Panning for Gold in the Ivory Tower – Using Split Dollar and Private Placement Life Insurance to Compensate Senior Executives of Tax-Exempt Organizations



Charitable organizations from hospitals to universities have a difficult time attracting and retaining top executive talent from the world of public corporations. Public corporations provide competitive compensation along with the ability to acquire substantial personal wealth with equity-based compensation arrangements such as non-qualified stock options as well as attractive non-qualified deferred compensation arrangements.

In recent years, the Public has placed tremendous focus on the compensation of the tax exempt organization’s leadership versus the percentage of funds allocated to the tax-exempt organization’s charitable purpose. The tax-exempt organization’s federal tax return (Form 990) is typically made available to the public. As the cliché goes, “You can run but you can’t hide”.

It is no secret that university presidents are very well compensated. However, they are not alone. A USA survey on the total compensation of Division I football and basketball coaches is staggering. The median compensation of university presidents in a survey of 190 public colleges in 2012 was approximately $490,000. The upper end of that is as high as $4 million per year. The median compensation in a survey of 482 private colleges in 2012 was $385,000. In 2011 over sixty four Division I Football coaches made in excess of $1 million per year. The compensation level at 68 Division I universities for basketball coaches parallels the salary of football coaches.

Following tax reform in January 2013, earned income is taxed at higher rates. University presidents and hospital CEOs are likely to be taxed in the new top marginal tax bracket of 39.6 percent before state income taxes. The ability to defer income is generally limited. 403(b) plan limits for employees of tax exempt organizations are able to defer $17,500 of their salaries in 2013. Employees age 50 or older may contribute an additional $5,500 per year. IRC Sec 457(f) plans are non-qualified deferred compensation arrangements for executives of tax-exempt organizations. These plans are subject to the restrictions of IRC Sec 409A.

Old News - Equity Split Dollar for Tax Exempt Executives

Prior to the adoption of final split dollar regulations in 2003, equity split dollar was used as a compensation tool to provide a substantial death benefit for the family of a senior executive and supplemental retirement income. The attractiveness of the employee benefit program was the ability to provide a substantial amount of future benefits at a low reportable tax cost for the executive. Under split dollar, only the amount of the economic benefit under the arrangement is reported on Form 990. This anomaly between a large life insurance premium and a low reportable tax cost, i.e... the economic benefit,  was very powerful for the university president or CEO of a tax-exempt hospital.

In some respect, equity split was not only the “greatest thing since sliced bread”, it was “greater than sliced bread”. After almost fifty years, the Service recognized that equity split dollar was in effect an interest free loan to the taxpayer. In an equity split dollar arrangement, the sponsor paid all or most of the premiums in exchange for an interest in the policy cash value and death benefit equal to the lesser of the policy cash value or premiums.

The taxpayer or his trust owned the excess cash value and death benefit. The tax cost for the arrangement was the lesser of the insurer’s term cost or PS 58 costs. The cash value in excess of premiums allowed the taxpayer to reimburse the Sponsor and use the excess cash value for tax-free supplemental retirement income.

The feeling regarding split dollar following the final split dollar regulations in 2003 is that is died a quiet and unnoticeable death. The fact of the matter is that these reports of split dollar’s demise have been incorrectly reported and exaggerated.

This article will outline compensation techniques for employees of tax exempt organizations using split dollar based on the final split dollar regulations. The planning results are powerful and address all of the compensation and political concerns impacting the tax-exempt executive.

Private Placement Life Insurance (PPLI)

PPLI is a customized variable universal life insurance policy that offers institutional pricing and unlimited investment flexibility. The policy can offer hedge fund and other alternative investments as part of the offering of funds within the policy.

PPLI is well suited for this technique. It is my contention that many life insurance agents do not make a clear distinction between a dollar invested for strictly for investment purposes from a

dollar invested for strictly for a traditional insurance planning purpose. Art for Art’s sake!

This split dollar arrangement is primarily a supplemental retirement program. As a result, a strong argument exists that the investment in the program based upon the stated planning purpose as well as the size of the investment, favors a more cost efficient life insurance policy such as PPLI.

I believe that the consultant or agent can be well compensated through a combination of a planning fee as asset-based product compensation or level product based commissions.

Split Dollar Overview

Split dollar life is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Generally speaking, two forms of classical split dollar arrangements exist, the endorsement method and collateral assignment method.

 Importantly, IRS Notice 2007-34 provides that split dollar is not subject to the deferred compensation rules of IRC Sec 409A. See § 1.409A-1(a)(5).The IRS issued final split dollar regulation in September 2003. These regulations were intended to terminate the use of a technique known as equity split dollar. The consequence of these regulations is to categorize into two separate regimes – the economic benefit regime or the loan regime.

Split Dollar under the Economic Regime

Under the economic benefit regime, the employee or taxpayer is taxed on the “economic benefit” of the coverage paid by the employer. The tax cost is not the premium but the term insurance cost of the death benefit payable to the taxpayer. The economic benefit regime usually uses the endorsement method but may also use the collateral assignment method.

In the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy’s premium. The company has in interest in the policy cash value and death benefit equal to the greater of the policy’s premiums or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.

Under the collateral assignment method, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employee collaterally assigns an interest in the policy cash value and death benefit equal to the greater of the cash value or cumulative premiums.

The economic benefit is measured using the lower of the Table 2001 term costs or the insurance company’s cost for annual renewable term insurance. This measure is the measure for both income and gift tax purposes. Depending upon the age of the taxpayer, the economic benefit tax cost is a very small percentage of the actual premium paid into the policy -1-3 percent.

Split Dollar Under the Loan Regime

The loan regime follows the rules specified in IRC Sec 7872. Under IRC Sec 7872 for split dollar arrangements, the employer’s premium payments are treated as loans to the employee. If the interest payable by the employee is less than the applicable federal rate, the forgone interest payments are taxable to the employee annually.  In the event the policy is owned by an irrevocable trust, any forgone interest (less than the AFR) would be treated as gift imputed by the employee to the trust. The loan is non-recourse.

The lender and borrower (employer and employee respectively) are required to file a Non-Recourse Notice with their tax returns each year (Treas Reg. 1. 7872-15(d) stating that representing that a reasonable person would conclude under all the relevant facts that the loan will be paid in full.

Split dollar under the loan regime generally uses the collateral assignment method of split dollar. In a corporate split dollar arrangement under the loan regime, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employer loans the premiums in exchange for a promissory note in the policy cash value and death benefit equal to its premiums plus any interest that accrues on the loan. The promissory note can provide for repayment of the cumulative premiums and accrued interest at the death of the employee.

Death Benefit Only (DBO) Plan Overview

The DBO Plan is a contractual arrangement between a corporation and an employee or contractor. The corporation agrees that if the contractor or employee dies, the corporation will pay a specified amount to the employee or contractor’s spouse or other designated class of beneficiaries’ children. Payments can be made on an installment basis or in a lump sum.

The payments are taxable income but can be structured so that the payments are estate tax-free. If the payments are made to a designated beneficiary that does not provide the employee with the ability to right to change or revoke the beneficiary designation, the payments can avoid estate taxation.

The DBO Plan is added to provide additional compensation to the executive at death. The loan reimbursements under the split dollar arrangement to the tax exempt organization is used for finance benefits under the DBO Plan.

The Strategy

The thrust of the arrangement for the university president or hospital CEO  is a split dollar arrangement coupled with a Death Benefit Only arrangement The DBO plan provides for the payment of benefits to a designated beneficiary of the executive at death. The designated beneficiary may include a family trust. This is an additional benefit above and beyond the split dollar arrangement.

The power of split dollar is how it is taxed to the participant. The participant is not taxed on the employer’s premium payment to a life insurance company but rather in one of two ways- the economic benefit method or the loan method- which will be described in detail below.

The loan method can be structured  a demand note basis or as a term loan. The rate for the demand loan is a blended rate short term applicable federal rate under IRC Sec 7872(e)(2)(A). The current rate for 2013 is .22 percent annually.

Over the last ten years, this rate has been as high as 4.9 percent. However, over the last several years, this rate has been less than one percent. In the event that rates increase, the demand loan arrangement can be amended to lock into the long term AFR which is currently 2.49 percent.

In the event is arrangement is structured on an interest free basis, the forgone interest will be imputed to the taxpayer as taxable income in a compensatory arrangement as well as imputed for gift tax purposes.

IV   Strategy Example

  1. The Facts

Joe Smith, age 55, is the President of Acme University in New York. He annual compensation in 2012 was $800,000. The University provides housing as well as a range of other benefit programs for Joe. Joe lives very comfortably except that his combined effective tax rate is approximately 50 percent. Joe would like to restructure his compensation package in order to maximize the tax effect of his compensation.

Joe would like to provide a legacy for his children. Joe has spent his entire career in Academia and unlike his peers did not have the opportunity to acquire wealth in corporate America through company stock programs


Under the new employment agreement, Joe will forgo $500,000 of compensation each year. The university will instead loan Joe $500,000 each year at a rate equal to the current long term AFR- 2.49 percent. The University is committed to loaning Joe $5 million over the next ten years. Joe will retire from the University at age 65. The loan is not repayable until Joe’s death

Joe enters into a split dollar arrangement with Acme University and the Smith Family Trust. Under the agreement, Joe agrees to become the  insured under a PPLI policy with an annual premium of $500,000 and death benefit of $15 million. The University has agreed to make the loans each year directly to the trustee. The trustee will use the loan proceed from Acme to fund the PPLI contract. The trust will be the applicant, owner and beneficiary of the policy. Joe’s wife is an income beneficiary of the trust along with the Smith children and grandchildren.

The split dollar arrangement uses the loan method. The loan is repayable at Joe’s death. The interest will accumulate each year at the current long-term AFR of 2.5 percent. The loan is a single loan agreement executed currently but with annual disbursements. . Under the new employment agreement, Joe will forgo $500,000 each year. The loan will provide for the capitalization of interest payments at 2.5 percent per year which will be repaid at Joe’s death. Joe will not have any income or gift tax consequences under the arrangement.

Under the arrangement, Acme University will have a collateral assignment interest in the policy equal to the greater of the policy cash value or policy’s cumulative premiums plus accrued interest. Acme’s access to the cash value is restricted under the arrangement until the earlier of the termination of the split dollar agreement, surrender of the policy or death of the insured, Joe Smith.

The University has also adopted a death benefit only (DBO) Plan which provides a lump sum payment to the Smith Family Trust at Joe’s death. Assuming death at age 85, the family can expect a single payment of $11.7 million. The payment is subject to income taxation but not estate taxation. The trustee may also elect to receive the payment over a five year period.

The Smith Family Trust as the policyholder will have an interest in the policy cash value for the cash value accrual in excess of premiums and 2.5 percent annual interest. The Trust will have a death benefit of $15 million less the accumulated loan principal and interest. The projected cash value at age 70 assuming an investment return of 8 percent is 9.5 million. The excess cash value over the University’s interest is $4 million.

The projected death benefit is still $15 million greater than the University’s collateral assignment interest in the policy at retirement. The excess cash value within the policy provides Joe with an additional $250,000 of tax free retirement income for a ten year period at retirement.  At Joe’s death the family will receive the DBO payment as well as the death benefit payment to the Trust.

Under the arrangement, Joe has had no tax consequences for either income or a gift tax purpose as the loan was fixed at the long term AFR - $2.5 million.


It is not easy to attract and retain top executive talent in the tax exempt world. Part of the equation is the attraction of the employment opportunity. The other part of it is how long will it last and what does the executive get to receive and show for my effort. The difficult and political terrain of the tax exempt world makes it difficult to pay senior leaders well without attracting a lot of moaning and groaning from the Peanut Gallery.

As a result, it is incumbent to use compensation methods that do not attract a lot of attention for compliance reporting purposes while providing senior management with long term security and benefits. The split dollar arrangement described above accomplishes these objectives while providing substantial benefits. The long term benefits rival those of the corporate executive without the volatility of corporate politics and watching the price of company stock doing somersaults and acrobatics.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

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