Split-dollar life insurance: economic benefit and loan regimes explained

Split-dollar life insurance is an arrangement in which two parties, usually an employer and an executive, share the premiums and the benefits of one life insurance policy. Since the Treasury issued final regulations in 2003, the IRS taxes these arrangements under one of two mutually exclusive systems: the economic benefit regime or the loan regime. Which one applies depends on who owns the policy and how the premium payments are structured.

What the regulation says

split-dollar arrangement arrangements are defined in Treasury Regulation 1.61-22. Under 1.61-22(b)(1), an arrangement qualifies when one party (the owner of the policy or the non-owner) pays some or all of the premiums, the paying party can recover them from the policy's death benefit or cash value, and the arrangement is not a group-term plan under IRC 79. Under 1.61-22(b)(2), certain compensatory arrangements between an employer and an employee, and corporation-shareholder arrangements, are treated as split-dollar arrangements even where the recovery element is missing.

The regulation applies to arrangements entered into after September 17, 2003. Older arrangements remain under prior rules unless they are materially modified after that date, in which case they are treated as new. Many surviving older plans were restructured or terminated for this reason.

Two terms matter throughout. The owner is the person named as owner on the policy, with some exceptions for compensatory arrangements. The non-owner is anyone else with an interest in the contract, other than the insurer. In a typical compensatory plan the employer pays and the executive owns, or the employer owns and the executive has an interest in the proceeds.

The economic benefit regime

Under the economic benefit regime, the owner of the policy is treated as providing benefits to the non-owner, and the non-owner is taxed on the value of those benefits each year. The regulation lists three components in 1.61-22(d)(2): the cost of current life insurance protection, any policy cash value the non-owner can currently access, and other economic benefits.

The cost of current protection is the amount of life insurance protection times a premium factor the IRS publishes. Historically that was the Table 2001 rate in Notice 2002-8, and insurers' published term rates may be available in some cases under later guidance. The IRS sets the specific factor in guidance, not the regulation, so a plan should use the current published factors.

The employer-owned endorsement arrangement is the classic example. The employer owns the policy and pays the premium. The employee has an endorsement naming a beneficiary for a portion of the death benefit. The employee reports the cost of that protection as income each year, and the employer recovers its premiums from the proceeds. A plan that grants the executive access to cash value triggers additional income to that extent.

The loan regime

Under the loan regime, the premium payments are treated as loans from the non-owner (usually the employer) to the owner (usually the executive or a trust). The regulation points to Treasury Regulation 1.7872-15 for the rules. The loan is typically documented with a note, repayable from the proceeds of the policy or from cash value, and secured by a collateral assignment of life insurance for business loans of the policy to the employer.

If the interest rate is below the applicable federal rate (AFR), the loan is a below-market loan, and the forgone interest is imputed. The interest is treated as paid by the borrower to the lender and, in a compensation setting, as additional compensation to the borrower. Interest can accrue and be repaid on exit, or be paid annually. The loan regime is more flexible, and many modern arrangements use it, but it has its own detail: term versus demand loans, fixed versus variable AFR, and reporting.

A public company has an additional concern. Section 402 of the Sarbanes-Oxley Act generally prohibits personal loans from a public company to its directors and executive officers, which has led many public companies to avoid loan-regime split-dollar for those individuals. Counsel should clear this before any new plan.

Which regime applies

In the compensatory setting, the rules of thumb are:

1. If the employer owns the policy, the economic benefit regime applies, and the employer is treated as providing benefits to the employee.
2. If the employee (or the employee's trust) owns the policy and the employer's payments are repayable and secured by the policy, the loan regime applies.
3. If the arrangement fits neither, general tax principles apply to the premium payments (1.61-22(b)(5)). A bonus-type payment, for instance, is just compensation. See section 162 executive bonus plans: how they work and how they are taxed.

The parties must treat the arrangement consistently, and each must fully account for all amounts under 1.61-22(b)(4).

Where it is used

Split-dollar appears in three common settings.

• Executive retention: the employer funds a policy that benefits a key executive and recovers its outlay from the proceeds. It overlaps with key person insurance and nonqualified deferred compensation and corporate-owned life insurance.
• Business owners: a company pays premiums on a policy owned by an owner's irrevocable trust for estate planning, often documented under the loan regime.
• Private split-dollar: a family member or trust, not an employer, funds premiums, subject to gift-tax rules.

Underwriting and policy design

Split-dollar uses cash-value insurance, whole life or universal life or variable products. The carrier underwrites the insured on health and financial grounds, and the amount of coverage is tested against the employer's reason for buying it. The insurance company will ask for the split-dollar agreement and, for loans, the note and collateral assignment. Policy illustrations should show the cash value and loan balance on the same schedule so that both parties see the exit math. See how insurers underwrite business life insurance for the underwriting process.

Hypothetical example

Say a 52-year-old executive's irrevocable trust owns a permanent policy. The employer advances $60,000 a year in premium under a loan agreement, secured by a collateral assignment of the policy, and the loan accrues interest at the AFR in effect when each advance is made. In the loan regime, the employer includes the accrued interest as its income, and the executive's trust has the interest as an obligation to be repaid from policy values or the death benefit. The employer is repaid before the beneficiaries. The numbers are invented for illustration, and the agreement and rate would need to be reviewed by tax counsel.

Other points to check

• Employer-owned policies and IRC 101(j): if the employer owns a policy on an employee, the notice-and-consent rules in Employer-owned life insurance: notice and consent rules under IRC 101 apply, and the employer files Form 8925.
• 409A: a split-dollar arrangement can raise 409A issues in some designs, so check with counsel.
• Exit: the agreement should say what happens at termination, death, sale of the company, and what the employer is owed.
• Accounting: the employer's balance sheet treatment differs between the regimes, so involve the CPA.

Key takeaways

• Treasury Regulation 1.61-22 taxes post-September 17, 2003 split-dollar arrangements under either the economic benefit regime or the loan regime.
• Ownership of the policy drives the regime: employer-owned usually means economic benefit, executive-owned with repayable advances means loan.
• Below-market loans create imputed interest at the AFR, so rate selection and documentation matter.
• Public company executives raise Sarbanes-Oxley loan questions that need counsel.
• The agreement should address exit, termination and what the employer recovers.