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What You Should Know About Split-Dollar Life Insurance Arrangements

How advisors can help clients take advantage of this powerful estate planning technique

By Richard L. Harris

Key Takeaways:

  • Split-dollar life insurance arrangements are best used in large cases.
  • Split-dollar life arrangements are complicated—either become an expert or work with someone who is.
  • A split-dollar arrangement is something that most professionals cannot do on their own.

History

Split-dollar life insurance arrangements have been around since 1964. This technique describes an arrangement in which one party (A) pays the major amount of the life insurance premiums and another party (B) gets to decide who receives the proceeds after repaying the money to the first party. The money that A pays toward the premium is considered an advance—not a loan. There is no interest payable to A. Before 2001, many split-dollar arrangements entitled the advancing party (A) to receive the lesser of the cash value of the policy or the premiums advanced. Any growth in cash value above the amount advanced by A was to B’s benefit. In effect, B got equity, which, in theory, at the time was not a taxable event. B received something of value—the right to name the beneficiary for the majority of the policy death benefit.

In a series of Revenue Rulings, the IRS said that the value of the policy was the equivalent of a one-year term premium for the face amount. The service used a table (PS 58) that showed what the value of the policy was each year. In one of the Revenue Rulings, the IRS said that you could use the PS 58 table or use the insurance company’s published one-year term rates.

Because split-dollar insurance was such an attractive arrangement for both estate planning and compensation purposes, the lower the imputed term cost, the better. The lower the rate, the fewer tax consequences there were for the party who got to name the beneficiary. The insurance companies devised very low “published” one-year term rates, even though very few, if any, of those term products were actually sold.

Up until 2001, what everyone understood to be the rules were relatively simple. But the Treasury Department and the IRS were not happy. They felt that the untaxed equity transfer that took place in these arrangements was abusive. They were also upset by the low rates that insurance companies were using to determine the taxable amount of the policy, particularly because the policies using those rates weren’t being sold. In 2001, the IRS came out with Notice 2001-10, followed by Notice 2002-8, to address the taxable amounts of such policies, and finally Treasury created regulations similar to the notices that went into effect in September 2003.

New era of regulations and loopholes

The insurance industry is very creative. If there is an apparent loophole or use of tax law that can benefit clients and result in sales, the insurance industry will drive a truck through it. (In some cases the loopholes and opportunities were fabricated, such as charitable split-dollar and Section 419 plans.) At the time, the IRS had been fighting the industry over split-dollar arrangements since 1996 and had gotten its nose bloodied. To try to anticipate any abusive scheme or interpretation of the rules, the two split-dollar regulations were long and complicated. They did away with future equity split-dollar arrangements and with insurance companies using published term rates for products that weren’t sold in order to determine the economic benefit. While they did grandfather prior equity split-dollar arrangements, they limited the benefits. The IRS also created a new, more up-to-date table, Table 2001, which is used to show the value of one-year term insurance. And they created a new type of split-dollar arrangement. In addition to the kind of arrangement that used advances and one-year terms to measure the tax consequences, they created a new type that treated an arrangement as a loan bearing interest.

Because of the changes and the complicated Revenue Rulings, split-dollar arrangements fell out of favor at the time. The vast majority of attorneys were not familiar with the regulations then, and even those who understood the regulations felt that split-dollar arrangements were no longer attractive.

Now

In the almost ten years since the regulations have been put into place, more attorneys have become familiar with them, and they now see the value of certain kinds of split-dollar arrangements. Some of the techniques attorneys have used involving gifts are no longer applicable to many clients because clients have used up almost the entire lifetime exemption amount. In the estate planning area, the split-dollar arrangements that are being done now are for very large life insurance cases. To participate in the sales that result from this type of arrangement, insurance professionals (and other financial services professionals who use life insurance) need to learn and understand the regulations and the uses for split-dollar arrangements or else align themselves with attorneys or life insurance professionals who do.

Why

One of the most important things that all financial professionals can do is to differentiate themselves in the eyes of potential clients and centers of influence. A great way to accomplish that is to develop an expertise—to be a source for information and ideas that are uncommon and beneficial. The split-dollar area represents one of those opportunities.

In estate and business continuation planning, one of the objectives for transferring wealth is to do so with few if any transfer taxes—the gift and estate taxes. Certain ways of using split-dollar regulations allow this to be done. For example, by following the split-dollar loan regulations, it is possible to achieve the following:

  • Have a transaction that has no gift, estate or generation-skipping taxes. (Currently, someone who is subject to estate and gift taxes and wants to pass assets to grandchildren faces a combined 56 percent federal transfer tax. In states that have “decoupled” and have their own estate and/or inheritance taxes, the number can be as high as 66 percent!)

  • Make a loan in which the interest rate is locked in for the life of the insured. (In June 2013, the rate for someone who has a government-table-determined life expectancy of more than nine years is 2.47 percent.)

  • Be able to accrue interest.

  • Have all of the above be specifically documented and allowed by regulation.

  • Create liquidity for an estate and conserve assets.

  • Enable the estate to get a substantial deduction if the estate is illiquid when the individual dies and does not have liquid assets to pay estate taxes. (This is covered by a series of Tax Court cases and known to attorneys.)

  • Produce, under the right circumstances, a transaction that involves three of an estate planning attorney’s favorite words: Freeze, Arbitrage, and Discounts. (See previous article about that subject.)

Conclusion

How many people do you know who have a need for insurance and are willing to pay for it if they can do so without paying gift, estate or generation-skipping taxes? How many potential clients would benefit from this approach? How many attorneys or accountants would like to accomplish any or all of the above for their clients? How large are the cases that develop? If you want to be the person who can make it happen, either become an expert or work with a professional who is.


About the Author

Richard L. Harris specializes in life insurance sales and consulting for high-net-worth individuals and their advisors. For more than four decades, he has been a trusted expert for accountants, attorneys and trust officers. A life insurance agent, he holds the professional designations of Chartered Life Underwriter, Registered Trust and Estates Practitioner, and Accredited Estate Planner. He may be reached at Richard@rlharrisllc.com or 973-470-5151.