now to sort through the rules and the numerical projections and determine which of our clients should be considering these loans and how they might best structure them, maintain them and eventually pay them off.

First, an entire class of prospects can be eliminated from consideration. Public corporations will not be implementing loan regime split-dollar plans due to the prohibition on extensions of credit to corporate shareholders and officers as prescribed in the Sarbanes-Oxley Act.

A similar situation may be found when dealing with officers and directors of certain nonprofit organizations. Many such organizations restrict compensation-related loans in their bylaws or charters. The existence of these restrictions should be determined before recommending loan regime split dollar.

In regard to public corporations, many tax advisors are assuming Sarbanes-Oxley would also extend to economic benefit regime plans. While its hard to imagine that these plans could violate the intent or spirit of the act, the fact that the act carries criminal penalties seems to have caused this conservative stance.

The remaining prospects for loan regime split dollar would seem most often to fall into the category of closely held business owners. While there are certainly corporate buy-outs and other business insurance applications for split dollar, it is often the personal estate planning and wealth transfer needs of these clients that create their desire to use the corporate checkbook to finance their life insurance.

In addition, loan regime plans under the new regulations maintain the leverage achieved when the corporation pays for a third-party-owned policy. The premium advances from the corporation are deemed to be loans to the insured and then a secondary loan to the third-party owner. The insureds gifts to a third-party owner may be limited to amounts needed to pay interest on the loans. By limiting the gifting, the insured may save annual gift tax exclusions and/or the unified credit.

Due to the uncertainties of estate tax repeal, there has been greater interest on the part of taxpayers to build flexibility into their estate liquidity planning. Private split-dollar arrangements should continue to be popular tools to provide funding for trust owned insurance while maintaining a means to access the policy values. These arrangements typically call for the use of a defective grantor trust so that interest payments by the trust will not be taxable income to the grantor. If interest is foregone, it will be considered a gift from the donor to the trust and then a retransfer of that amount to the donor.

Similarly, if loan principal is later forgiven, a gift is deemed to be made by the donor to the trust. For this reason, loan forgiveness may best be done over a period of years once premium gifts have ended. This method of loan crawl-out will also be useful in employer sponsored plans when there is no desire to pay back the premium loans.

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 kirchner.ted@pennmutual.com.


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.