How Split Dollar Life Insurance Works

Split-dollar life insurance isn’t an insurance product or a reason to buy life insurance. Split-dollar is a strategy that allows the sharing of the cost and benefit of a permanent life insurance policy. Any permanent life insurance policy that builds cash value can be used. 

Key Takeaways

  • Typically split-dollar life insurance plans are created by an employer and employee, or a shareholder and a corporation.
  • A qualified attorney or tax advisor should be consulted or used when creating a split-life plan's legal documents.
  • A split-life insurance plan isn't actually a policy, it is a contract used to show how life insurance will be shared among beneficiaries.
  • Split-dollar plans are terminated in two ways: at either the employee’s death or a future date included in the agreement. 

What Is Split-Dollar?

Most split-dollar life insurance plans are used in business settings between an employer and employee (or corporation and shareholder). However, plans can also be set up between individuals (sometimes called private split-dollar) or by means of an irrevocable life insurance trust (ILIT). This article primarily discusses arrangements between employers and employees; however, many of the rules are similar for all plans.

In a split-dollar plan, an employer and employee execute a written agreement that outlines how they will share the premium cost, cash value, and death benefit of a permanent life insurance policy. The agreement lays out what the employee needs to accomplish, how long the plan will stay in effect, and how it will be terminated. It also includes provisions that restrict or end benefits if the employee leaves the job or fails to hit agreed-upon performance metrics.

Since split-dollar plans are not subject to  Employee Retirement Income Security Act (ERISA) rules, latitude exists in how an agreement can be written. They must still adhere to specific tax and legal requirements. An attorney or tax advisor should be consulted when drawing up the documents.

Split-dollar plans are frequently used by employers to provide supplemental benefits for executives and to help retain key employees.

Split-dollar plans also require record-keeping and annual tax reporting. Generally, the owner of the policy, with some exceptions, is also the owner for tax purposes. Limitations also exist on the usefulness of split-dollar plans depending on how the business is structured (for example as an S Corporation, C Corporation, etc.) and whether plan participants are also owners of the business.

History and Regulation of Split-Dollar Plans

Split-dollar plans have been around for years. In 2003, the IRS published new regulations which outlined two different acceptable split-dollar arrangements: economic benefit and loan. While some tax benefits were removed that year, split-dollar plans still offer advantages such as:

  • Term insurance: This is based on the IRS' interim table of one-year term premiums for $1,000 of life insurance protection (Table 2001 rates), which may be at a lower cost than the actual cost of the coverage, particularly if the employee has health issues or is rated.
  • The ability to use corporate dollars to pay for personal life insurance: Plans can leverage the benefit, especially if the corporation is in a lower tax bracket than the employee is.
  • Low-interest rates: They are available if the applicable federal rate (AFR) is below current market interest rates when the plan is implemented. Plans with loans can maintain the interest rate in effect when the plan was adopted, even if interest rates rise in the future.
  • Options to help minimize gift and estate taxes.

Economic Benefit Arrangement

Under the economic benefit arrangement, the employer is the owner of the policy, pays the premium and endorses or assigns certain rights or benefits to the employee. For example, the employee is allowed to designate beneficiaries who would receive a portion of the policy death benefit. The value of the economic benefit the employee receives is calculated each year.

Term insurance is valued using the Table 2001 annual renewable term rates, and the policy cash value is any increase that occurred during the year. The employee must recognize the value of the economic benefit received as taxable income every year. However, if the employee makes a premium payment equal to the value of the term life insurance or cash value received, then there is no income tax due.

A non-equity arrangement is when an employee’s only benefit is a portion of the term life insurance. In an equity split-dollar plan, the employee receives the term life insurance coverage and also has an interest in the policy cash value. Plans may allow the employee to borrow against or withdraw some portion of cash value.

Loan Arrangement

The loan arrangement is significantly more complicated than the economic benefit plan. Under the loan arrangement, the employee is the owner of the policy, and the employer pays the premium.

The employee gives an interest in the policy back to the employer through a collateral assignment. A collateral assignment places a restriction on the policy that limits what the employee can do without the employer’s consent. A typical collateral assignment would be for the employer to recover the loans made upon the employee’s death or at the termination of the agreement.

The premium payments by the employer are treated as a loan to the employee. Technically each year, the premium payment is treated as a separate loan. Loans can be structured as term or demand and must have an adequate interest rate based on the AFR.

But the rate can be below current market interest rates. The interest rate on the loan varies, depending on how the arrangement is drafted and how long it will stay in force.

Terminating Split-Dollar Plans

Split-dollar plans are terminated at either the employee’s death or a future date included in the agreement (often retirement). 

At the premature death of the employee, depending on the arrangement, the employer recovers either the premiums paid, cash value, or the amount owed in loans. When the repayment is made, the employer releases any restrictions on the policy and the employee’s named beneficiaries, which can include an ILIT, receive the remainder as a tax-free death benefit. 

If the employee fulfills the term and requirements of the agreement, all restrictions are released under the loan arrangement, or ownership of the policy is transferred to the employee under the economic benefit arrangement.

Depending on how the agreement was drafted, the employer may recover all or a portion of the premiums paid or cash value. The employee now owns the insurance policy. The value of the policy is taxed to the employee as compensation and is deductible for the employer.

Who owns a split-dollar policy?

That depends on the arrangement. Under a "loan" arrangement, the employee owns the policy and the employer pays the premium. Under an "economic benefit" arrangement, the employer owns the policy, pays the premium and endorses or assigns certain rights or benefits to the employee

What are the benefits to the employee of a split-dollar plan?

First of all, the employer pays the premium. Tax-free loans and withdrawals may be made and cash values may grow on a tax-deferred basis.

What are the benefits to the employer?

The employer can choose who gets the benefit. There are fewer restrictions that traditional plans and plan costs may be lower.

The Bottom Line

Like many non-qualified plans, split-dollar arrangements can be a handy tool for employers looking to provide additional benefits to key employees.

Article Sources
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