Overview

In the last ten years, life insurance producers and their counsel have quietly transferred great fortunes with minimal gift and estate taxation using intergenerational split dollar life insurance programs. This planning technique relies on the use of private split dollar using the restricted collateral assignment split dollar and the economic benefit regime. The typical planning scenario involves a senior patriarch or matriarch that is out of tricks, i.e., had completed used their unified credit, were advanced in years, and usually uninsurable. 

The split dollar arrangement usually insures the second generation and provides a contractual restriction that limits the ability of the senior generation to recover its interest until the earlier of the death of the insured, or the termination of the arrangement or surrender of the policy. Due to a combination of the restriction and the age of the insured(s), the value of the split dollar receivable is heavily discounted. The range of discount is anywhere from 75-95 percent.

It takes a while for the IRS to catch up on these planning innovations, and eventually they do. The Government lost a case challenging inter-generational split dollar in Tax Court in Estate of Morrissette, (Estate of Clara M. Morrissette v. Commissioner, 146 T.C. No. 11 (April 13, 2016)). The IRS lost a second significant inter-generational split dollar case in the Estate of Marion Levine, Deceased v. Commissioner of Internal Revenue, case number 9345-15. Based on the Government’s legal theory that “We Don’t Like What You Are Doing”, most practioners and insurance agents have modified the planning by switching to the loan method regime of restricted collateral assignment split dollar.

This article focuses on the use of the same planning techniques in compensatory split dollar arrangements, i.e. Employer/Employee arrangements. This planning as a discriminatory benefit for select and highly compensated provides an exciting method to transfer benefits to business owners and executives as a form of non-qualified deferred compensation. To the best of my knowledge, the use of inter-generational split dollar in the employer/employee context has received little attention thus far.

In all likelihood, post-election tax reform will result in lower corporate tax rates causing many business owners to switch their tax election from S corporation or LLCs taxed as a partnership, in favor of regular corporation tax treatment. The retained earnings will be taxed at lower marginal rates than the business owner’s individual marginal tax bracket creating favorable tax leverage. Retained earnings can be transferred using the split dollar arrangement with a substantial reduction in taxation based upon the planning methodology of inter-generational split dollar.

Lastly, an explanation for the title of the article. Most you who read my articles know that I am a big fan of Latin music. The Boogaloo was the fusion of American Soul music in the mid-1960’s in Spanish Harlem with traditional Afro-Cuban rhythms (aka rumba, guaracha et al). The dance associated with the music was referred to as “Shing a Ling”. If you want to sample this music, go back to the beginning with Pete Rodriguez and Joe Cuba. If you want to listen to an updated version of the Boogaloo, listen to the Boogaloo Assassins. Like the Boogaloo, inter-generational split dollar in a compensatory setting has plenty of rhythm and movement.

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 corporation 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 executive’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 executive’s family trust.

Strategy Example

Joe Smith, age 45, is the owner of Acme, Inc. The company has made an election to be taxed as a regular corporation. The company has several million dollars of retained earnings and would like to distribute some of these funds in a tax efficient manner to Joe as a supplemental and discriminatory benefit. The company plans to advance these funds using collateral assignment split dollar using the loan method.

Executive Smith arranges a new family trust to purchase a $2.5 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 Corporation bonuses the annual interest payment of $2,750 per year, based on the long term applicable federal rate of 2.75 percent.

Split Dollar Summary

                       Corporation                               Executive

As you can see the program provides substantial benefits. At age 65, Joe Smith would have a cash value of $1.46 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 $10.3 million, tax-free. In the event the corporation decides to transfer its receivable in the split dollar arrangement by sale in Year 11 by sale, the estimated fair market value of the split dollar receivable would be approximately $21, 600 reflecting a discount of approximately 95 percent of premiums paid.

Summary

I have believed for some time that the use of limited liability companies taxed on a pass-through basis rather than tax treatment as a corporation, has been oversold to small business owners. The anticipated reduction of the corporate tax marginal tax brackets through Tax Reform should accelerate the recognition of the favorable tax leverage as a regular corporation.

The tax leverage available to corporations will allow business owners to adopt discriminatory benefit programs such as split dollar life insurance as a supplemental retirement program and death benefit program. The split dollar program suggested in this article also has merit for S corporations with significant retained earnings and profits from earlier C corporation days and regular corporations with significant earnings and profits.

In the current low interest environment, the loan method of split dollar provides a significant improvement over the distribution of retained earnings as bonuses or the payment of qualified dividends.