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. 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 Point #1, she would make her Point #2, that I was not Panamanian either. My Dad (of blessed memory) always said that when President Carter signed the Panama Canal Treaty in 1977, Canal Zone kids lost the only country they ever knew.
I watched those “wonder years” from the outside looking in. While the Vietnam War was raging in 1968, Panama had a mostly non-violent revolution and change of government. As the revolution was occurring, my older brother, age 11 and I, age 8, rode the public bus (Chiva) to the bus terminal in Panama to see the revolution firsthand. The bus terminal also happened to be in a dangerous neighborhood where no American kid would ever go. Yes, this was with our mother’s permission. I still wonder today what she was thinking.
The show provided with me with a sense of what it must have been like growing up in America. I enjoyed a version of that but not an entirely “Red, White and Blue,” version except the Panamanian flag has the same colors. As the Country endures a pandemic, economic turbulence, and social unrest, many of us are just trying to imagine better days or at least different days.
Split dollar version was a beautiful tax shelter in the best sense of the word. The wonder years of split dollar life insurance are largely thought to be behind us. Other than the application of intergenerational split dollar in the last decade for ultra-high net worth taxpayers in very specialized planning situations, split dollar life insurance is largely forgotten and rarely spoken of by financial advisors and life insurance agents. What a mistake!
This article is the first segment of articles 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 agreement between two or more parties to shares the rights and benefits of a life insurance policy. The genesis of split dollar life insurance dates back to the mid-1950s and evolved through the decades to support the purchase of permanent life insurance in the realm of employer-sponsored purchases of life insurance as an executive benefit for executives and business owners. Split dollar also developed in the family estate planning context known as Private Split Dollar. Split dollar life insurance was highly effective from the standpoint of a benefits program which provided substantial financial benefit to the executive with minimal taxation to the executive relative to the amount of premiums paid by an employer.
“Old School” or traditional split dollar life insurance was divided between the endorsement method and collateral assignment methods. In the endorsement method the employer is the owner of the policy. The policyholder owns an interest in the policy equal to the entire cash value and a death benefit equal to the cash value. The employer “endorses” the excess death benefit to the executive who nominates a beneficiary for the “endorsed” portion of the death benefit.
The executive is taxable each year on value of the “economic benefit” which is measure by the term insurance cost associated with the endorsed death benefit amount. The measure for the economic benefit is the lower of the one-year term cost or Table 2001 cost based on the age of the insured and net amount of risk payable to the executive.
In the collateral assignment method, the executive is the policyholder. 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 from traditional life insurance but still offers tremendous, but unappreciated benefits. Final Split Dollar Regulations became effective for plans established or materially modified after September 17, 2003. Interest in split dollar life insurance largely disappeared at this point. Endorsement Split Dollar life insurance follows the Economic Benefit Regime set forth in Reg. 1.61-22(b)-(h). The two methods – endorsement and collateral assignment - continue to exist but limit the executive’s share to the policy cash value without current taxation.