Prospects for Split Dollar Plans

A wide range of situations call for the use of split dollar plans.  These plans can be used profitably in public corporations as well as in closely held ones.  Despite that broad applicability, we will focus attention on its applicability to the closely held business since the majority of agents will find entrée to those organizations to be far easier than to public corporations.

Bear in mind the characteristics of closely held businesses as we review the use of split dollar plans.  One of those important characteristics is that usually the business owner and its manager are the same person or persons.

The Closely-Held C Corporation

A closely held corporation may be a regular corporation or one that elects to be taxed as an unincorporated business, i.e. an S corporation.  Regardless of how it chooses to be taxed, a closely held corporation just refers to one whose stock is not publicly traded.  

Owners of a close corporation might choose regular corporation status because:

Employee benefits for business owners are tax deductible and
The corporate tax bracket may be lower than the stockholders' tax bracket, causing corporate funds to be more tax-efficient than personal funds

The fact of different income tax brackets for the corporation and its owners may play a big part in the selection of a split dollar plan.  When a corporation is in a lower income tax bracket than its owners, the corporation pays less in income taxes to net $1 of after-tax income than its owners.  

As a result of that difference in taxation, every personal expense that can be paid with corporate dollars results in a savings, sometimes a very substantial savings.  This is the reduction in costs that causes the split dollar plan to be attractive to owners of regular corporations.  In a sense, the corporate owner is turning a personal expense into a corporate expense and saving taxes in the process.

Using Corporate Funds to Meet Personal Financial Needs

A life insurance policy that is part of a split dollar plan can solve the same personal needs that personally-owned life insurance can, such as providing:  

An income to surviving family members
Additional retirement income, and
Estate liquidity

Even though these are common uses of life insurance in split dollar plans, there are many other uses to which life insurance may be put whether purchased within a split dollar plan or not.  

Life insurance is commonly used to replace a breadwinner's income.  There are many "rules of thumb" that are offered to estimate need, but the preferable method of determining how much life insurance should be purchased is through an analysis of the survivors' income needs.  Following determination of the life insurance need:

The split dollar plan document is created by an attorney
The employer pays the agreed-upon portion of the premium
The application for life insurance is completed, and
Any supplementary documents are drafted
An executive insured under a split dollar plan may create additional retirement income by accessing the policy's cash value after the life insurance in the plan is rolled out to him or her.  (This method may be less attractive because of recent IRS split dollar rulings.)  Alternatively, the life insurance policy in the split dollar plan may be used as an informal funding vehicle to provide a salary continuation plan for the executive when the split dollar plan is terminated.  Under such an arrangement, the employer may keep the policy in force in order to recover its costs to provide the salary continuation plan benefit.       
Providing estate liquidity is often accomplished through the use of life insurance in a split dollar plan.  The plan may use a single-life policy or a survivorship policy.  If the executive wishes to keep the death benefits from being included in his or her federal gross estate, the split dollar plan may be arranged between the employer and a third party-often an irrevocable trust-in a third-party split dollar arrangement.  In such an arrangement, the executive normally makes an annual gift and transfers the gift to the trust.  The trust then pays the portion of the premium that would normally have been paid by the executive.  
At the death of the executive, the personal beneficiary's share of the death benefits is paid to the trust which, then, purchases estate assets or loans funds to the estate to pay estate taxes and other settlement costs.  Upon estate settlement, the trust-held assets are distributed to the trust beneficiaries.  These trust beneficiaries are customarily the executive's heirs.

Of course, split dollar plans can be used to meet certain business needs.

 Using Split Dollar Plans to Meet Business Needs

There are many business needs that can be met with life insurance in split dollar plans.  Its most frequent use, however, is in connection with buy-sell agreements.  Two of the most common situations involve funding:

Cross purchase agreements between stockholders or partners, and
One-way buy-sell agreements involving a sole proprietor or sole corporate owner

S Corporation Use of Split Dollar Plans

An S corporation is a domestic corporation that elects to be treated like a partnership for tax purposes.  A corporation electing S corporation status (provided it meets the S corporation requirements) will generally not be subject to tax at the corporate level, and revenues and expenses will flow through to the shareholders.  As a result of that tax treatment, there is no distinction in the S corporation between its tax bracket (since it doesn't have one) and the tax brackets of the shareholders.  For that reason, there is no tax advantage in a split dollar plan for shareholders in S corporations as there is in regular corporations.  There may be other reasons for split dollar plan use in S corporations, however.

Shareholders in S corporations often find split dollar plans appropriate for funding a cross purchase agreement when the shareholders' ages differ.  The reason for split dollar use in such a case is fairly straightforward: it permits the shareholders to share the total premium burden equally.  
We noted just above that the lack of a corporate tax bracket in an S corporation removes the tax motivation from the split dollar plan involving shareholders.  The same issue does not apply to other S corporation employees.  Instead, split dollar plans insuring executives in an S corporation that are not also shareholders enjoy the tax treatment given to C corporations.

Unincorporated Firms' Use of Split Dollar Plans

Split dollar use in proprietorships and partnerships has the same limitations that it has in S corporations.  The lack of difference between the tax brackets of the business and its owner means that there is no split dollar tax advantage.  Just as we found in the case of S corporations, however, there may be other reasons for its use.

Among proprietorships, the primary split dollar application concerns its use by non-owners.  The business that is a proprietorship may have the same executive attraction and retention problems experienced by other businesses. Addressing those issues is the primary use of split dollar in a proprietorship.  

Partnership use of split dollar plans is somewhat broader than it is in a sole proprietorship.  Split dollar plans can help equalize the allocation of premiums in a buy-sell agreement between partners of different ages.  A partnership may also use a split dollar plan to keep a valued executive happy rather than making him or her a partner.


Using a Split Dollar Plan in the Family

Although the bulk of split dollar plans involve an employer and an employee, they are not the only application of split dollar.  Split dollar plans are sometimes used in intra-family situations.  Typical uses of split dollar plans in the family involve:

Ensuring a married child's financial security, and
Equalizing an heir's inheritance