Preserve Gift Exemptions with a Private Split Dollar Arrangement

Author: Sam Jacobs

Today, a generous federal estate tax exemption exists that's likely to approach $14 million per person by the time the current legislation expires at the end of 2025, when the amount is scheduled to sunset to approximately $5 million. For those whose wealth exceeds the exemption total, who want to preserve the exemption and annual gifting amounts, or who are hesitant about making an irrevocable transfer of liquidity from the estate and into a trust, a private split dollar (PSD) arrangement may be the solution to effective wealth transfer.

A PSD plan is an agreement between two parties to share the costs and benefits of a life insurance policy. Employers have long sponsored split dollar strategies to provide tax-efficient, nonqualified compensation or life insurance for estate planning and wealth transfer for business owners and key employees.

A PSD arrangement doesn't involve compensation and isn't related to employment. Rather, it's most often used in families in which one family member needs life insurance and another family member has the money and willingness to pay the premiums.

When does a private split dollar arrangement make sense?

PSD arrangements are normally used in three situations:

1. To transfer family wealth while minimizing gift and estate taxes. In these cases, a parent or grandparent establishes an irrevocable life insurance trust (ILIT) to benefit children or grandchildren. The ILIT purchases a life insurance policy under a PSD agreement with the parent or grandparent. The value of the gift to the ILIT is the economic benefit (discussed later in detail), not the amount the parent or grandparent advances to pay premiums. (Note: Any direct or indirect transfer or distribution to a grandchild may be subject to generation-skipping transfer tax.)
2. To increase the wealth that a parent or grandparent can pass on to younger family members while still retaining the ability to recover some or all of their money if their personal circumstances, personal objectives or tax laws change. A PSD arrangement may be revoked or terminated; if it is, the parent or grandparent may be entitled to recover the greater of the policy's cash value or the premiums paid.
3. To temporarily pay life insurance premiums for coverage to benefit a family member. A good example is when a child gets married or has children. When a young couple isn't yet financially stable and need a life insurance policy on the life of the breadwinner, a parent can pay the premiums so their child can purchase insurance coverage on their spouse.

The arrangement

Most often, a parent or grandparent acts as both the premium payor and the insured, while the children, grandchildren or an ILIT for their benefit are usually the policy owner and beneficiary. In a PSD arrangement, the ILIT or child purchases the policy, and the parent or grandparent pays the premiums and is entitled to recover the greater of the policy's cash value or the total premiums advanced when the agreement terminates.

Termination can occur at the insured's death or at any other time specified in the PSD arrangement. If the insured dies while the arrangement is still in place, death benefits are first used to repay the premium payor the greater of cash values or premiums advanced. The remaining death benefits are paid to the policy beneficiary.

Steps for implementing a private split dollar arrangement

1. The ILIT or child buys a life insurance policy on the parent.
2. The parent advances cash to the policy owner to pay the premium.
3. The parent is deemed to make a gift to the economic benefit value annually.
4. The ILIT or child collaterally assigns policy to the parent, according to the terms of the split dollar agreement.
5. At the parent's death, the parent's estate receives a portion of the policy death proceeds equal to the greater of all premiums advanced of the policy's cash value.
6. The ILIT or child receives the remaining policy death benefit proceeds.

Income and gift tax considerations

The split dollar regulations finalized in 2003 permit participants in a split dollar arrangement to use either the "economic benefit regime" or the "loan regime," as contained in Regulation §1.61-22 and Regulation §1.7872-15, respectively, to determine how they will be taxed.

Because PSD arrangements are designed to deliver death benefits, the income tax consequences of the economic benefit regime are more often beneficial than those of the loan regime. Thus, at least initially, the participants usually choose the economic benefit regime.

Economic benefit regime

In the economic benefit regime, the premium payor's gift tax consequences are based on the value of the life insurance protection known as the "economic benefit." Functionally, the economic benefit is the term insurance costs for that amount of coverage as determined using IRS Table 2001. The current age of the insured and the amount of the death benefit that would be paid to the policy beneficiary if the insured died during the current tax year are the most important factors in determining the economic benefit.

The premium payor — usually the parent or grandparent — receives death benefits equal to the greater of the cash values or premiums paid; all remaining death benefits are paid to the policy beneficiary, usually the children or grandchildren, or an ILIT for their benefit. The premiums paid into the policy aren't a part of the economic benefit calculation. In the economic benefit regime, life insurance policies can be owned in two ways:

• Non-equity collateral assignment arrangements. The non-premium payor — usually the children, grandchildren, or an ILIT for their benefit — owns the policy and assigns back to the premium payor an interest in the policy equal to the greater of the policy cash values or the total premiums paid. If the insured dies, death benefits are first used to pay the greater of the cash values of premiums paid to the premium payor or their estate, and then the remaining death benefits are paid to the policy owner's beneficiary. In PSD arrangements, this ownership method is most often used, and this article assumes the non-equity collateral assignment arrangement is being applied.
• Endorsement arrangements. The premium payor owns the life insurance policy on the life of another family member and that family member is responsible for the economic benefit cost associated with their share of the death benefit. The death benefit is split to permit the premium payor to recover the greater of the policy cash values or the premiums paid; any remaining death benefits are paid to the non-premium payor's beneficiary. This method is seldom used in PSD arrangements because the death benefits would be fully included in the premium payor's taxable estate.

Loan regime

Death benefits that are generally income tax free may also be available under the loan regime. A loan arrangement usually provides income tax-free death benefits to the children, grandchildren or an ILIT for their benefit as the borrower after the loan is repaid. However, the borrower's cost for that protection is usually greater than under non-equity collateral assignment split dollar. That's because the interest costs of a loan arrangement are generally higher than the economic benefit in the economic benefit regime. This difference can change over time as the insured ages.

In a loan regime split dollar, it's important for the stated interest to be at or above the applicable federal rate (AFR) in effect during the month in which a premium loan is made, as published by the IRS each month. Otherwise, the difference between the amount of interest charged under the arrangement and the minimum interest required by reference to the appropriate AFR will be imputed as gifts to the trust and, in the case of certain term loans, the undercharging of interest payable over the life of the loan may be treated as a gift by the premium payor to the policy beneficiary in the first year on a present value basis.

Private split dollar advantages

• The arrangement is private; parent may act alone in deciding the structure and amount of gift is measured by economic benefit value, rather than amount of premium payment.
• The policy owner receives the death benefit income and estate tax free.
• The parent retains some control over the arrangement, without owning the policy. The parent may potentially recover the greater of the cash value or premiums paid by terminating the agreement.
• The parent may forgive the repayment obligation in the future, resulting in a taxable gift.

Documenting a private split dollar arrangement

Every PSD transaction should be in writing. The two essential documents are the PSD agreement and a collateral assignment from the policy owner to the premium payor filed with the insurance company. The collateral assignment should be carefully drafted because, in most PSD situations, the premium payor is also an insured and doesn't want the entire policy death benefit to be taxed in their estate at death.

To limit estate tax exposure to the greater of cash values or premiums paid, the premium payor shouldn't have an incident of ownership in the policy, as described in IRC §2042. Standard collateral assignments may contain language that constitutes an incident of ownership in the policy; it may also give the premium payor the right to take over ownership of the policy, which could be an expensive mistake. The collateral assignment is limited; it should exclude rights that could be an incident of ownership.

Types of life insurance policies

PSD arrangements are primarily designed to provide death benefits, so if cash value accumulation is important, a different strategy should be considered. Life insurance policies that have low premiums relative to the death benefits delivered or which may include secondary death benefit guarantees from the insurer are often used.

Survivorship policies that insure the lives of two people and pay death benefits at the second death are often used in PSD arrangements. These policies should be considered when it makes sense to receive the death benefit at the death of the second insured. Survivorship policies are often more attractive for two reasons:

• Premiums are generally lower than a single life policy paying the same amount of death benefit.
• The economic benefit value is generally lower in a survivorship life insurance policy while both insureds are alive. In survivorship policies, the economic benefit value is based on the likelihood of both insureds dying in the same year.

Terminating a private split dollar arrangement

Planning should always consider the possibility that a PSD arrangement may need to end before the death of the insured. For this reason, it's often wise to create an exit strategy when the arrangement is initiated.

There are several ways to terminate a PSD arrangement. The first step is to review the agreement, which may include specific provisions for ending the arrangement. PSD agreements often give the premium payor the right to terminate the agreement at any time.

The following are reasons to terminate a PSD arrangement:

• The premium payor has a financial crisis and needs funds fast.
• Tax laws have changed, making the PSD arrangement unnecessary or obsolete.
• The premium payor's objective has changed.
• The economic benefit value has become too high.
• One of the insured in a survivorship policy has died, and the new economic benefit value (based on the surviving insured's age) has become too high.

Even if the agreement doesn't specifically address termination, the premium payor may release their rights under the agreement. In this case, the collateral assignment should also be released. The release is usually considered a taxable gift from the premium payor to the policy owner.

• If the PSD agreement was originally designed so that the premium payor never had an "incident of ownership" in the policy as defined by IRC §2042, this release of rights shouldn't trigger estate inclusion under the three-year rule of IRC §2035.
• If the premium payor had an incident of ownership in the policy, then they would usually have to survive for at least three years following the date of the release for the policy death benefits to be estate tax free. If the policy is a survivorship policy, estate tax inclusion may be avoided, as long as one of the insureds survives for at least three years after the date of the release.

If a termination is being considered because the economic benefit value is getting too high, it may be worthwhile to consider converting the arrangement from a PSD arrangement to a private loan. This conversion may make sense when the economic benefit value gets too high, or in a survivorship policy when one of the insureds dies.

The option to convert to a loan arrangement may be specifically provided in the agreement. If it isn't, the parties may be able to convert by mutual agreement. That is, the PSD agreement could be terminated, and the premium payor could receive a promissory note for their interest from the policy owner. The note should have a principal amount equal to what the premium payor would have received if the insured had died on the date of the termination. The note should bear a fair market interest rate and can be structured as either a demand loan or a term loan.

The main advantage to ending the PSD arrangement and switching to a private loan is that the economic benefit is no longer the measure of the gift tax consequences. While the PSD arrangement was in place, the premium payor made an annual taxable gift to the policy owner equal to the economic benefit, regardless of whether any premiums were paid.

The decision whether to switch to a loan arrangement includes the fact that, under the PSD arrangement, the policy owner usually isn't required to make any payments to the premium payor. In a private loan arrangement, however, interest on the note must be paid annually (unless the loan is structured as an interest-free loan).

It can also make sense to convert to a private loan arrangement if the policy cash value begins to exceed the premiums advanced under the PSD agreement, which is when the policy is developing "equity." If the PSD arrangement remains in place, this equity belongs to the premium payor, who's entitled to recover the greater of cash value or premiums paid. This results in a larger taxable estate for the premium payor and a reduction in the death benefits that ultimately are delivered to the policy beneficiary. Converting to a private loan before the buildup of equity means that the equity belongs to the policy owner and is paid out as generally income tax-free death benefits at the second surviving insured's death.

Gallagher can help you and your clients face the future with confidence. Contact a Gallagher consultant today to learn how private split dollar can be a useful wealth transfer tool.