When the Internal Revenue Service unveiled finalized regulations respecting split-dollar life insurance arrangements in September of 2003, many observers viewed the development as the death knell for a popular business planning vehicle. For those clients still clinging to the technique, the subsequent release this year of the IRS’ finalized 409A deferred comp regulations were expected to deal the final blow.
Things haven’t quite worked out that way. Split-dollar plans — arrangements in which the employer and employee divide between them policy premiums and benefits according to a predetermined formula and written agreement — are meeting with varying levels of interest among small businesses. Though the arrangements generally are less attractive than previously because of the harsher post-2003 tax treatment, experts say they continue to play a valuable role in executive compensation planning, often as a supplement to non-qualified deferred comp plans.
Not least, experts say that 409A has clarified what’s permissible under the arrangements — and not just for corporate execs. An offshoot of the technique, private split-dollar, is gaining traction among life insurance professionals engaged in estate planning.
“Many agents incorrectly assume that split-dollar life insurance plans are no longer advantageous,” says Peter McCarthy, a senior advanced marketing consultant at ING Americas-U.S. Financial Services, Hartford, Conn. “In fact, split-dollar still offers a very good — and perhaps even better — sales opportunity. Now that the 409A rules are finalized, planning with the tool is on firmer ground.”
Deborah O’Neil, vice president of the Advisors Support Group at AXA-Equitable, New York, agrees, adding that private split-dollar plans are now a favored technique among the affluent for reducing gift taxes. “In many of the larger estate planning cases, split-dollar is almost always looked at, especially as an alternative to premium financing,” she says. “It offers a great way to avoid transfer tax costs.”
Yet, while validating a heretofore uncertain estate planning technique, the finalized 409A regulations have complicated matters for advisors seeking to use split-dollar in the corporate realm for executive compensation planning. The rules contain numerous provisions respecting the application of both grandfathered and non-grandfathered arrangements, including those structured as an “economic benefit” and or “loan regime” plans.
Perhaps most significant for advisors is IRS Notice 2007-34, which offers guidance on the application of 409A to split-dollar and was issued in tandem with the finalized regs. Among other things, the notice stipulates that loan regime split-dollar plans may be treated as non-qualified deferred compensation — and hence subject 409A’s restrictions on the timing of deferrals, distribution elections and permissible distribution events, as well as potentially substantial interest and tax penalties for running afoul of the regs — if amounts on a split-dollar loan are “waived, cancelled or forgiven.”
“While the owner and executive may have a verbal understanding to cancel or forgive a [split-dollar] loan, they cannot have a contractual agreement,” says McCarthy. If you put it in writing, you undermine the integrity of the loan agreement. The IRS won’t accept this.”
Of greater import to many advisors is what the IRS has mandated since the service released its finalized split-dollar regulations in 2003. Plans now are taxed according to two methods: Loan regime and economic benefit regime.
Under the first method, the IRS treats premiums paid by the employer as a below-market loan to the employee and thus subject to tax rules for such loans. The 2003 rules require that an employee recognize income each year in the amount of the imputed interest. With respect to the second, the employee realizes taxable compensation each year in the amount of the “economic benefit” (i.e., insurance coverage funded by the employer’s premium contributions).
Under the economic benefit regime, the economic benefit cost to the executive is determined by Table 2001 term rates, promulgated by the IRS in 2001, or (if available and in compliance with 409A) alternative carrier term rates. Under the loan regime, the interest cost is based on the applicable federal rate or AFR.
Sources interviewed by National Underwriter say the post-2003 tax environment has had a chilling effect on equity-based plans, arrangements in which the employee is vested in the policy’s cash value to the extent it exceeds the employer’s premium payments. Since 2003, the IRS has treated the employer’s premium contributions as loans to the employee and so subject to interest costs.
Clark McCleary, past president of the Society of Financial Service Professionals, Newtown Square, Pa., and a principal of McCleary & Associates, Houston, Tex., says that since 2003 he has rolled most insurance policies used to fund clients’ equity split-dollar arrangements in alternative plans, such as Section 162 executive bonuses and supplemental executive retirement plans or SERPs.
“With equity plans, there is an additional cost –a taxable benefit– above and beyond the cost of insurance premium,” says McCleary. “Why buy into a plan that has a lot of moving parts just to increase your cost?”
Despite their added costs and increased complexity, split-dollar plans continue to find a place among small businesses, sources say. To keep the arrangements financially attractive, many business owners bonus up the executive’s compensation to cover the additional tax cost.
Other companies are substituting non-equity-based economic benefit plans (formerly known as endorsement split-dollar) for their old equity (formerly collateral assignment) plans. While post-2003 endorsement-type plans generally will carry a higher economic benefit charge than arrangements predating that year (again because of the reduced availability of more favorable alternative carrier term rates) the plans nonetheless escape 409A’s myriad provisions, since they limit the executive to a pre-retirement death benefit.
Also, say sources, businesses continue to bundle the split-dollar plans with other executive comp arrangements. McCleary says that many of his business-owner clients use split-dollar to informally fund SERPs. Brian Titus, a second vice president of the advanced planning group at the Phoenix Companies, Hartford, Conn., says that split-dollar arrangements also frequently are paired with deferred comp plans.
“When you marry split-dollar with a deferred comp plan, you can convert the pre-retirement death benefit portion of the arrangement into an income tax-free life insurance policy for the beneficiary, as the death benefit will be paid under the split-dollar arrangement” says Titus. “So you’re funding two separate plans with a single life insurance policy.”
Irrespective of the arrangement, market-watchers say that advisors need to consult regularly with clients to ensure the split-dollar plan not only stays in compliance with current regulations, but also promotes client objectives. Among them is keeping plan costs affordable.
To that end, a change in the arrangement may be necessary. O’Neil observes that clients will typically start out with an economic benefit plan because of its lower cost relative to the loan regime. The tables turn, however, as soon as equity starts to accrue inside the policy. Thus, O’Neil recommends a switch from economic benefit to loan regime just prior to this point.
Advisors, she adds, also need to counsel clients on appropriate exit strategies. Without a means of retiring the plan, the client could be facing steep tax and interest costs, particularly in the case of a loan regime. The employer can, for example, surrender the policy and recapture the premium costs; or distribute the policy’s cash value to the executive as a bonus.
Implementing an exit strategy, sources say, is just as important for an increasingly popular application of split-dollar plans among the affluent: Private financing of trusts for estate planning purposes. Michael Weinberg, an estate planner and president of The Weinberg Group, Denver, says that private split-dollar is an excellent tool for generating liquidity to retire estate taxes while minimizing gift taxes.
One solution he favors, side-fund split-dollar, calls for (among others steps) the creation of an intentionally defective grantor trust, funded with assets (such as appreciated stock or partnership interests) in addition to a life insurance policy; implementation of a non-equity collateral assignment split-dollar plan between the grantor (insured) and the trust; and repaying the grantor for their split-dollar advances from the trust side fund.
“This technique typically involves annual premiums in the hundreds of thousands of dollars and clients who are in their 60s, 70s or 80s,” says Weinberg. “It’s for the affluent individual who has a large estate liquidity need and who has to fund insurance premiums beyond what the annual gift tax exclusion and the lifetime exemption allow.
“In the past two years,” he adds, “I’ve placed more than $1 million in premiums using private split-dollar. And I’m leveraging the technique for another client this year. Insofar as estate planning, we’re witnessing a split-dollar renaissance.”