Many highly compensated employees desire a high level of life insurance coverage to protect their families both before and after retirement – and they want a cost-effective way to make that happen. Most employers want to provide meaningful benefits that help recruit, reward, and retain valuable, essential employees while having minimal impact on the company balance sheet.
A business-owned “endorsement” split-dollar life insurance arrangement (also called an “economic benefit” split-dollar plan) has the power to achieve all of these goals at once, creating potential for a win-win situation for both employer and employee.
For employers, endorsement split-dollar offers a flexible, cost-efficient way to incentivize and compensate key employees, and enable the firm to achieve its business goals in a tax-efficient and economically effective manner.
For employees, this type of split-dollar plan can protect their beneficiaries without the need to pay insurance premiums. However, they will need to pay income taxes each year on the value of the imputed “economic benefit” they receive.
How a business-owned endorsement split-dollar arrangement works
With a business-owned split-dollar arrangement, the employer purchases and owns a permanent life policy on the life of an employee and pays the premium to keep the coverage in force for a specified period of time. The employer then endorses a portion of the death benefit to the employee who designates a beneficiary (or beneficiaries) to receive those death benefit proceeds. The remainder of the death benefit or the cash value of the policy is used to recover the employer’s costs.
While the employee does not have to pay the premiums for the life insurance policy with a split-dollar plan, he or she is responsible for paying income taxes on the “economic benefit” received as a result of the insurance protection. This is considered additional taxable compensation and its value (based on an IRS’ Table 2001 factor) is roughly equivalent to the cost of a corresponding one-year term life policy. So, the potential taxes to be paid by the employee are considerably lower than if taxes were based on the actual premiums paid by the employer.
Endorsement Split-Dollar Plan [1]
The employer establishes a split-dollar agreement with the employee. The employer owns the policy and agrees to endorse a portion of the death benefit to the employee’s beneficiaries.
The employer pays the premiums to the insurance company on the life of the employee.
The employee is taxed on the value of the “economic benefit” of the policy, equal to the value of a term life policy with an equivalent death benefit. If the employee dies:
The employer receives the death benefit at least equal to the policy’s cash value.
The employee’s beneficiaries receive the employee’s portion of the death benefit, federal income tax free.
If the employee dies prematurely, the beneficiaries receive the employee’s portion of the death benefit proceeds income tax-free. But if the employee retires or leaves the company, there is typically an option to purchase the policy from the employer for either the amount of premiums paid or the cash value of the insurance policy, depending on how the agreement was written.
Alternatively, the company can choose to give a bonus to the employee to cover the cost of purchasing the insurance plus any taxes due. In this situation, the company must pay taxes on the gains in the policy’s cash value before releasing the policy, but will receive a tax deduction for the amount of the bonus.
Employee-owned “loan regime” split-dollar arrangements
With the endorsement split-dollar arrangement, the employer is the owner of the life insurance policy. With a “loan regime” split-dollar plan, it is the employee who owns the life insurance. The employer loans the employee the required premium for a specified period of time and the employee reimburses the employer by using the policy’s cash value to repay the loan.
The additional compensation that is deemed to be received by the employee is based on the interest cost on the outstanding loan or, at the employee’s discretion, the interest can be paid separately and compensation avoided. This type of split-dollar arrangement may work best for non-public or closely-held companies rather than public organizations because of loan restrictions created by federal and certain state laws.
Benefits for the employer:
Cost-efficiency, flexibility and cash for other uses
Because purchasing life insurance effectively leverages a smaller expense (the premium) to deliver a larger future sum (in the form of insurance proceeds or cash value), it provides a highly cost-efficient way for employers to provide an important – and significant – benefit to key employees. It also becomes a less expensive alternative to giving away cash through direct incentives such as bonuses.
In addition, when properly structured, the cash value that builds inside a split-dollar policy also can be redeployed by the employer/company through tax-free policy loans or outright distributions to meet a variety of business needs. As an employee’s value to the organization grows over time, the company can also choose to use the wealth that builds in the split-dollar policy to add, increase or change benefits.
While the value of the insurance policy (premiums paid plus cash surrender value) appears as an “other asset” on the company’s balance sheet, the company also accumulates “other income” over time from any growth in the cash value and from the insurance proceeds paid to the company if an insured employee dies. So, the life insurance purchased under the split-dollar agreement becomes a valuable asset and a source of cash for the company.
Benefits for the employee:
More insurance at less cost, plus future ownership
For the employee/executive split-dollar offers the potential to reduce out-of-pocket risk management costs. Although he or she will need to pay income taxes on the economic benefit based on an imputed term insurance rate, that cost will be far less than what the total premium would otherwise be for the same death benefit. So, the insurance coverage becomes both a good incentive for the employee to remain with the company and good value if he or she does.
Later on, when the agreement terminates, or if the employee retires or leaves the company, the employer has the option of:
Surrendering the policy for its current value and realizing any gains (and taxes on the gains).
Allowing the employee to purchase the policy for its cash value or premiums paid.
Treating the policy as a bonus from the company to the executive – with the asset effectively moved from the employer’s balance sheet to the employee’s net worth statement.
With the bonus option, the policy’s cash value is “bonused” to the employee, so the insurance is owned outright and the employee receives a portable, flexible source of supplemental income via the policy’s cash value in the future. In this case, the value of the policy is taxable to the employee as compensation and deductible for the employer as a benefit expense.
An elegant funding tool
Employer-owned endorsement split-dollar life insurance arrangements are a remarkably flexible and cost-efficient benefit option for recruiting, rewarding, and retaining valued employees who will advance an organization’s vision and business objectives. By including it among the benefit solutions offered to highly compensated individuals, an employer can successfully leverage company assets while providing a high-value, reasonably-priced, long-term benefit to a select group of employees.
Contact us or visit Executive Life Insurance to evaluate an endorsement split-dollar plan for your team.
[1] All examples provided are for illustrative purposes only and are not intended to serve as investment advice since strategy is dependent upon your individual facts and circumstances.