Introduction

Split dollar life insurance arrangements are sophisticated financial tools that provide unique benefits and flexibility for both employers and employees. Understanding the nuances of these arrangements, particularly the differences between the loan regime and the economic benefit regime, is essential for optimizing tax efficiency. This blog will delve into these differences and explore strategies for switching regimes during the loan’s lifetime to minimize taxes, complete with detailed examples.

Split Dollar Life Insurance: An Overview

Split dollar life insurance is a strategy where the premium costs and benefits of a life insurance policy are shared between two parties, typically an employer and an employee. The primary objective is to provide life insurance coverage to the employee while allowing the employer to recover its costs, either through policy loans or from the death benefit proceeds.

Loan Regime vs. Economic Benefit Regime

Loan Regime

In the loan regime, the employer loans the premiums to the employee to pay for the life insurance policy. The employee owns the policy, and the loan accrues interest. The critical characteristics of the loan regime include:

• Interest Accrual: The loan from the employer to the employee accrues interest, which can be at a market rate or an imputed rate if the actual interest rate is below market rates.
• Loan Repayment: The employee is responsible for repaying the loan, typically from the policy’s cash value or death benefits.
• Taxation: The interest on the loan may be deductible, and the employee may have to pay taxes on the imputed interest.

Calculation Example:

• Annual premium: $1,000,000 for 10 years
• AFR (Applicable Federal Rate): 5%
• Loan repayment period: 25 years

Interest accrued annually on a $1,000,000 loan:

• Annual interest = 1,000,000 * 0.05 = 50,000

Economic Benefit Regime

In the economic benefit regime, the employer owns the life insurance policy and provides the employee with the economic benefit of the death protection. Key features include:

• Economic Benefit Cost: The employee is taxed on the economic benefit cost of the life insurance, which is typically calculated using IRS Table 2001 rates.
• Policy Ownership: The employer retains ownership of the policy, and the employee has a right to the death benefit.
• Taxation: The cost of the economic benefit provided to the employee is considered taxable income.

Calculation Example:

• Assume Table 2001 rate for $20,000,000 coverage for a 40-year-old: $1.65 per $1,000
• Annual taxable benefit: $1.65 * 20,000 = $33,000

Switching Regimes for Tax Efficiency

One of the strategic advantages of split dollar life insurance is the ability to switch between regimes to optimize tax outcomes. Here’s how switching regimes can be beneficial:

Switching from Loan Regime to Economic Benefit Regime

1. Taxable Interest Mitigation: If the interest on the loan is becoming burdensome, switching to the economic benefit regime can mitigate the taxable interest issues.
2. Simplified Tax Reporting: The economic benefit regime simplifies tax reporting as the employee is taxed only on the economic benefit cost, rather than dealing with imputed interest calculations.

Switching from Economic Benefit Regime to Loan Regime

1. Leverage Policy Cash Value: If the policy has built up significant cash value, switching to the loan regime allows the employee to leverage this value for personal use while repaying the loan.
2. Potential Tax Savings: By structuring the loan repayment carefully, it may be possible to achieve tax savings, especially if the loan interest rates are favorable.

Case Study: A CEO’s Strategic Use of Split Dollar

Example 1: Regular Loan Interest Payments

Scenario: A 40-year-old CEO opts for a split dollar arrangement with a 10-pay premium of $1 million annually, an AFR of 5%, and plans to repay the loan in 25 years. The policy’s death benefit is $20 million, and the policy’s cash value has an expected ROI of 7%.

Yearly Calculations:

• Loan Regime:
  • Annual premium loaned: $1,000,000
  • Annual interest at 5%: $50,000
  • Over 10 years, total premiums loaned: $10,000,000
  • Interest on total loan after 10 years: $500,000 annually
• Economic Benefit Regime:
  • Table 2001 rate for a 40-year-old: $1.65 per $1,000 of coverage
  • Annual taxable benefit: $1.65 * 20,000 = $33,000

Switching Strategy:

• Initially, the CEO uses the loan regime to take advantage of lower immediate taxes on the interest.
• After 10 years, the policy’s cash value grows due to the 7% ROI.
• Assume the policy’s cash value is approximately $14 million after 10 years.

Switch to Economic Benefit Regime:

• Taxable benefit cost increases with age based on IRS Table 2001 rates:
  • Age 51: $2.71 per $1,000
  • Age 52: $2.89 per $1,000
  • Age 53: $3.07 per $1,000
  • …
  • Age 65: $10.76 per $1,000
• CEO is taxed on the economic benefit cost, which increases annually.

Benefits:

• The CEO avoids paying higher taxes on the accumulated interest under the loan regime.
• By leveraging the policy’s cash value growth, the CEO can use these funds to repay the loan or for other financial needs.

Summary of Tax Savings: Switching from the loan regime to the economic benefit regime after 10 years allows the CEO to avoid paying taxes on the $500,000 annual interest that would have been accrued on the $10,000,000 loan. Instead, the CEO is taxed on the increasing economic benefit cost, which starts at $54,200 for a 51-year-old and increases each year based on age. This strategy saves the CEO a significant amount in taxes over the life of the policy.

Example 2: Accrued Loan Interest

Scenario: The same 40-year-old CEO opts for the loan regime with the same terms but chooses to accrue the loan interest back to the loan principal rather than paying it annually. The CEO stops accruing the loan in policy year 10 and switches to the economic benefit regime in year 11.

Yearly Calculations:

• Loan Regime with Accrued Interest:
  • Annual premium loaned: $1,000,000
  • Interest accrued annually at 5%, compounded:
    • Year 1: $1,000,000 * 1.05 = $1,050,000
    • Year 2: $1,050,000 * 1.05 = $1,102,500
    • Year 3: $1,102,500 * 1.05 = $1,157,625
    • …
    • Year 10: $1,000,000 * (1.05^10) = $1,628,894.63
  • Over 10 years, total premiums loaned: $10,000,000
  • Accumulated loan amount after 10 years:
    • Each $1,000,000 accrues to $1,628,894.63, so:
    • Total loan after 10 years: $16,288,946.30

Switch to Economic Benefit Regime in Year 11:

• Annual taxable benefit for a 51-year-old using Table 2001 rate: $2.71 per $1,000 of coverage.
• Taxable benefit cost: $2.71 * 20,000 = $54,200 annually.
• The cost increases with age based on IRS Table 2001 rates:
  • Age 51: $54,200
  • Age 52: $57,800
  • Age 53: $61,400
  • …
  • Age 65: $215,200

Benefits:

• The CEO avoids paying higher taxes on the accumulated interest under the loan regime.
• By leveraging the policy’s cash value growth, the CEO can use these funds to repay the loan or for other financial needs.

Summary of Tax Savings: Switching from the loan regime to the economic benefit regime after 10 years allows the CEO to avoid paying taxes on the accrued interest, which totals $6,288,946.30 over 10 years. Instead, the CEO is taxed on the increasing economic benefit cost, which starts at $54,200 for a 51-year-old and increases each year based on age. This strategy provides significant tax savings by reducing the taxable amount compared to the accrued interest on the loan.

Risks of Using Split Dollar Without Proper Documentation and Annual Reviews

While split dollar arrangements can offer significant tax advantages, they come with risks if not properly documented and reviewed annually. Without proper documentation, there is a risk of IRS scrutiny and potential disallowance of the arrangement, leading to unexpected tax liabilities.

Documentation Risks

Proper documentation is essential to ensure that the split dollar arrangement is recognized as a legitimate financial tool. Failure to document the terms and conditions of the arrangement can result in the IRS reclassifying the arrangement, leading to adverse tax consequences.

1. Increased Tax Liability: Without proper documentation, the IRS may determine that the arrangement is not a valid loan or economic benefit arrangement. This could lead to the recharacterization of the premiums paid as taxable income, resulting in a significant tax liability.
2. Penalties and Interest: If the IRS disallows the arrangement, the employee could be subject to penalties and interest on the unpaid taxes, further increasing the financial burden.

Annual Review Risks

Annual reviews are crucial to ensure that the split dollar arrangement continues to meet IRS requirements and to make necessary adjustments based on changes in interest rates, policy performance, and other factors.

1. Failure to Pay Taxes: If the taxes on the economic benefit cost or the imputed interest are not paid annually, the IRS may assess additional taxes, penalties, and interest.
2. Accounting and Record-Keeping: Proper accounting and record-keeping are essential to track the premiums paid, interest accrued, and the economic benefit provided. Failure to maintain accurate records can result in IRS audits and disallowance of the arrangement.
3. Changing Regulations: Tax laws and IRS regulations can change over time. Without annual reviews, the arrangement may become non-compliant with new rules, leading to adverse tax consequences.

Importance of Professional Guidance

To mitigate these risks, it is essential to work with a split dollar service provider who can review the arrangement annually and ensure compliance with IRS regulations. A professional can provide guidance on documenting the arrangement, paying taxes, and making necessary adjustments to optimize tax benefits.

Standard Disclosures

This document is for educational purposes only and is not intended as tax or legal advice. The information provided is assumed to be accurate but cannot be guaranteed. Always consult with your attorney, advisor, or CPA before implementing any split dollar strategy.