Split-Dollar Life Insurance Significant Changes In Store For The Future

Originally published September 6, 2002

"Split-dollar life insurance" is a widely used method of providing death benefit coverage, primarily to executives. After decades of scant formal guidance on the issue, the Internal Revenue Service has issued two major announcements on the tax treatment of split-dollar in the past two years. New guidance on split-dollar arrangements was issued early in 2002 and the IRS is promising to issue proposed regulations soon. This article describes the structure of split-dollar arrangements, the advantages that such arrangements provide to employers and employees, and the changing position of the Internal Revenue Service regarding the tax consequences of such arrangements. Although split-dollar insurance arrangements can be made between private individuals, the article focuses on the use of split-dollar in the employment context.

Background and Structure of Split-Dollar Arrangements for Employees

Split-dollar insurance is not a special type of policy, but rather an arrangement that "splits" the benefits payable under a life insurance policy, and often the premiums paid for the policy, between two parties. Under a split-dollar arrangement, an employer pays all or part of the premiums, and the employer and employee "split" the death benefits that are payable under the policy. Usually the employee is the individual insured under the policy; i.e., the person whose death will trigger the payment of death benefits. Sometimes the policy is a so-called "second-to-die" policy, with death benefits paid upon the last to die of the employee or spouse.

Repayment to the employer occurs at death or surrender of the policy. Depending on the agreement, the employer will be entitled to at least the amount of premiums that it has paid with respect to the policy; the employee's beneficiary receives the rest. In many cases, the employer is entitled to the greater of the premiums it has paid or the cash surrender value in the policy. Thus, split-dollar arrangements are essentially a means for employers to finance life insurance benefits for employees; the employer is repaid its costs when the death benefits are paid or the policy otherwise terminates.

Split-dollar arrangements are generally evidenced by a separate contract between the parties, as well as by provisions in the insurance policies used to fund such arrangements. There are two general methods of dividing the rights of the parties in split-dollar arrangements; the "endorsement method" and the "collateral assignment method."

Endorsement Method. Under an endorsement method, the employer owns the policy and the employee's right to a share of the benefits is secured by an policy endorsement stating that all or part of the policy's benefits will be paid to the employee (in cases in which the employee is entitled to some payment upon surrender) or the employee's beneficiary. The contract between the parties typically states that the employer is the owner, and specifies the portion of premium that the employer and employee each will pay, and the portion of the cash surrender value (if any) and death benefit that will be received by the employer and the employee's beneficiary. Typically the employee elects the beneficiary to receive its share of any policy proceeds. The contract may also describe the circumstances under which the policy may be given or sold to the employee.

Collateral Assignment Method. Under this method, the employee is the owner of the policy at the outset and the employer is given the right (in both the contract and usually by a provision in the policy) to a portion of the benefits secured by a "collateral assignment" of the policy to the employer. The documentation between the parties generally explains the portion of the premiums to be paid by each party, the portion of the policy proceeds that is collaterally assigned to the employer, and the circumstances (if any) under which the collateral assignment will be extinguished so that the employee will own the entire policy.

The division of the premiums to be paid by each party varies, often based on the tax consequences desired by the parties. In some cases, the employer pays the entire premium. In a commonly-used arrangement, the employee pays the amount of premium equal to the amount of income that would be imputed to him under the tax law. Depending on the applicable guidance from the Internal Revenue Service ("IRS" or "Service"), which, as discussed below, has changed throughout the years, an employee that pays a premium equal to the imputed income might avoid any current income tax.

Split-dollar arrangements often provide that when an employee terminates employment or retires, the arrangement will end and the policy will be "rolled out" to the employee so that the employer no longer retains an interest in the policy. The rollout can be accomplished by a sale or a transfer of the employer's interest in the policy. Sometimes any excess cash value in the policy is used to finance the rollout. The income tax consequences of the rollout depend in part on the type of arrangement used by the parties, and on the applicable IRS guidance.

Advantages of Split-Dollar Arrangements

Employers and employees have found split-dollar arrangements to be an attractive part of a benefit package for a number of reasons. The arrangements are sufficiently flexible to accommodate a variety of circumstances. Moreover, unlike group-term policies, the employee can enjoy an ownership interest in the policies; this became a particularly attractive feature once cash value policies and so-called "equity" split-dollar began to be used. Split-dollar arrangements are often seen as a relatively inexpensive way for employers to provide significant insurance benefits to employees, since the employer will be repaid. Thus, the only cost to the employer is the time value of the money lost between the date the premiums are paid and the date...