What is split-dollar life insurance?

Most people only need a personal life insurance policy to protect their loved ones in the event of their death. But some people, particularly business owners and key employees, may also need a life insurance plan to protect against the impact their death would have on their business. 

Some businesses fill this need with split-dollar life insurance. It isn’t technically a life insurance product, it’s a formal agreement between two or more parties to share the ownership and benefits of a permanent life insurance policy with a 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) and/or as a benefit in executive compensation packages.

How a split-dollar plan works

Split-dollar life insurance is an agreement in which the payment anddeath benefitof a permanent insurance policy with a cash value is shared, usually between an employee and their employer. In business contexts, it’s often a form of company-owned life insurance that benefits both you and your employer.

Every split-dollar policy must involve two or more parties and share the costs and benefits of a cash value life insurance policy. 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 your agreement.

Though it’s possible to employ a split-dollar agreement for a personal life insurance policy, 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 (though your own state might have its own, 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/or 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: an economic benefit/endorsement agreement and 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 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 (i.e., 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. Often 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.

Pros and cons of split-dollar life insurance

It’s less likely that you’ll see a split-dollar contract today, after tax regulations for the benefit became stricter in 2003. [2] However, it still has some uses in small business and estate plans. Depending on your situation, these are the pros and cons of a split-dollar agreement:

Pros:

• Employer subsidizes the premiums for a costly permanent policy

• Helps employers attract top talent if offered as a benefit

• Can shield your permanent policy from estate taxes

• Cash value may provide additional retirement savings

Cons:

• If you leave your employer you must give up your policy or pay the premiums yourself 

• Cash value accounts generally have a low rate of return

• Can complicate your taxes as an individual or as an employer

• Permanent policies are more expensive than term life insurance

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.