Split-Dollar Arrangements for Life Insurance — An Overview

Introduction to Split-Dollar

A Split-dollar arrangement is a way of funding the purchase of life
insurance between two parties. It is not an insurance policy. In split-dollar,
one party provides the majority of the funding while the other party controls
most of the death benefit. Split-dollar insurance can be used in an estate
planning context to help fund insurance purchases when there are not adequate
annual gifts (presently $12,000/year) to do so.

Application of Split-dollar

What are the economic benefits of split-dollar? One party can make an
advance, not a loan, to another party, in a form such as an insurance trust
(ILIT). The party that makes the advance is entitled to receive back the
greater of their cash outlay or the cash surrender value of the life insurance
policy. Because that party gets any death benefit over and above the outlay or
cash surrender value, there is an economic benefit to the trust. Each year this
is measured by the cost of one-year term insurance. The IRS has issued Table
2001 showing the cost at each age. This gets expensive as the insured gets
older, so a mechanism is needed to unwind the arrangement.

Second to Die Split-dollar

If two people are insured, the table addresses the likelihood of both people
dying in the same year. The likelihood of both dying in the same year is low,
so the economic benefit is very low. However, once the first of the insured
dies, the single life Table 2001 will then be used, and the benefits will be
calculated based on standard insurance.

Exit Strategy

Exit strategies do exist in this type of arrangement. You could, for
example, use a low value GRAT. It has little value currently, but it will have
a value when the GRAT ends, and then the ILIT can use that money to pay back
the advance to the payor. The taxable term costs end. There should be no gain
since the policy won’t have that much cash value. The trust should be
structured as a grantor trust to avoid a transfer for value rule. Recent IRS
rulings give examples that provide some security to this determination.

The IRS, in 2003, created another variation of split-dollar, called “loan
split-dollar” or “collateral assignment split-dollar”. This is when an
individual makes a loan to another party that is used to purchase the
insurance. The lender receives back a note that bears interest. The interest
can either be paid currently or accrued. However, if you want to avoid the
interest being considered either a gift or a below market loan, the interest
has to be pegged at the applicable federal rate published monthly by the IRS.
The short-term rate is for 3 years or less, mid-term for 3-9 years and the
long-term rate for more than 9 years. Demand loans are the fourth category, and
are the average of the January and July short-term rates for the year. So long
as the interest rate at minimum equals the Applicable Federal Rate, or AFR,
there are no tax consequences.

The ILIT owns the policy outright, and has an obligation to repay the loan
to the individual in the future. Once the loan is made, the trust can pay
interest or accrue interest. If interest is accrued, you must have a grantor
trust to avoid adverse income tax consequences. If, for example, the loan is to
be repaid at death, and the insurance policy is structured for the value to
increase, the insurance can cover the loan and the interest. This technique
only works for older insureds. Otherwise, you still need a method of getting
money into the insurance trust, or ILIT, to repay the loan. A GRAT (grantor
retained annuity trust) with the ILIT as the named beneficiary can be used to
accomplish this.

An interesting transaction can be created with a large one-time loan to the
trust. You must understand the definition of split-dollar to understand this
technique. If you make a loan to the ILIT, and it is collateralized by the
death benefit or the cash value, or both, of the life insurance policy, then, by
definition, it is considered a split-dollar loan. The trust uses this large one
time loan to buy a policy, and to invest the balance of the money. Interest
then accrues on the loan. The policy is structured so that premiums disappear
at some point in the future. A secondary guaranteed universal life policy would
fit the bill for this. The insurance company will guarantee that if you make
specified payments, the policy will be guaranteed for some period of time, up
to life. Some insurers illustrate these policies to age 121. At some point in
the future, the loan will be repaid from the money in the trust, and the loan
is then terminated. You will be left with a fully paid for insurance policy,
and no taxable gifts. No gifts have occurred, because it has been a loan from
inception. This is advantageous over the GRAT approach, since there is no
inclusion ratio for this technique and this technique can be used to set up an
insurance dynasty trust.

Split-dollar and Dynasty Trusts

Another twist on the above can present further planning opportunities.
Instead of loaning cash, you can loan an asset to the trust. Use the cash flow
to pay the premiums and use the same asset to repay the loan. You’ll have to
use a discounted value of the asset on the repayment. This is a great technique
for those with non-liquid assets, such as real estate, to fund an insurance
dynasty trust.

IDIGIT/Defective Trusts and Split-dollar

An intentionally defective grantor trust (IDIT) is a popular technique to
transfer assets. Generally, however, this technique requires that the trust has
some funding, although there are differences in opinion on how much funding
needs to be used. This could require a taxable gift to “seed” the trust.
Because the split-dollar transaction described above is covered by the
split-dollar regulations, it could offer another method to accomplish a seeding
of a trust without a gift tax. The death benefit of the insurance policy could
be used to repay the loan, instead of using the assets transferred to the trust
to repay the loan.

Conclusion

Split-dollar is complex, but offers significant planning opportunities in a
number of estate planning circumstances. Knowing what all of your options are
can help you select the best structure for you.

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The discussions above are general and complex, and competent legal and tax
advice must be sought before implementing any of the ideas discussed.