Due to death or divorce, second marriages and new family structures are commonplace in today’s society. Second families raise critical financial, inheritance, and estate planning considerations. There is often the desire to maintain the standard of living for the second family while providing for the first family. A cash-value life insurance policy using a traditional (non-equity) split dollar arrangement may provide the right solution.
In a split family, the breadwinner’s second family typically has the benefit of his or her current earnings and investments. For that family, a support need is unlikely to arise until the breadwinner’s death. Since the first family no longer has the immediate benefit of the breadwinner’s earnings and investments, there is a void to be filled. Split-family split-dollar satisfies the desire to provide for both a first and second family.
A split-family split-dollar arrangement uses one life insurance policy to insure the breadwinner. A non-equity collateral assignment split-dollar plan between the two families is implemented. Under the split-family split-dollar plan, the current spouse retains the right to the pure risk insurance or “net-amount-at-risk” portion of the policy to sustain the family upon the loss of the breadwinner. The first family is entitled to the policy cash values under the split-dollar arrangement. The first family will enjoy access to the policy values, filling the void caused by the loss of the immediate financial support of the breadwinner.
With split-family split-dollar, the policy premium is paid by the breadwinner. This does not constitute a gift or income to the current spouse, who owns the net-amount-at-risk of the policy, under the unlimited marital deduction of Internal Revenue Code (IRC) Section 2056. The premiums associated with the policy cash values owned by the first family may not be taxable if they fall within IRC Section 1041 and are “incident to divorce.”
Moreover, policy cash values may be used to satisfy income obligations ordered by a divorce court. Otherwise, the premiums may be taxable gifts that can be sheltered from gift tax using the gift tax annual exclusion and/or the breadwinner’s lifetime exclusion equivalent.
Estate inclusion of the policy to the breadwinner should not pose a problem since he or she is not a party to the split-dollar arrangement. The mere payment of policy premiums does not, by itself, cause estate inclusion issues.
Split-family split-dollar vs. an ILIT
Certainly, when the desire is to provide for both a first and second family, life insurance owned by an irrevocable trust may be appropriate. A primary benefit of trust-owned insurance is asset protection. In addition, if properly established, trust-held assets are protected from state elective share statutes (which allow the spouse to “elect against the will” and claim up to one-third of the breadwinner’s assets potentially, destroying the asset distribution plan).
Disadvantages of trust-owned life insurance include limited access to the assets held in trust and the ongoing costs associated with the trust (gifts of premiums and administration costs). Split-family split-dollar can provide for both families without these disadvantages.
Due to the vicissitudes of family dynamics, certain protective actions for the arrangement may be desired. These may include the following:
o The collateral assignment of the policy cash values may be made irrevocably so that it can not be removed or altered after the contract date.
o If there are spendthrift concerns with the first family, the breadwinner may place a “restrictive endorsement” on the policy that will allow the breadwinner to control activity related to the policy. The endorsement does not give the breadwinner beneficial interests in the policy; it ensures that the breadwinner is given notice and can approve actions taken related to the policy (withdrawals, pledging of values, etc.)
o The policy on the breadwinner may be “split-dollared” between an irrevocable trust and the first family. This eliminates the potential for the second spouse to revoke the policy or the split dollar arrangement. The irrevocable trust is drafted for the benefit of the second family and the policy cash values are collaterally assigned to the first family. Depending upon the dynamics within and between the two families, using an irrevocable trust for policy ownership may be warranted and worth the additional cost.
If properly established, split-family split-dollar plans allow all parties to enjoy the policy benefits of a life insurance policy without income, gift or estate taxes. With one policy insuring the breadwinner, the current family is provided for if the breadwinner dies. Needs of the first family are also provided for with the cash values of the same policy. Split-family split-dollar may thus offer an effective and efficient tool to satisfy financial, legal and moral obligations.
Janice A. Forgays, Esq., CLU, is vice president – advanced markets, at Sun Life Financial, Wellesley Hills, Mass. You can e-mail her at .