Splitting the Difference for Key Employee Retention

In today’s competitive labor market, many business owners have found themselves competing to attract and retain valuable employees. Traditional benefit offerings are important, and sometimes even necessary, but have often fallen short when it comes to attracting top talent. Business clients may wish to consider more non-traditional benefits, including split-dollar life insurance, as a way to create an edge when it comes to hiring key employees. Split-dollar life insurance structures can take on many forms—and can serve multiple purposes, including providing a fund to keep the business running when a key employee dies. Business clients should be advised on the rules and various options for implementing a split-dollar program that can benefit the employer and employee alike.

Economic Benefit Split-Dollar Plans

An economic benefit split-dollar life insurance plan is one of the most common types of split-dollar arrangement. In these arrangements, the employer is the technical owner of the life insurance policy. The employee, however, is permitted to name a beneficiary by filing a supplemental form (known as an endorsement).

So, in the end, the employer and the employee share the death benefit provided under the life insurance policy. The employer pays the policy premiums. If the arrangement is still in effect when the employee dies, the employee includes the economic benefit of the policy in their taxable income.

The endorsement form divides the death benefit between the employer and the employee’s chosen beneficiaries. There is always the option to allow the employer’s beneficiaries to receive the entire death benefit. If the policy terminates before the employee dies, the employer can transfer the policy to the employee or keep it and remove the employee’s beneficiaries (i.e., remove the endorsement).

One downside to the economic benefit regime is that the employee must include the policy’s economic benefit in taxable income. The value of that benefit is calculated based on the death benefit, the employee’s age and the Table 2001 risk factors published by the IRS.

Typically, these arrangements end when the employee retires. The contract will contain a roll-out provision that provides the terms governing how the contract will terminate upon the employee’s retirement.

Loan Structure with Collateral Assignment

Under the collateral assignment structure, the employee owns the life insurance policy and the employer’s interest is secured by collateral assignment of the policy. The employer actually pays the policy premiums. Premium payments are treated as loans from the employer to the employee.

The employee who benefits from the arrangement must pay annual interest on the “loan” of the amounts used to pay the policy premiums. Essentially, the loan is “secured” by the policy’s death benefit or cash value (depending on the type of policy)—meaning that a portion of the death benefit or cash value is assigned to the employer.

Often, these arrangements are treated as below-market loans. Interest is imputed at the applicable federal rate (AFR). The amount of the imputed interest is considered to be taxable income (and is deductible by the employer except in the corporation-shareholder context).

The collateral assignment is filed with the insurance carrier. Until the “loan” amount is repaid in full, the employee can only access the policy’s cash value to the extent that the cash value exceeds the loan balance. When the employee dies, the employer can either forgive the loan or use the remaining cash value to repay the loan balance. The same is true if the arrangement is terminated before the employee dies—the employer can forgive the “loan” or the employee can repay the amounts, whether via the policy’s accumulated cash value or the use of outside funds.

These arrangements can benefit both employer and employee. The employer can offer a valuable employment benefit and the premium payments can be covered by the death benefit. The employee technically owns the policy and can access the cash value and/or provide a tax-free death benefit to their heirs.

Conclusion

Split dollar arrangements can be extremely complicated. For some business clients, the benefits of the non-traditional employment benefit may be worth exploring. However, clients should always consult competent tax and legal professionals to avoid unpleasant surprises.

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