A versatile planning tool: Split-dollar insurance bridges the "generation gap"
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.
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.