A note on our perspective: Summit Legacy’s expertise is in the insurance and executive benefits applications of split dollar; arrangement design, policy selection and funding, in-force review, and exit planning. The tax, legal, and drafting dimensions of split dollar require qualified tax counsel. We write about the insurance and planning implications because that’s where we work every day.
Split dollar is the most misunderstood arrangement in executive benefits, and the misunderstanding starts with the word arrangement.
Split dollar is not a product. You cannot buy one. There is no split dollar policy, no split dollar carrier, no split dollar illustration that stands on its own. What exists is a life insurance policy and a written agreement between two parties about who pays the premium, who owns what, who receives what at death, and how the arrangement ends.
That distinction is not academic. It is the reason split dollar works well when it is designed carefully and fails expensively when it is sold as a product.
Over the past three months, we have looked at the executive benefit problem from several angles, with particular attention to law firms and professional services businesses: how firms compete for the people who matter most, how they build meaningful benefits outside the qualified plan system, and how those commitments sit alongside the economics of a partnership or a closely held business.
Split dollar is where several of those questions converge. It can allow an organization to provide a significant life insurance benefit to a particular executive while retaining an economic interest in the dollars it contributes. Done well, that solves a problem a simple bonus cannot. Done badly, it leaves both parties managing an arrangement nobody knows how to unwind.
The Structure, Briefly
Final regulations issued in 2003 govern arrangements entered into, or materially modified, after September 17, 2003, and establish two mutually exclusive regimes. That second clause matters more than it reads: a material change to an older arrangement can pull it into the current rules as a new arrangement as of the date of the change.
Under the economic benefit regime, the employer generally owns the policy and endorses a portion of the death benefit to the executive’s designated beneficiary. The executive is taxed annually on the value of that current life insurance protection, measured using Table 2001 rates or the insurer’s published alternative term rates where those rates qualify. The employer recovers its premium outlay from the death benefit or from policy cash value.
Under the loan regime, the executive or a trust owns the policy, and the employer’s premium payments are treated as a series of loans secured by a collateral assignment. To avoid below-market loan treatment, those loans generally need adequate stated interest under the applicable federal rate rules. Otherwise, the arrangement can produce imputed transfers and imputed interest income. The loan’s structure, whether it is documented as a term loan, a demand loan, or a hybrid, determines which AFR applies and whether the rate is fixed for the duration.
The choice between the two regimes is the single most consequential decision in the arrangement. It should be driven by the insured’s age, the intended duration, and the exit. It is too often driven by which structure the illustration software presents first.
Where Split Dollar Earns Its Complexity
There are four situations where we think split dollar can genuinely earn that complexity rather than becoming a more elaborate version of a simpler solution.
Tax-exempt organizations. A hospital, university, or foundation trying to build a meaningful retirement benefit for its chief executive runs into Section 457(f), which taxes the benefit when the substantial risk of forfeiture lapses rather than when the executive receives the money. The executive can owe tax on money they have not been paid. That timing mismatch makes conventional deferred compensation difficult to use well in the tax-exempt sector.
A properly structured bona fide loan regime arrangement can avoid the 457(f) timing problem, because the premium funding is treated as a loan rather than as deferred compensation. That makes it one of the relatively few structures that addresses the timing problem directly. The words bona fide are carrying real weight there: the arrangement needs a genuine expectation of full repayment and real security in the policy. The loan terms also need to address interest appropriately, since below-market interest can create imputed compensation and interest consequences under Section 7872. Interest that is forgiven becomes compensation when it is forgiven. And the arrangement still has to survive the reasonable compensation review and excess benefit rules that apply to any tax-exempt organization’s executive pay. Meet those conditions and the structure can work well. Skip them and what you have is a compensation arrangement with a loan label on it.
Employers that value cost recovery. A Section 162 bonus arrangement is simple, deductible to the extent the total compensation is reasonable, and gone. The company writes a check and never sees the money again. With split dollar, the employer is generally structuring its premium outlay around eventual recovery rather than permanently giving the money away. The premiums are generally not deductible where the company is directly or indirectly a beneficiary, and that is the trade.
Which of those is preferable depends entirely on the organization’s actual objective. A company that values current deductibility and is comfortable treating the payment as an unrecoverable compensation cost may be right to bonus it. A company with a strong balance sheet and a long planning horizon may prefer to preserve an economic interest in what it contributes, and would have chosen that if anyone had laid the comparison out. In our experience, that comparison is rarely presented at all.
An adjacent business planning application: cross-purchase funding. In a traditional cross-purchase agreement, each owner must insure every other owner, which means a four-owner company can require twelve policies funded with after-tax personal dollars. That expense and administrative friction can contribute to cross-purchase arrangements becoming underfunded or falling out of date. Split dollar allows the business to fund those premiums while the owners retain ownership of the coverage, with the company recovering its outlay from the proceeds.
Selective benefits where a broad-based program does not solve the problem. This is the situation the last three months have been building toward. A firm has a specific managing partner, a specific revenue producer, a specific executive whose retention or protection is a distinct economic question, and no interest in changing the benefit structure for the entire employee population to address it. Qualified plans are subject to nondiscrimination requirements and generally cannot simply be designed around one favored executive. Group coverage is calibrated to the average participant. Split dollar can be aimed at one person, sized to that person’s actual economic significance, and structured so the firm is not simply absorbing the cost.
That selectivity is the point. It is also what makes the design discipline described below non-optional.
Where It Doesn’t
We talk clients out of split dollar more often than into it, for reasons that are usually one of these five.
The premium is too small. Below a certain size, the annual reporting, the in-force review, the documentation maintenance, and the eventual unwind cost more in attention than the arrangement returns in value. A Section 162 bonus or a restricted bonus arrangement is the honest answer, and we would rather say so at the outset.
The executive is an insider at a public company. Section 402 of the Sarbanes-Oxley Act prohibits personal loans to directors and executive officers of public issuers. The SEC has never issued guidance on whether a loan regime split dollar arrangement is a covered extension of credit, so the question is technically open. Practitioners have generally treated it as prohibited since 2002, and we would not advise a client to be the test case.
The insured is already old enough that the cost curve bites inside the intended term. Economic benefit costs rise with age, and they rise steeply in the later years. Under Table 2001, the cost per thousand dollars of protection is roughly twenty times higher at age seventy than at forty, and roughly fifty times higher at eighty. An arrangement designed to run twenty years on a sixty-two-year-old is a fundamentally different proposition from the same arrangement on a forty-five-year-old. The illustration at inception rarely makes that obvious, because the early years are exactly where the arrangement looks best.
The employer wants flexibility it is not willing to give up. Split dollar creates a long-lived relationship between the employer, the executive, and a specific policy. If what the company actually wants is to hand an executive something portable, with minimal continuing employer involvement and no ongoing obligation on either side, a bonus structure serves that objective better and everyone should say so early.
Nobody has agreed to own the administration. Split dollar is a maintained arrangement, not a completed transaction. If no one at the company and no one on the advisory team is accountable for the annual work, the arrangement will drift.
Five Ways Split Dollar Arrangements Fail
One: no exit was modeled at inception. This is the most common failure, and it is a failure of process rather than of design. The arrangement is documented, the economics work in year one, and no one has modeled what year fifteen looks like or what specifically has to happen for the arrangement to end cleanly. The exit is not a detail to be worked out later. It is the design.
Two: the economic benefit regime runs past its useful life. An arrangement that is efficient at fifty becomes punitive at seventy-two, for the reasons described above. Compounding the problem, this is not a decision that is easily revisited. Because the regime follows policy ownership, changing regimes later can require a policy transfer, create tax consequences where equity has accumulated, and effectively restart the arrangement under the post-2003 rules as of the date of the change. There is a path from one regime to the other. It is rarely a cheap one, and it is rarely the path anyone planned on.
Three: the Section 101(j) requirements were missed. Endorsement split dollar is employer-owned life insurance. Section 101(j) requires written notice to and consent from the insured employee before the policy is issued, along with annual reporting on Form 8925. Fail to meet the notice and consent requirement and the employer’s proceeds can become taxable above its basis, which defeats the entire economic purpose of the arrangement. There is relief for inadvertent failures under Notice 2009-48, but it is narrow. The failure has to have been inadvertent, the employer has to have made a good faith effort to comply, the correction generally has to happen by the due date of the return for the year the contract was issued, and consent can never be obtained after the insured has died. In practice, this is a requirement to get right before issue rather than one to plan on curing.
Four: the loan documentation does not match the intent. A loan regime arrangement documented as a series of demand loans behaves very differently from one documented as a term loan, particularly across a changing rate environment. Whether interest is paid currently or accrued, what constitutes default, and what happens to accrued interest at termination all need to be settled in the document rather than assumed.
Five: nobody reviews the policy. Split dollar arrangements are funded with permanent policies whose illustrated crediting rates, costs, dividends, or other assumptions may look materially different today from what was assumed at issue. When the loan balance or cumulative premium receivable grows faster than the policy’s available cash value, the planned exit can become increasingly difficult to execute. An arrangement designed to unwind from policy value may no longer have enough value to do it. Too often, the parties discover this when someone finally requests an in-force ledger, which is well after the point where it would have been correctable.
The Exit Is the Design
A split dollar agreement should give a clear answer to each of the following before anyone signs it. What happens at retirement. What happens on termination for cause. What happens if the executive leaves voluntarily before the arrangement has run its course. What happens on death before the planned rollout. What happens on disability. What happens if the business is sold, which, given the volume of private equity activity in professional services and closely held businesses, is not a remote scenario.
The most useful test we know for an existing arrangement is this: ask both parties to describe, in a sentence each, how it ends. Then compare the answers. When they do not match, and they frequently do not, the arrangement has a problem that no policy performance will fix.
What We Ask Before We Recommend One
What is the actual insurance need, described independently of the funding structure?
What is the exit, and who holds the power to trigger it?
How long is this arrangement expected to run, and what does the annual cost look like in the last five years of that term rather than the first five?
Who is accountable for the annual administration, and what happens when that person leaves?
If this arrangement had to be unwound in year twelve, what would that cost, and who would bear it?
When those questions do not have answers, the answer is usually that split dollar is not the right structure. We would rather say that at the outset than manage the consequences of not having said it..
A Different Application: Split Dollar in Personal Planning
Everything discussed above concerns split dollar as an executive benefit and business planning structure. The same regulations support a very different application, one that operates between family members rather than between an employer and an executive, and frequently involves an irrevocable life insurance trust.
The problem it addresses is a funding problem. A family has a real and permanent insurance need, often tied to estate liquidity or to keeping a business intact through a transition, and a premium that annual exclusion gifting cannot carry. Split dollar offers a way to fund that premium without the transfer tax cost of writing gift checks for the full amount.
That version of the arrangement asks its own set of questions. Who controls it. What the funding party’s interest is worth, and when. What happens to that interest in the estate. And where the line sits between an arrangement built around a genuine insurance need and one built around a tax result, which is a distinction the Tax Court has drawn more than once, and not always in the taxpayer’s favor.
Those questions deserve more than a few paragraphs at the end of an executive benefits discussion. We will take up split dollar in personal and family planning separately next month.
| Summit Legacy works with businesses and tax-exempt organizations on split dollar design, in-force review of existing arrangements, and exit planning, often in collaboration with specialist partners on the most technically complex applications. If you have an arrangement in place that has not been reviewed recently, or a situation you think may call for one, we would welcome the conversation. |
IMPORTANT DISCLOSURES
The information provided in this article is for general informational purposes only and does not constitute legal, tax, financial, or investment advice. Life insurance products involve costs, risks, and potential tax consequences that vary based on individual circumstances. Corporate-owned life insurance (COLI) arrangements are subject to the requirements of IRC Section 101(j), including notice and consent requirements applicable to employer-owned life insurance. Guaranteed issue underwriting is subject to group eligibility requirements and is not available in all circumstances. Cash balance plans are subject to ERISA and IRS qualification requirements and must be administered by a qualified actuary; contribution limits vary based on participant age and plan design. Non-qualified deferred compensation arrangements are subject to IRC Section 409A. Disability insurance products and high-limit specialty market coverage involve underwriting requirements and benefit limitations that vary by carrier and program design. Results illustrated are hypothetical and will vary based on individual and plan circumstances. Consult a qualified tax advisor, legal counsel, and financial professional before implementing any executive benefits strategy. Securities offered through Integrity Alliance, LLC, Member SIPC. Integrity Wealth is a marketing name for Integrity Alliance, LLC. Summit Legacy is not affiliated with Integrity Wealth.
