Split Dollar Plan

Collateral assignment Split Dollar has been widely used in the employer/employee context. In the employer/employee context, the employee or his or her trust owns a policy on the employee's life (the policy can also be a survivorship policy on the lives of the employee and his or her spouse).

The policy owner assigns all or a portion of the cash value to the employer who is paying the bulk of the premium as security for the repayment of those premiums. If the parties wish to end the arrangement, the policy owner will need to repay the premium payer. If termination of the arrangement occurs due to death, the death benefit is used to repay the premium-paying party.

Whether a collateral assignment is defined as equity or non-equity Split Dollar depends on the amount of the employer's cost recovery. In a non-equity collateral assignment Split Dollar, the employer is generally entitled to recover the GREATER of net cash surrender value or premiums paid.

In equity collateral assignment Split Dollar, the employer is generally entitled to recover the LESSER of net cash surrender value or premiums paid. Cash value in excess of the employer's premium payments augments the benefit of the employee, and gives the employee an "equity" interest in the policy's cash value.

The employer bonuses to the employee an amount equal to the employee's tax liability on the market-rate interest imputed to the outstanding premium "loans." The employee then uses the bonus to pay his/her tax liability. Assuming overall compensation is reasonable, the employer can deduct the bonused amount, which the employee must include in income. Another alternative is for the employer to bonus both the tax liability on the imputed interest and the tax on the bonus, resulting in no out-of-pocket cost to the employee, assuming the employer is paying the full premium.

Yes. As with any premium financing, good planning requires consideration of a lifetime exit plan for any Split Dollar arrangement. Eventually the economic benefit costs of an endorsement or non-equity arrangement may become prohibitive. Further, interest charges under the Loan Regime can become onerous. Also, if a policy is expected to generate significant equity the parties may wish to exit the plan before such equity arises in order to insure that such equity inures to the benefit of the employee or trust with minimal adverse tax consequences. Third-party premium financing and self financing (e.g., as with switch dollar) may also be considered. In addition, zeroed-out grantor retained annuity trusts (zeroed-out GRATs), charitable lead trusts (CLTs), and FLP/LLC planning should all be considered as part of the overall insurance and estate plan.

A Split Dollar rollout occurs when the arrangement is terminated and the employer is repaid for its aggregate premium advances under the arrangement. A rollout often occurs at the employee's retirement.

Unless the employee or other insured dies while the Split Dollar arrangement is in effect, the arrangement will eventually terminate as specified in the agreement between the parties, such as the employee's retirement. A lifetime exit strategy from a Split Dollar arrangement has traditionally been known as a "rollout". The policy is transferred to the employee. The employer is repaid out of policy values or other employee assets. After the rollout, the employee may use dividends (when applicable) and paid-up additions to offset any further premium payments.

Under the Loan Regime, the policy owner is entitled to a full policy basis.

Under the economic benefit regime, the employee or trust generally will not receive any basis in the contract unless and until the arrangement is terminated. Specifically, the employee receives no basis for the economic benefit amounts (payment of economic benefit or the taxes on the economic benefit). Basis is deemed to belong to the employer.

The Sarbanes-Oxley Act of 2002 can be viewed as affecting Loan Regime Split Dollar agreements.

The Sarbanes-Oxley Act of 2002, enacted in response to highly publicized corporate accounting scandals, raises a concern over the suitability of Split Dollar arrangements for certain executives in public corporations. This legislation generally prohibits "extensions of credit" from public corporations to "executive officers." In plain English, it is a federal crime for a publicly traded company, directly or indirectly, to enter into a loan arrangement with certain directors and officers.

If a Split Dollar arrangement is deemed to be a loan for federal tax purposes, and is taxed under the Loan Regime (discussed later), will it also be treated as a prohibited "extension of credit" for federal securities law purposes? The answer is unclear under the language of the law as it was enacted.

Some insurance companies fear that the law may be interpreted broadly to mean that even arrangements taxed under the economic benefit regime (discussed later) are subject to the Sarbanes-Oxley loan prohibition. In other words, how the arrangement is viewed for tax law purposes may have no bearing on how it is viewed for securities law purposes.

Unless and until this issue is favorably resolved, the safe course may be to follow the guidance of the client's counsel.

Executive bonus life insurance arrangements, in which W-2 compensation rather than a loan is involved, may be an alternative for public corporations until this issue is resolved.

The American Jobs Creation Act of 2004 created IRC Section 409A. There is concern that §409A, which deals generally with the federal income taxation of nonqualified deferred compensation plans, may be broad enough in its scope to reach some Split Dollar life insurance arrangements. Consider, for example, an endorsement method Split Dollar arrangement in which the agreement between employer and employee provides that the arrangement will terminate at a certain point and the policy will roll out to the employee. Is that a form of deferred compensation subject to the rules of §409A? In other words, even though we have final Split Dollar regulations, we can't ignore statutory provisions that could also apply to a particular arrangement.

There appear to be two avenues of hope for avoiding the application of §409A to Split Dollar. First, IRS guidance [Notice 2005-1, Q.-3(c)] says that the definition of a nonqualified deferred compensation plan does not include a "death benefit plan" that provides death benefits as defined in Reg. §31.3121(v)(2)-1(b)(4)(iv)(C). The question here, then, is whether a particular Split Dollar arrangement meets the fairly narrow definition of death benefits in the cited regulation. This will require a legal interpretation by the client's attorney.

Second, the definition of a nonqualified deferred compensation plan does not include certain "short-term deferrals" [Notice 2005-1, Q.-4(c)]. These rules seem to anticipate primarily an employment situation in which an employee's bonus is paid based on some multi-year calculation, even though it's technically "earned" year-by-year. However, the language of this exception may be broad enough to save some Split Dollar arrangements from §409A. Again, this will require a legal interpretation by the client's attorney.

The Pension Protection Act of 2006 added income inclusion rules and exceptions with regard to company-owned life insurance and will affect endorsement Split Dollar agreements. The Pension Protection Act of 2006 added company owned life insurance provisions that have a significant impact on any business that is the owner and beneficiary of life insurance on an employee. IRC Sec. 101 was amended by adding subsection (j). This new rule provides that the death proceeds will be income except to the extent of premiums and other amounts paid by the employer for the contract. The excess proceeds would be ordinary income to the company.

There are exceptions to the income inclusion rule if the notice and consent requirements, which follow, are met. There are three elements to the employee notice and consent requirements. They must be met before the policy is issued:

• The employee must be notified in writing that the employer intends to insure the employee's life. The notice must state the maximum face amount for which the employee could be insured at the time the policy is issued.

• The employee provides written consent to being insured under the policy and that the insurance may continue after the insured terminates employment.

• The employee must be informed in writing that the employer will be directly or indirectly a beneficiary of any proceeds payable on the death of the employee.