When Big John graduated from college in 1972, he decided to open a
motorcycle
repair shop rather than go into teaching. Today, he owns a major
brand dealership
with 15 employees. One of them is Little John, who joined the
company two years
ago after getting his master's degree in business administration.
Little John
is the designated heir to his father's business.
They have put together a buy-sell agreement, funded with life
insurance on
Big John's life. But when Little John saw the premium he would have
to pay on
his father's $2 million policy, a family crisis nearly ensued. It
was averted
when their New York Life agent suggested a split-dollar insurance
arrangement
that would dramatically reduce Little John's cash outlay.
This scenario is not all that uncommon. With the 20-something
Generation Xers
eager to prove themselves and make their marks beside their Baby
Boomer parents,
more and more family-owned businesses are looking at split-dollar
insurance
as a tool to help pave the way for the eventual transfer of assets
across the
generations. They're also finding out that this insurance
arrangement has a
number of other uses.
The split-dollar concept is simple. It is a funding arrangement
that helps
one individual obtain life insurance at a cost lower than would
otherwise be
possible. This is achieved by sharing (splitting) the premium with
another individual
or entity, such as a business. The arrangement, provided by a
written agreement,
generally calls for the sharing of premiums in exchange for the
sharing of death
benefits and, in some cases, cash value.
Split-dollar insurance is a versatile arrangement that works well
in a number
of situations, not just generational transfers of assets. For
instance, split-dollar
insurance can be effective:
- As a select benefit to favor a key employee or co-owner in a
business,
with the business helping these individuals obtain coverage to
protect their
families for a lower immediate outlay of cash to pay
premiums.
- As a benefit for employees or owners who are rated (or perhaps
significantly
older) and might not otherwise be able to afford life insurance
coverage unless
at least a portion of the cost is paid by the business.
- As a funding tool for deferred compensation and salary
continuation plans.
- As a funding vehicle for buy-sell agreements, especially when
there are
large age discrepancies between the parties. (As with Little John
and Big
John, if the agreement calls for a younger, lower paid employee
to purchase
life insurance on an older business owner, the cost for the
coverage could
be significant — and perhaps prohibitive for the younger
employee, if he
or she had to pay the entire premium alone.)
Above, we saw how a split-dollar arrangement can help fund a buy-
sell agreement.
Under another option, it can be used by an older employee or owner
to obtain
coverage to protect his or her family. Under this plan, the
employee applies
for and owns the policy and names his or her personal beneficiary.
The business
pays all or a portion of the premium. In return, a portion of the
proceeds equal
to that paid by the business in premiums is assigned to the
business.
At the employee's death, the business is reimbursed in full, and
the remainder
of the proceeds is paid to the employee's beneficiary. If the
employee leaves
the company or retires, he or she could pay the business for
premiums contributed
(often out of the cash value itself) and take full possession of
the policy.
Example: An employer and employee buy a $100,000 policy on the
employee's life.
As part of an agreement, they split the premiums. At the time of
the employee's
death, the business has contributed $18,000 in premiums. The
business is reimbursed
that amount from the proceeds, while the employee's beneficiary
receives $82,000.
Tax Considerations
It is important to be aware of the potential tax ramifications of a
split-dollar
life insurance plan. In general, premiums are not deductible by
either the employee
or the employer. Any money "bonused" to the employee to help pay
premiums will
generally be treated as taxable income to the employee and as a
deductible business
expense by the business.
Proceeds are generally received without income tax by either the
employer or
the employee's beneficiaries (although the "alternative minimum
tax" may apply
if proceeds are payable to a corporation).
The "Economic Benefit" needs to be understood. Under federal tax
law, any portion
of the economic benefit of the coverage that is not paid by the
employee is
considered to be a form of compensation. This is calculated using
the P.S. 58
tables or the insurance company's one-year term rate, whichever is
lower. To
avoid this, the amount the employee pays is often equal to the
"economic benefit"
of the protection received by the employee in that year.
The Bottom Line
Split-dollar insurance can be a valuable business planning tool
that bridges
the generation gap by enabling younger or lower-paid employees and
family members
to purchase coverage to achieve specific goals. It can benefit your
company
and favored employees including owner/employees and designated
heirs. However,
especially when factoring in the tax aspects, it is important to
work with people
who are knowledgeable.
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