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).