Traditional Split Dollar Plan Approach
We noted in our general discussion of nonqualified plans that one of their strengths was their ability to change shape to meet the objectives of the employer and the plan participant. This characteristic is true for split dollar plans as well. As a result of this flexibility, there are many ways to split a life insurance policy in a split dollar plan. We will begin our split dollar plan discussion with an examination of a traditional split dollar plan.
In a traditional split dollar plan, the part of the policy premium paid by the employer is equal to the increase in policy cash value each year. At some point, the cash value increase will normally exceed the policy's annual premium. When that occurs, the entire annual premium is paid by the employer. The portion of the policy's annual premium that is not paid by the employer is paid by the insured executive.
Typically, in a whole life insurance policy, the premium increase in the early years is quite small, and, in the first year, it is usually zero. What that means, of course, is that the insured is required to pay the entire first year premium since the employer's portion of the premium is limited to the increase in cash value. For this reason, split dollar plans that employ a traditional split dollar approach usually use life insurance policies that have high early cash value increases. (Other split dollar approaches-and there are many-do not require high early cash value increases to moderate the insured's early premium payment levels.)
In a traditional split dollar plan, the employer owns the life insurance policy and endorses to the insured the right to name a beneficiary. As a result of this endorsement of rights, this type of split dollar plan has come to be known as the endorsement method. The insured's personal beneficiary receives any death benefits that are in excess of the employer's interest in the policy. In the case of a traditional split dollar plan, that interest is an amount equal to the policy's cash value.
In split dollar plans, the employer's interest continues to grow as it makes additional premium payments. As a result of that growing employer interest in the policy, its share of the policy's death benefits increases. To the extent that the employer's share of death benefits increases, the personal beneficiary's share decreases.
Even though the decrease in the death benefit share received by the personal beneficiary may not be particularly large, the decline may not be consistent with the personal beneficiary's need for life insurance protection. In such cases, the personal beneficiary's death benefit can be kept at the level of the original face amount (assuming the policy is a participating whole life insurance policy) by using the fifth dividend option.
By selecting the fifth dividend option, an amount of one-year term life insurance equal to the policy's cash value is purchased each year by application of the dividend. Any dividend declared in excess of the amount required to purchase the term insurance can be applied under one of the other dividend options. The employer's portion of the policy death benefit in the traditional split dollar plan is equal to its aggregate premium payments which, in turn, is equal to the cash value. Since the additional term insurance purchased by the dividend is equal to the employer's portion of the death benefit, the personal death benefit portion generally remains level and is equal to the policy's face amount.
If the policy in the split dollar plan is a non-participating policy, i.e. it is not eligible for dividends, the same result can be obtained by using an increasing term insurance rider. In an increasing term insurance rider used in connection with a split dollar plan, the rider death benefit is usually equal to the policy's cash value. An increasing term insurance rider requires an additional premium.
If a universal life policy instead of a whole life policy is used in the split dollar plan, the personal beneficiary's death benefit may be kept at a level amount by selecting death benefit Option B. In a universal life insurance policy with this death benefit option, the death benefit is equal to the initial face amount plus the cash value. Since the death benefit under this option is increased by the policy's cash value (which is payable to the employer), the personal beneficiary's death benefit remains level at the initial specified amount level. In some universal life insurance policies, a death benefit Option C is available and is particularly appropriate to split dollar plans. Under an Option C death benefit, the total death benefit equals the initial face amount plus the aggregate premiums paid. Under Option C as well, the personal beneficiary's portion of the death benefit will tend to remain level.