Most people only need a personal life insurance policy to protect their family financially if they die. But some people, particularly business owners and key employees, may also need a life insurance plan to protect against the financial impact their death would have on their business.
Some businesses fill this need with split-dollar life insurance, which is a formal agreement between two or more parties to share the ownership and benefits of a permanent life insurance policy and cash value component. Split-dollar contracts are most often used by companies to decrease the financial impact of losing a key executive (like a CEO) or as a benefit in executive compensation packages.
How split-dollar life insurance works
In business contexts, it’s often a form of company-owned life insurance that benefits both you and your employer. The cost of the policy and the benefits of the cash value growth are shared between an employee and their employer.
Every split-dollar policy must involve two or more parties and share the costs and benefits. But agreements can differ in:
Who pays the premiums
Who owns the policy
Who names the beneficiaries
How the death benefit and cash value is split
When and under what circumstances the agreement ends
All of these details should be laid out in the contract establishing the split-dollar life insurance agreement.
While split-dollar life insurance policies are usually implemented for business purposes, it’s possible to employ a split-dollar agreement for a personal life insurance policy. However it’s only useful if you need to minimize your estate taxes. Most people won’t need to worry about this because federal estate taxes only apply to assets above $11.7 million (some states have lower limits). [1]
Who is the owner of a split-dollar life insurance policy?
The ownership of split-dollar life insurance is determined by you and the other party involved in the agreement, though each ownership model comes with its own advantages and disadvantages. A policy can be owned by:
You: You can own a life insurance policy while another party makes part or all of the payments.
Your employer: Like key person insurance, your employer can own the policy and use their portion of the payout to recoup business expenses related to your passing.
A business partner: Small business partners may include a split-dollar contract in their buy-sell agreement, which dictates what happens if one owner exits the business.
A trust: Placing your life insurance policy in an irrevocable life insurance trust means it won’t be counted in the value of your estate.
A family member: Assigning ownership of a permanent policy to a loved one is another method of minimizing future estate taxes.
There are two types of ownership agreements between businesses and employees:
Economic benefit & endorsement agreement
Collateral assignment & loan regime
Economic benefit & endorsement agreement
If your employer owns and pays premiums for the life insurance policy in a split-dollar agreement, but you and your beneficiaries get some of the benefits, those benefits are assigned to you using an endorsement agreement.
How it’s taxed: The term economic benefit refers to the way the IRS taxes the policy. The policy is taxed as employee pay, and calculated annually based on the benefits in your policy and the premiums paid by your employer.
Collateral assignment & loan regime
If you own the life insurance policy in the split-dollar agreement but your employer pays the premiums and gets some of the policy benefits, you assign those benefits to your employer with a collateral assignment agreement.
How it’s taxed: The IRS treats the premiums paid by your employer as an annual, interest-free loan to you (a loan regime). Their share of the policy benefits repayment for the loan. You pay tax on the interest that would have been charged if this were a traditional loan (known as the applicable federal rate or AFR).
Loan regime agreements are more complex to set up, but have greater tax benefits because you are not taxed on the value of your policy benefits.
In either type of agreement, how and when your split-dollar plan ends is laid out in the contract. Most of the time, if you leave the company for another job or retire, the company either terminates your policy or gives you the option to port it at your expense.
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Pros and cons of split-dollar life insurance
Because tax regulations for the benefit became stricter in 2003, [2] split-dollar contracts are not as common anymore. However, it still has some uses in small business and estate plans. There are some pros and cons of split-dollar life insurance:
Pros:
Employer subsidizes the premiums for a generally costly permanent policy
Helps attract top talent as an employee benefit
Can shield your permanent policy from estate taxes
Cash value may provide additional retirement savings
Cons:
If you leave your job, your employer must give up your policy or you will have to pay the premiums yourself
Cash value accounts generally have a low rate of return when compared to traditional investments
Can making filing taxes complicated for the individual or the employer
Permanent policies are more expensive than term life insurance and usually unnecessary
How does split-dollar life insurance work for estate planning?
Also known as private split-dollar life insurance, these are agreements between individuals or involving an irrevocable life insurance trust. The contracts protect your life insurance proceeds from an estate tax.
Depending on how you execute the plan, you may face a gift tax, which applies to assets gifted between family members. There’s a yearly limit of $15,000 and a lifetime threshold equal to the estate tax limit. [3] Work with a certified financial planner if you want to explore this option.
If you are interested in making split-dollar life insurance part of your business or estate plans, make sure to consult a licensed professional. The best plan for you will depend on the financial needs of your business, business partners, and your family.
Frequently asked questions
How does split-dollar life insurance work?
Split-dollar life insurance agreements allow two or more parties to share the benefits of a permanent life insurance policy. The policy owner and division of benefits can vary.
How is a split-dollar arrangement taxed?
If the arrangement is between employer and employee, you pay taxes based on the premiums paid by your employer or on the value of the benefits you could receive from the life insurance policy.
Who pays for a split-dollar life insurance policy?
It’s different for every agreement but premiums are usually paid in whole or in part by you, your employer, and/or a business partner.
Who should get split-dollar life insurance?
Employers could consider including a split-dollar agreement in a benefits package or as part of a buy-sell agreement between business partners. High-net worth individuals might be able to use a policy to avoid estate taxes.
