Managing Liquidity with Split-Dollar Life Insurance

Tax News You Can Use | For Professional Advisors

December 9, 2024

When it comes to the estate tax, owners of illiquid assets face a unique set of challenges. Illiquid assets, like business interests, real estate investments and valuable collections, can generate significant estate tax obligations at the owner’s death without providing a straightforward way to pay that tax. Tax payments must be made in cash, not in kind. While it may be possible to sell those assets to pay tax, it is not always possible to maximize the value on a sale if it must occur before the estate tax return is due. Life insurance is a common solution to this liquidity problem, and split-dollar life insurance is a way of structuring the payment of the premiums in a tax-effective manner.

Estate Taxation of Insurance Proceeds

The proceeds of life insurance policies owned by the decedent are includible in the taxable estate. However, if a third party, such as an irrevocable life insurance trust (ILIT), owns the policy, the proceeds are not included in the insured’s estate and do not generate estate tax. For taxpayers with assets exceeding the estate/gift/GST tax exemptions ($13.61 million in 2024 for a single person, $27.22 million for a married couple), a third-party-owned life insurance policy can save tax of 40% on the policy proceeds, reducing both the amount of coverage needed and the premium cost.

However, using an ILIT to own the life insurance introduces gift tax issues. The transfer of an existing policy to a trust is a taxable gift. Transferring money to pay the premiums or having the grantor or the grantor’s employer pay the premiums on policies owned by the ILIT are also gifts subject to gift tax. And it is this issue that split-dollar life insurance is designed to solve.

What is Split-Dollar Life Insurance?

A split-dollar agreement is a way of allocating the premium cost and death benefit of a life insurance policy between two parties. While they are typically between an employer and an employee or a business and its owners or executives, theoretically they can be between other individuals or entities, including other trusts. As an example, in employment split dollar, the employer pays the premiums on a life insurance policy on the employee’s life. The employer is repaid for those premium payments later, often upon the death of the employee, with the beneficiary selected by the employee receiving the remaining death benefits. This article focuses on split dollar between a business and a shareholder who may also be an executive or other employee.¹

In economic benefit endorsement split dollar, the company owns the policy, with an endorsement to the policy providing the benefit to the shareholder that allows the shareholder to name a beneficiary for a portion of the death benefits. The other basic type of split-dollar arrangement is the loan regime with collateral assignment. In this case, the shareholder (or more typically an ILIT created by the shareholder) owns the policy, with the company providing premium payments that are treated as loans. There is a collateral assignment that requires the recipient of the proceeds to repay the company for the premiums paid when the plan terminates (often at death, but it can be earlier), with the rest of the death benefit going to the beneficiary designated by the policy owner — typically the ILIT. The shareholder must repay the interest on the loan annually. There are two other variations on collateral assignment split dollar. One is “non-equity collateral assignment” (NECA) split dollar, where the company does not have an equity interest in the policy, and switch-dollar, where the policy switches from NECA to loan regime at a specified point in time — a technique often used when the policy is on the joint lives of the shareholder and their spouse.

Income and Gift Taxation of Premium Payments

In an endorsement-style split dollar, the company pays the premiums and the shareholder is taxed on the “economic benefit” of the policy as compensation. The economic benefit is the annual renewable term cost for the death benefit, usually determined according to a table published by the IRS. This is based on the size of the policy, the insured’s age and other risk factors, and it therefore increases each year as the insured grows older. If an ILIT is the endorsee, rather than the shareholder, in this type of arrangement, the shareholder is also treated as having made a gift for gift tax purposes to the ILIT. For gift tax purposes, the difference between this and a normal ILIT is that the annual economic benefit is typically a small fraction of the entire premium amount.

In a loan-style split dollar, the payment of the premium by the company is an interest-bearing loan to the shareholder or the ILIT. The interest is typically at the long-term applicable federal rate published by the IRS. The interest must be paid annually. For an ILIT to make those interest payments, it needs to have assets other than the policy, typically received as taxable gifts from the shareholder. Alternatively, the shareholder pays the interest, which is treated as a taxable gift to the ILIT. In either case, the gift tax cost is lower than it would be if the shareholder made cash gifts to the ILIT to pay the entire premium, as would be necessary without the split-dollar agreement.

Repaying the Company

In all of these scenarios, the company is entitled to repayment of premiums it paid. If the split-dollar plan is still in place at the shareholder’s death, the proceeds of the death benefit are available for that purpose. However, there are often reasons to unwind the split-dollar arrangement while the insured is still living, including when the company is sold to a third party, when the shareholder becomes disabled or retires, or when the cost of the insurance is no longer something the company wants to bear. Some strategies include:

• Using a loan against the cash value of the policy to repay the company. This may not cover the entire amount owed, but it can be one source of funds
• Surrendering the policy for its cash value
• Building up additional assets in the ILIT to enable repayment of the loan (from the gifted assets, from income earned by the gifted asset or by loans against the gifted assets). This can be accomplished by annual exclusion gifts, GRATs or sales (since the ILIT is typically a grantor trust)
• Having the company forgive the loan, distribute the policy or give the shareholder a cash bonus. Any of these could create significant income tax costs for the employee, so it is important to choose when and how to do this in collaboration with the shareholder’s income tax preparer.