Rediscovering the Magic of Split Dollar Life Insurance
The TV series The Wonder Years is one of my favorite TV series. The series depicts the social and family life of a boy, Kevin Arnold, in a typical American suburban middle-class family from 1968 to 1973, covering the ages of 12 through 17. The location where the Arnold family lives is never specified other than being suburb, but some episodes have license plates showing California and New York. This time period parallels my own childhood and adolescence. The difference in my case is the fact that I grew up in the Panama Canal Zone. As my wife (aka Mrs. Nowotny or Long Suffering) would say, I was almost American. But as she would quickly state for her Point #2, I was not Panamanian either.
My dad (of blessed memory) would say that when President Carter signed the Panama Canal Treaty in 1977, Canal Zone kids lost the only country they ever knew. I watched those years from the outside looking in. The show gives me a sense of what it must have been like. I enjoyed a version of that but not that version. As the Country endures a pandemic, economic turbulence, and social unrest, many of us are trying to imagine and reimagine better or at least different days.
The wonder years of split dollar life insurance are largely thought to be behind us. Other than the application of intergenerational split dollar for ultra-high net worth taxpayers in very specialized planning situations in the last decade, split dollar life insurance is largely forgotten and rarely spoken of by financial advisors and life insurance agents. What a mistake!
This article is intended to highlight some of the magic that still exists in split dollar life insurance planning and why tax planners and their clients need to dust off and reconsider split dollar life insurance.
Overview of Split Dollar Life Insurance
Split dollar life insurance is not a type of life insurance product but rather a contractual arrangement between two or more parties to share the rights and benefits of a life insurance policy. The genesis of split dollar life insurance dates back to the mid-1950s and has evolved through the decades to support the purchase of life insurance in the employer-sponsored purchase of life insurance as well as the family estate planning context. Split dollar life insurance is a sophisticated planning technique.
“Old School” split dollar life insurance was divided between the endorsement method and collateral assignment methods. In the endorsement method, the policyholder owns an interest in the policy equal to the cash value and death benefit and “endorses” the excess death benefit to the executive who nominates a beneficiary of the “endorsed” death benefit. The executive is taxable on value of the “economic benefit” which is measured by the term insurance cost associated with the endorsed death benefit amount.
In the collateral assignment method, the policyholder (executive) collaterally assigns an interest in the policy cash value and death benefit equal to the employer’s premiums. Under prior law, the executive enjoyed the excess cash value without current taxation and death benefit subject to the annual economic benefit valuation. It was a beautiful tax shelter in the best sense of the word. That was then and this is now!
“New School” split dollar life insurance is quite different but still offers tremendous but unappreciated benefits. Final Split Dollar Regulations became effective for plans established or materially modified after September 17, 2003. Endorsement Split Dollar Life Insurance follows the Economic Benefit Regime set forth in Reg. 1.61-22(b)-(h). The two methods continue to exist but limits the executive’s share to the policy cash value without current taxation.
The split dollar regulations introduced Loan Method Split Dollar, which in the current low interest rate environment provides powerful planning opportunities. In the Loan Method, the executive owns the policy and the employer enters into a loan arrangement with the employer having a collateral assignment interest in the policy cash value and death benefit equal to the accrued loan using a market rate of interest. The market rate of interest for Loan Method Split Dollar plans must be equal to or greater than the Applicable Federal Rate (AFR). The current long-term AFR is 1.17 percent for July 2020.
Below-market rate or interest-free loans are sometimes used in loan regime split dollar. When no interest is charged by the Lender, these below-market or interest-free loans follow special tax rules governed by Internal Revenue Code Section 7872. The amount of inadequate interest is imputed to the executive as taxable income.
Under Sec. 7872, if no interest or an inadequate rate of interest is charged on a loan, the IRS recharacterizes the loan into an “arm’s length” transaction and imputes an interest rate (known as the “Applicable Federal Rate” or “AFR”) that is deemed to have been received by the Lender and paid by the Borrower. Demand loans may be used in split dollar plans. The current rate for demand loans is .89 percent annually.
The upside for the policyholder in a Loan Method Split dollar arrangement is the opportunity to enjoy the excess cash value and death benefit on a tax-free basis. The policyholder executive in a PPLI policy can enjoy the tax-free inside buildup of all of the cash value in excess of the employer’s collateral assignment interest accruing at 1.17 percent annually. The financial and tax arbitrage for taxpayers in a number of tax planning scenarios is abundant.
The planning opportunities under prior split dollar regulation may have represented the “Wonder Years” in life insurance and tax planning for financial advisors. However, one of the lessons in life and tax planning is that we are blessed with wonder and opportunity in every circumstance. Future articles on split dollar life insurance will highlight the benefits of split dollar in the current “Wonder Years.”