The renaissance of Split Dollar using loans as leverage can present an excellent opportunity to solve a number of issues facing executives today. As Bob Birdsell illustrates, this leverage allows participants to invest in the S&P that contains downside risk protection. And the only cost to the participant is the tax cost on the imputed interest tied the short term AFR and his/her cash contribution.
There was a time, not that long ago, when Split Dollar Life Insurance Plans were popular and executives valued them because they were a convenient and cost-effective way to purchase personal life insurance. Just to clarify, Split Dollar Life Insurance Plans are not a type of life insurance, but rather a way to purchase/finance life insurance. The most popular of the various forms was referred to as “Equity Split Dollar”, and perhaps it was that name that ultimately caught the attention of the IRS.
The structure of an “Equity Split Dollar Plan” is simple. It involves two parties, an executive and his/her company. The policy would be owned by the executive and assigned to the company while the executive was employed there. The company agreed to pay the majority of the premiums on a cash value life insurance policy, while the executive either contributed nothing or just a small amount generally equal the cost of term insurance. The sponsoring company would be entitled to recover the premiums advanced upon termination, death or retirement, and the executive was entitled to the difference. For example, the total premiums over the executive’s career might be $400,000 or more, and the cash value at retirement could easily exceed $700,000. In this simple example, the executive would be entitled to $300,000, that is all the cash value in the policy in excess of what is advanced by his/her employer in premiums ($700,000 minus $400,000 in premiums equals $300,000).
It was a tidy arrangement for both parties. For the company there was little or no P&L impact since they held an assignment on the policy. For the executive it satisfied two needs: 1) personal and family protection and security and, 2) an attractive way to accumulate cash on a tax advantageous basis. The fact that the cash accumulating in the policy was never subject to income tax provided a not so subtle advantage of equity split dollar life insurance, at least until the IRS took notice of the arrangement and changed the rulebook.
Out of the ashes, however, a new and potentially equally advantageous arrangement emerged.
The year everything changed was 2002. This is the year when the IRS issued new regulations pertaining to Equity Split Dollar and effectively torpedoed the arrangement outlined above. Out of the ashes, however, a new and potentially equally advantageous arrangement emerged. It is beyond the scope of this article to drill down into all the nuances of the new regulations pertaining to Split Dollar. Rather I will briefly outline how Split Dollar can still be employed as an effective Executive Benefit Program in today’s complex sea of new regulations and paralyzing laws.
The Stealthy use of Loans
Allow me to pose a seemingly naive question or two. If you were able to secure a 15 year term loan from a third party and pay only the mid or short- term AFR interest rate, would you consider that an attractive arrangement? Second, if you took the loan proceeds and invested them so that your IRR is between 5% and 10% tax free, would that make good investment sense? You might question what the AFR rate is and can the spread between the loan rate and the earnings rate be maintained. An alternative to actually paying the cost of the interest would be to simply pay income taxes on that amount (more on that later). To get a better handle on the AFR rate, let’s take a look at the historical short-term and mid-term rates:
AFR RATES OVER THE LAST 10 YEARS:
2014 .32 1.19
2013 .25 1.65
2012 .24 .95
2011 .20 1.27
2010 .32 1.52
2009 .69 2.64
2008 1.36 2.84
2007 3.88 4.13
2006 4.97 4.73
2005 4.34 4.52
When the IRS changed the rules on Split Dollar, they may have opened a new and potentially superior opportunity for executives and companies seeking to assist their key people with wealth creation opportunities and personal protection plans. Let us illustrate this new type of split dollar by using an example of how this new arrangement could be structured.
Here is the premise: A highly compensated employee has expressed a desire to accumulate more cash for his future retirement needs and is willing to make a personal contribution to accomplish that objective. This executive is 50 years old and is willing to contribute up to $25,000 a year for 10 years. He is maxed out in his 401(k) Plan and is uncomfortable investing any more in the company non-qualified deferred compensation plan because of the limitations and restrictions imposed under 409A. He has also undergone a heart bypass which has rendered him uninsurable. The company has identified approximately 100 other executives in similar circumstances within the company, not with the medical condition but similar circumstances relating to the personal financial requirements.
A plan was conceived which has the potential of providing an answer to this executive’s issues as well as those in similar circumstances; it is referred to a “Split Dollar Loan Arrangement”. Here is a brief summary and introduction to the plan:
• First, in order for the plan to have value for all the executives a guaranteed issue (GI) life insurance plan is negotiated with an excellent insurance company. No medical underwriting is required.
• Second, the sponsoring organization is willing to commit cash to the transaction but not inclined to create a negative P&L, hence the introduction and use of loans. The only limitation on this arrangement will involve loans to executives who are subject to Sarbanes Oxley. For those few, a “work-a-round” could be made which would not involve loans.
• Third, the cash commitment will be in the form of a term loan to be made each year for 10 years with repayment made at the end of 15 years. The interest rate to be charged will be initially set at the “Short-Term” AFR and will be assumed (for illustrative purposes) to average 1.5% (the current short term AFR is approximately .35%) on the outstanding balance. The company agrees to impute the interest to the executives rather than to collect it. The company can deduct the cost. The only cost to executives is the tax cost on the imputed interest.
• The structure of the arrangement is as follows:
The company will match dollar for dollar the amount the executive contributes to the plan in the form of loans, up to a maximum of $25,000 per executive. The key is that the amount of the loan can be structured in many different versions going from financing a very small percent to all of the premiums.
The loan will be recovered at the end of 15 years or upon the executive’s termination, disability or death.
A simple agreement will set forth the obligations and responsibilities of each party.
The policy will be assigned to the company during the term of the agreement and the accruing cash values will offset all the P&L charges.
In our example, we have assumed, the executive is prepared to invest $25,000 a year for 10 years and the company will match that amount through the loan program outlined above.
The company will be 100% secured at all points and recover their investment at the beginning of the 16th year, or at death, termination or disability. The executive has secured a life insurance policy without medical requirements in excess of $1,000,000 and will accumulate substantial cash value over his remaining working career. At age 65 the net projected cash value he will enjoy is in excess of $350,000. This is equal to an IRR of 7% on an annual investment of $25,000. The policy earnings assumptions were based on a 7% return and the cash was invested in an Indexed S&P 500 account. The policy furthermore, provides downside protection of 1% and the upside is limited to 12%. Finally, if required, part of the face amount can be used for long term care issues.
The renaissance of Split Dollar can present an excellent opportunity to solve a number of issues facing executives today. First, the sponsoring organization can secure, without medical evidence of insurability, a substantial life insurance policy for their key personnel. Second, when the sponsoring organization makes a loan commitment to the eligible executives or other highly compensated employees and/or independent contractors, the leverage it creates will be dramatic. As illustrated in the body of this article, this leverage allows the participant to invest in the S&P that contains downside risk protection. The only cost to the participant is the tax cost on the imputed interest tied to the short term AFR and his/her cash contribution.