ELITE ADVISOR BEST PRACTICES

New Twist on Split Dollar

Using CSD to facilitate the sale of a business in a way that minimizes capital gains taxes.

By Elite Advisor Report interview with Guy Baker, BMI Consulting, and Tim Voorhees, Matsen Voorhees

Key Takeaways:

  • Capital split dollar (CSD) allows companies to take current interest deductions on borrowed money when the funds are used to purchase life insurance as part of a compliant compensation program.
  • CSD allows companies to loan capital to the owner, children, spouse and key management for the purpose of buying life insurance coverage.
  • CSD enables a company to loan funds from its retained earnings (or Accumulated Adjustments Account), or it can arrange a loan from an outside lending source.
  • Using CSD can substantially reduce a family’s tax liability by converting capital into income through policy loans and a death benefit.
  • CSD is also a great technique for equalizing estate benefits among children who do not participate in the family business.
  • CSD can help a business seller defer recognition of capital gains and receive tax-free income in lieu of taxable income when transferring a business to a third party or the next generation. Such capital gains planning is referred to as capital gains split dollar (CGSD).

Due to great interest in this topic last month, Elite Advisor Report reconnected with Guy Baker and Tim Voorhees to dive deeper into the nuances of CSD. Guy is a co-developer of the Capital Split Dollar program. Tim Voorhees is one of the top estate and business attorneys in the country. They have combined efforts to create a new concept called “capital gains split dollar.” This interview explores the merits of capital split dollar and a new twist—using split dollar to facilitate the sale of a business in a way that minimizes capital gains taxes.

Tim, remind us about capital split dollar.

Voorhees: As we discussed in our previous interview, split dollar is not a new concept. It has been in existence since the 1950s. It was one of the most popular benefit strategies used by large, publicly traded companies to provide meaningful estate and income protection to C-level executives. It was discontinued when the Sarbanes-Oxley Act of 2002 disallowed loans from public corporations to officers of those companies.

CSD is a permutation of this popular strategy for closely held businesses. It allows the company to loan capital to the owner, children, spouse and key management for the purpose of buying life insurance coverage. The company can loan funds from its retained earnings (or Accumulated Adjustments Account), or it can arrange a loan from an outside lending source.

Guy, what are the primary ways a corporation can help the owner by using CSD?

Baker: Fundamentally, insurance is protection against a premature death. Any time there is a liability, life insurance can provide cheap dollars to fund the liability in a tax-efficient manner. This is true for providing estate tax liquidity, funding the “buy sell” between shareholders or partners, and creating income at retirement for top executives. CSD can even be used to mitigate the high cost of transitioning a business interest among family members. For example, through the creative use of CSD, a generation ONE seller of a business can receive tax-free income instead of taxable payments and the generation TWO buyer can fund the purchase with pretax dollars. Saving taxes on both sides of the transaction improves the after-tax IRR dramatically.

You mean an owner can use CSD to pass a business interest to his or her child or a key person?

TV: That’s correct. Instead of selling the business to a key man or a son/daughter and triggering a capital gains tax, the owner can compress the business value by adding a substantial liability related to the funding of a large life insurance policy. This policy can build significant cash value for the benefit of the owner or seller of a business. Using CSD can save the owner’s family substantial taxes by converting capital to income through policy loans and death benefit. The buyer of the business is motivated to fund the policy because payments can be tax deductible and because agreeing to fund the policy can allow the buyer to purchase the business at the compressed value.

Why is this economically sound?

GB: Businesses have used life insurance for more than 60 years to provide secure lifetime income as well as liquidity at death. Growing cash value securely in a life insurance wrapper is a widely accepted technique. Life insurance investments can fund a Section 162 (executive bonus) plan, a deferred compensation plan, a COLI program or a split dollar program. The company can fund policies that estate planners use to equalize benefits among children who do not participate in the family business.

With capital split dollar, it is possible to make all of the company’s insurance expenses tax deductible. Now, with capital gains split dollar, these benefits can extend to both the buyer and the seller of a company. The buyer can take compensation deductions to generate write-offs not typically available to the purchaser of a company. The seller can have the purchase price fund insurance policies that grow tax-free and make tax-free payments to the seller or the seller’s family.

Is CSD legal?

TV: We have a Circular 230 opinion letter written last year by Alan Jensen from the Holland and Knight law firm. Alan is chairman of the ABA committee on the taxation of life insurance and one of the most respected tax attorneys in the country. His opinion letter spells out the merits of CSD and why it conforms to the Internal Revenue Code. This opinion has been reviewed by numerous other legal professionals in conjunction with CSD strategies.

How are split dollar programs implemented?

TV: As with any advanced strategy, clients are best served when planning team members provide integrated design, drafting and funding support. During the design phase, advisers need to help clients calculate the portion of their wealth that will be lost to taxes without additional planning. Calculators from Matsen Voorhees, LLP such as the Income Tax Estimator and theEstimated Taxes at Death on Qualified Plan Assetss can help. Once the client sees the potential loss of wealth from income and estate taxes, it is wise to develop a grid with “before and after” numbers, perhaps by using the Potential Benefits of Planning calculator. An experienced planner can calculate specific before-and-after numbers, as in this capital gains split dollar illustration:

The drafting attorney needs to craft a split dollar agreement, collateral assignment and life insurance trust to help the client realize the benefits illustrated during the design phase. Typically the lawyer also facilitates the funding of the capital split dollar program while working with insurance and loan underwriters. With capital gains split dollar, both the buyer and seller of a company will normally be represented by legal counsel.

What are the next steps?

GB: Insurance professionals need to look for business owners who want to reduce taxes while maximizing after-tax benefits for key executives or successor owners. Producers should have experienced team members who can facilitate integrated design, drafting and funding solutions. If advisors would like more education, they can request copies of past articles about split dollar written by the authors of this article or email the Elite Advisor Report with questions that they want answered in future articles.


About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com

Tim Voorhees, JD, MBA, is an estate planning lawyer and investment adviser based in Irvine, California. He is the president of the Registered Investment Advisory firm described at Voorhees Family Office Services.com and the managing partner of the tax law firm described at MatsenVoorhees.com. Feel free to email Tim at tim@vfos.com.

Readers of this document should consult with independent advisors regarding the tax, accounting and legal implications of the proposed strategies before any strategy is implemented. Nothing in this presentation is intended to offer securities or investment advice. Tax and regulatory rules affecting strategies in this document may change often and have varying interpretations. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or for promoting, marketing or recommending to another party any matters addressed herein.