Split-Dollar Insurance

Life insurance is the last of the late, great tax exempt sources of cash. The group-term life policies used as a basic fringe benefit are fine, as far as they go. But in the case of most business owners, the coverage provided is inadequate to meet their financial responsibilities. Yet individual, permanent life insurance is a luxury few can afford to buy with after tax dollars.

"Split-dollar" life insurance was developed to fill this gap. The term "split-dollar" is derived from the fact that the premiums for the life insurance policy on an employee are split between the insured employee and his or her employer. In the most traditional form of split-dollar, the employer pays the portion of the premium that relates to the yearly build-up in the cash value, while the employee pays the portion that relates to the term (pure insurance) protection.

Split-dollar insurance, prior to September 17, 2003, was an important benefit for the employee and, ultimately, it cost the employer nothing: the premium costs paid by the employer were recouped by sharing the death benefit with the insured's beneficiary or, by the employee's purchase of the employer's premium costs (and hence the policy) at retirement. This type of policy required no IRS approval and an employer could select for (or exclude from) participation anyone it chose. Thus, it was a good way to cover owners and any co-owners or key employees.

The advantages to an owner/shareholder included:

• low-cost insurance protection
• a way to get money out of your business, since life insurance proceeds are tax-exempt
• a way to prevent uninsurability in later years due to illness
• the ability to extend coverage after retirement, paying the employer the total of its contributions over the years by getting a loan using the policy as collateral
• a way to base the premium cost on your age at date of issue rather than on age at the date the policy is purchased from the employer

If the employer paid the employee's part of the premiums and called it a bonus to the employee, the cost could be deducted by the business, but it was taxable compensation for the employee.

As of September 17, 2003, no doubt as a result of the Enron debacle, new regulations were issued for split dollar arrangements initiated going forward. The final regulations provide that the tax treatment of split-dollar life insurance arrangements will be determined under one of two sets of rules, depending on who owns the policy.

If the executive owns the policy, the employer's premium payments are treated as loans to the executive. Consequently, unless the executive is required to pay the employer market-rate interest on the loan, the executive will be taxed on the difference between market-rate interest and the actual interest.

If the employer is the owner, the employer's premium payments are treated as providing taxable economic benefits to the executive. The economic benefits include the executive's interest in the policy cash value and current life insurance protection.