A split dollar arrangement is a plan in which a life insurance policy’s premium, cash values, and death benefit are split between two parties. A split dollar arrangement can be helpful in estate liquidity planning to minimize income, estate, and gift taxes. This type of plan has been used for years to help individuals with the funding of large premiums, and/or to reduce the cash flow required to fund a much needed life insurance policy.
Generally, under a split dollar plan, a permanent life insurance policy’s death benefit and cash values are split between the owner and non-owner of the life insurance contract. Typically, one party has the cash flow to fund the majority of the policy premiums. Cash values in the policy can potentially accumulate and pledged to the party paying the greater part of the premium as security for repayment. Any cash value growth beyond the premiums paid is gain from the transaction. Below are 2 types of Split Dollar arrangements:
Economic Benefit Regime
Under the economic benefit regime, you or your company will advance the annual premium each year, and if an Irrevocable Life Insurance Trust (ILIT) is the policy owner, you will also make a gift of the economic benefit amount each year to the trust. The economic benefit amount can be significantly lower at younger ages because it is based on the annual “term” cost of the death benefit and not the policy’s full premium.
In a corporate context in which you or your ILIT is the owner of the policy and your company lends you or your trust the premium, you must annually report the economic benefit cost as income. In a family or corporate context in which a trust is owner of the policy, the economic benefit amount also constitutes a gift for federal gift tax and generation-skipping transfer tax purposes.
Under the loan regime, you or your company loan the annual premium to you or your trust. The loan is repaid either during lifetime using a portion of the policy’s net cash value and other available funds, or at death using the life insurance proceeds. The loan balance is equal to cumulative premiums paid in addition to capitalized loan interest, if any. The ILIT has two choices in how the loan is structured: pay loan interest (or capitalize it) at a fair market rate, or be deemed to have paid such interest under IRC §7872, the below-market loan rules.
Unlike a split dollar plan under the economic benefit regime, a loan arrangement includes a loan interest component that is applied to the cumulative premiums paid instead of an economic benefit cost related to the death benefit as discussed above.