To be successful in today’s competitive business environment, business owners need to understand far more than just the products they sell and the services they offer. They need to be marketing specialists, human resource managers, public relations experts, and sometimes, even the cleaning service. They need to keep their key employees happy and productive. And if they want to remain successful, they need to be both long-range planners and sound money managers.
But that’s not breaking news. As the owner of a small business or professional practice, you’ve known all of that – and probably taken on all of those roles – for years. But what you may not know is that, under current tax law, there are a variety of planning and money management strat- egies available that can lessen the amount of time you spend playing different roles, and increase the amount of time you spend focusing on your business.
One such strategy involves using dollars from your business or practice to pay for personal life insurance protection on you or select key employees. Commonly known as a “Split Dollar Plan,” this strategy allows you to pay for your personal life insurance with business dollars, or create an arrangement to share the cost and benefits of a life insurance policy on your key employees to whom you want to extend an extra benefit. When your key employees feel valued and appreciated, they work harder and remain loyal. And as the owner of a small business or practice, you benefit from increased productivity and a working environment that allows for growth and progress – two essential elements of a successful business.
So how can a Split Dollar Plan help? First and foremost, it allows you to obtain personal life insurance protection on yourself for the benefit of your family or business, and on select key employees for their personal benefit and the benefit of their families. Few selective benefits are as powerful, affordable, and flexible as life insurance – just ask anyone who’s been able to remain in their home or maintain their standard of living following the unexpected death of a breadwinner, or used the cash values of their policy for education expenses, additional retirement income, or other lifetime needs. In addition, a Split Dollar Plan can help you attract, retain, and motivate high quality employees, as well as reward them and yourself for the success of your business.
For example, depending upon how the plan is structured, your employees may be able to draw from the policy’s cash value at retirement as a supplemental source of retirement income (a concept commonly referred to as “golden hand-cuffs”). Or they may be able to access policy cash values to assist with other life events such as paying for children’s college expenses. (Loans and withdrawals will reduce one’s stated cash value and death benefit). In addition to these benefits, you can use a Split Dollar Plan to fund a buy/sell agreement whereby the policy’s death benefit is used to purchase the business interest of a partner or co-owner in the event of death.
Another key component of a Split Dollar plan – again, depending upon how it is structured – is that it may allow you as the business owner to recover all of your plan costs at the death of a covered employee. Thus, you (via your business) are able to provide your key employees with a valuable employee benefit with little or no long-term out-of-pocket cost.
How do Split Dollar Plans work?
Under most Split Dollar Plans, your business or practice pays the policy premiums while retaining an interest in the policy’s cash value, death benefit, or both, in order to eventually recover the premiums paid. Participating employees receive the right to decide who will receive the death proceeds (the “beneficiary”), and depending upon how the plan is structured, they may also receive the right currently or at a specified point in time (e.g., retirement) to access policy cash values – again in excess of any interest the business may have retained.
To clarify exactly how Split Dollar Plans are taxed, the Internal Revenue Service issued regulations which affect all split-dollar arrangements entered into (or materially modified) after Sept. 17, 2003. Under those regulations, all Split Dol- lar Plans now fall under one of two basic categories, called “tax regimes”: an “economic benefit regime” or a “loan regime.”
If the business owns the policy and pays the premiums, the plan falls under the “economic benefit regime.” If the business pays the premiums, but you or your key employees own the policy, the plan falls under the “loan regime”, with premium payments essentially treated as a series of loans to you or the insured-employee.
Let’s take a closer look at the two “regimes” to see how each operates.
Under an “economic benefit regime” Split Dollar Plan, your business owns the life insurance policy, your business pays all of the policy premiums, and your business retains the exclusive right to all of the policy’s cash value, from which it can recover all of its premium payments. You or the insured- employee decides who will receive the policy’s death proceeds in excess of the cash value. Each year, the “economic benefit” of the death proceeds, determined under IRS tables, is considered taxable income to the insured-employee. While that economic benefit is generally small, you can mitigate that taxable event by paying a bonus in the amount of the tax liability.
Under this type of Split Dollar Plan, your business would not receive an income tax deduction for policy premiums it pays, but neither would those premiums be taxable as income to you or the insured-employee. However, because this type of arrangement gives you complete control over the policy’s cash values, you could elect to transfer a portion of those values to your employee(s) as an additional benefit in the future – maybe at their 10, 15, or 20-year anniversary with your company, or perhaps at retirement. Should you elect to do this, the amounts transferred would then be considered taxable income to your employee(s) and income tax-deductible to your business.
Thus, an “economic benefit regime” Split Dollar Plan can work for both you and your key employees. It can help you retain and reward quality people (and recover all your costs in the process). And it can provide cost-effective life insurance protection for your employee(s), while funding what essentially amounts to a deferred compensation plan.
Under a “loan regime” Split Dollar Plan, you or your employee(s) own the policy and the busi- ness pays for all or part of the policy premiums. Premium amounts paid by the business are treated as a loan (or series of loans) to the insured-employee(s), and are charged a corresponding rate of interest. If the actual loan interest rate specified in the split dollar agreement is less than the “applicable federal rate” set by the IRS, then the difference is treated as additional income to the insured-employee.
As with economic benefit regime Split Dollar Plans, the business would not be able to tax deduct the premiums, but neither would they be considered taxable income to you or your key employee(s). Because the policy is owned by the individual, they may access policy cash values via policy loans on an income-tax free basis in order to supplement retirement income, meet other obligations, or take advantage of opportunities. At an employee’s death or at termination of the agreement, the business would recover all premiums paid via a claim against the death benefit or policy cash values.
For many business owners, life insurance is an essential part of their overall estate plan because it can provide the needed cash to pay federal and state death taxes, business and personal debts, and other estate settlement costs. In addition, policy proceeds can be used to protect the financial secu- rity of family members, or create an inheritance for heirs who aren’t actively involved in the business. A “loan regime” split dollar plan between your business and an irrevocable life insurance trust is a cost-effective and tax-efficient way to create income tax-free and estate tax-free cash for your estate planning needs. Our firm has created the Professional Retirement Plan (PRP) using the loan regime design to effectively allow C corpora- tion Executives to set money aside (equivalent to pre-tax money) for retirement in a tax advantaged way (with correct design, tax free withdrawals). The major goal of the PRP is to allow for greater spendable retirement income than a comparable ERISA based plan (e.g., 401k,Profit Sharing Plan, IRA,etc).
While the mechanics of Split Dollar Plans may sound a bit complicated, in actuality they are fairly simple and straightforward. They allow you to select whom you want to benefit and by how much; they do not require IRS approval; there are no ERISA reporting requirements; they can be used to supplement other company-sponsored employee benefit plans; they can be used to fund personal insurance needs; and through various agreements, the cash values and death proceeds can be structured to accommodate the interests of both you and your key employees.
Is a Split Dollar Plan right for you and your business? Maybe. As you consider the various planning and money management strategies available to you, consider also the power and flexibility of life insurance, and the ease and simplicity of a Split Dollar Plan. It might just allow you more time to focus on what you do best – running your business.
The information presented above should not be construed as tax advice applicable to each individual. Please consult a qualified tax advisor regarding your individual circumstances.
–by Patrick R. Davidson, MBA Business Consultant and Wealth Coach, Provident Financial Services; Patrick Davidson can be reached at 208-371-4696.
A Split Dollar Plan can help you attract, retain, and motivate high quality employees, as well as reward them and yourself for the success of your business.