Put Me in Coach! Using Split Dollar Life Insurance Plans to Compensate Division I Coaches

by Gerald Nowotny
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Overview

In August 2016, the national sports media provided details regarding the compensation package for Coach Jim Harbaugh at the University of Michigan. It comes as no surprise to anyone that Division I football and basketball coaches make a lot of money and usually more than the college presidents of the universities of where they coach. Personally, I have always personally questioned this practice, but I understand that college football is Big Business that pays a lot of bills for the universities.

The program described a life insurance purchase on the life of Coach Harbaugh for a policy with a $75 million death benefit and annual premiums of $2 million per year for seven years. Two years of premium ($4 million) were advanced in 2016. Most likely, the policy was backdated to save age facilitate the payment of premiums in the first policy year.

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. For college coaches at a Division I School the idea of financial security can be short-lived because a coach is only as valuable as the most recent “win-loss” record. Cash compensation is subject to taxation at ordinary. Qualified retirement plans provide little opportunity for the heavily compensated coaches to defer substantial amounts of money.

In the glory years of equity split dollar, tax-exempt organizations used split dollar as a method to provide additional supplemental retirement and death benefits for senior executives. Tax-exempt organizations receive constant scrutiny from the public that monitors the compensation of the organization’s leadership along with the percentage of funds allocated to the tax-exempt’s charitable purpose.

The split dollar program allows the tax-exempt organization to provide substantial contributions into the program while only reporting a small fraction of the contribution on the organization’s annual Form 990 to the IRS. The reporting requirements only required the reporting of the “economic benefit” and not the policy’s annual premium. Using this same methodology, Michigan would only have to report approximately $68,250 as annual compensation for the $2 million annual premium payment in 2016.

This article is designed to illustrate how split dollar strategy can provide substantial financial benefits during lifetime and at death for coaches and their families that can last substantially past a volatile coaching career.

Summary of the University of Michigan Split dollar Program

The Michigan program for Coach Harbaugh uses the loan method of split dollar. This article will outline the benefit of this technique for Division I coaches such as Coach Harbaugh. The financial planning and economic benefit for the coaches and their families is significant. A $75 million death benefit is nothing to sneeze at! College coaching is a precarious and volatile way to make a steady living. Here today and gone tomorrow!

This type of program can provide significant long-term financial benefits and security for the coach and his family.  According to a USA survey of 120 Division I football coaches, the average compensation package ranged from $500, 000 at the bottom to $7 million at the top. Division I basketball coaches make similar money. Coach K from Duke is at the top of the hill with total compensation around $7 million. Query: I wonder if his kids got free tuition at Duke. The program also allows the university to recover its cost when the coach dies. It also allows the University for tax compliance purposes to avoid reporting excessive compensation for university employees.

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. The cash value in excess of the lender’s interest is available to the policyholder as a source of tax-free benefits during lifetime. The policyholder may take distributions as a recovery of basis tax-free and then take tax-free policy loans. The death benefit is also income tax-free and potentially estate tax-free.

Death Benefit Only (DBO) Plan Overview

The university may “piggy back” or add an additional benefit plan to allocate the death benefit that it receives as part of its cost recovery under the split dollar arrangement. These funds can be paid to the Coach’s family pursuant to a death benefit only (DBO) option. 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. My planning suggestion is to have the designated beneficiary as the coach’s family trust.

Strategy Example

Joe Smith, age 45, is the head football coach at State University, a Division I powerhouse. His is about to sign a new seven contract. In lieu of additional cash compensation, the university has agreed to lend Coach Smith, $1 million per year for five years. The university is willing delay repayment and annual interest payments until the coach passes away into Football Heaven.

Coach Smith arranges a new family trust to purchase a $25 million policy on his life. The underlying is an equity indexed universal life policy. The crediting rate is 8.5 percent. In this case, the University bonuses the annual interest payment of $95,000 per year, based on the long term applicable federal rate of 1.9 percent.

Split Dollar Summary

                       University                                   Coach

Year

 Age

Net Premium

Due as Loan Receivable

Cash Value (net of loan receivable)

Death Benefit

1

45

1 million

$1 million

      0

$25 million

10

55

5 million

5 million

3.44 million

$25 million

20

65

5 million

5 million

14.55 million

$25 million

30

75

5 million

5 million

43 million

$43 million

40

85

5 million

5 million

98 million

$103 million

As you can see the program provides substantial benefits. At age 65, Coach Smith would have a cash value of $14.55 million that could be accessed on a tax-free basis as supplemental retirement income. In the event of death at age 85, the projected death benefit payable to the family trust would be $103 million, tax-free.

Summary

“Big Time” college sports is also very big business. The coaches are paid more than the university presidents of the universities where they coach. The financial justification is the revenue that a top football or basketball program brings to the university. From the perspective of the coach, the job is a “pressure cooker,’ and a financial blessing as long as it lasts. Coaches need to identify and implement tax-advantaged strategies for supplemental retirement income and wealth creation that reallocate current income taxed at ordinary rates. Joe Paterno donated $4 million to Penn State over is coaching career. The split dollar program and it substantial death benefit would also allow coaches to give something back to the school where they left so much of themselves while enjoying an excellent retirement with tax-free benefits.

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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