An Effective Way To Leverage Gifts and Reduce Estate Taxes

Split-dollar life insurance is not a different type of insurance. Instead, it is an agreement between two parties to share the cost of premiums on a life insurance policy and in some fashion split its proceeds, even though only one party owns the policy. Split-dollar agreements are typically entered into by a corporation and an employee as a way of deferring income or increasing benefits to the employee. But they can also be entered into by the insured and a beneficiary, or by a beneficiary and an irrevocable life insurance trust established by the insured. These nonemployment arrangements are considered private split-dollar insurance agreements.

Gift and Estate Planning Advantages

One advantage you can reap from establishing a split-dollar arrangement is that it helps to protect your life insurance proceeds from estate taxation. It does so by separating the cash value of the policy from the death benefit. Because a person or entity other than you (the insured) typically owns the policy, the life insurance proceeds are removed from your estate. The policy’s beneficiaries and the policy owner share the proceeds according to the agreement’s terms.

A typical estate planning strategy is to establish an irrevocable life insurance trust (ILIT) to own a life insurance policy on your life, pay the insurance premiums and distribute the trust proceeds to the trust beneficiaries (your heirs). You would then make annual gifts to the trust to cover the premiums. Because the amount you contribute to the trust is considered a gift to the trust beneficiaries, any contributions of more than $10,000 per beneficiary (the annual exclusion amount) will be subject to gift tax. If the premium required per beneficiary on a large insurance policy is greater than that limit, or if you have already exceeded the $10,000 annual exclusion amount for some or all of the trust beneficiaries, you will have made a taxable gift. This is where a split-dollar agreement can come to the rescue.

Under the terms of the split-dollar agreement, the trust typically pays only a small part of the premium (often less than 5%), usually an amount equal to the economic benefit (the current actuarial value of the death benefit based on a one-year term policy). Another party, such as your spouse, child or a family partnership, pays the remainder of the premium. Through this arrangement you contribute a relatively small amount -- considered a gift to the beneficiaries -- to the trust to cover its portion of the premium. The split-dollar arrangement therefore allows you to give beneficiaries a potentially tax-free gift that’s worth much more in future benefit than the amount you contribute for the premium.

Beneficiary Access to Cash Value

One disadvantage of removing life insurance proceeds from your estate is that you can lose access to the policy’s cash value. A properly structured private split-dollar arrangement, however, can provide access to cash value for your spouse or other beneficiary.

One way to provide access is through a split-dollar agreement between your spouse and an ILIT that owns and is the beneficiary of the insurance policy. Under the agreement, the ILIT pays only the part of the premium equal to the economic benefit of the amount at risk. Your spouse pays the remainder of the premium. During your life, your spouse may have access to the policy through a loan or a partial surrender of the policy. When you die, your spouse will receive an amount equal to the cash value of the policy. The ILIT will receive the remainder of the death benefit. Over time, the ILIT’s interest in the death benefit can become substantially greater than your spouse’s cash value interest in the policy.

Careful Planning Is Important

The only authority directly addressing private split-dollar agreements are private letter rulings issued by the Internal Revenue Service in which the split-dollar agreement was made between an ILIT and the insured’s spouse. Despite the absence of authority, private split-dollar insurance has been an accepted planning technique for some time, though you should still use caution.

If you want to leverage your $10,000 annual gift tax exclusion or provide your beneficiaries with access to the cash value of your life insurance policy, a private split-dollar arrangement may work for you.

 We would be glad to discuss your situation and help you structure an agreement that achieves your financial objectives.

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