A significant issue with respect to split dollar plans-particularly in the current unsettled IRS climate-is their taxation, and we will examine the taxation of split dollar plans in some detail. Before considering how split dollar plans are taxed, however, we will discuss some of the traditional split dollar concerns and its principal variations.
Traditional Split Dollar Concerns
In a traditional split dollar plan, the employer pays a portion of the premium equal to the annual cash value increase, and the executive pays the balance. A substantial disadvantage of the traditional split dollar approach is that the executive usually must pay the entire annual premium him- or herself in the first couple of years.
Although some of the premium burden can be lifted from the executive through the use of a life insurance policy with high early cash values, the executive's premium in the early years is still fairly large. This is the crux of the first-year premium problem in traditional split dollar plans.
An additional concern in traditional split dollar plans has to do with the reportable economic benefit (REB) that may arise. The REB approximates the value of the current benefit received by the insured. If the life insurance policy in the plan is owned by the employer, the insured executive must report as income in that year the amount of the REB in excess of his or her share of the premium payment.
The executive's premium share in the early years of a traditional split dollar plan (remember the share in the first year is usually the entire premium) exceeds the REB. However, the insured cannot carry that excess forward to offset the REB in later years when the employer may be paying the entire premium and the insured must recognize imputed income. As a result of these limitations, certain split dollar variations have developed.
Variations on the Traditional Split Dollar Plan
There are four principal variations on traditional split dollar:
Employer pay all
Employee pay REB, and
Let's briefly consider each of these variations. In each case, we will assume that the policy in the split dollar plan is owned by the employer. In the actual case, the policy may be owned by either the employer or the executive. As we will see, later in this section, the tax results will be different depending upon which party owns the policy.
Level Outlay Split Dollar Plans
We know that, in the traditional split dollar plan, the employer pays the portion of the premium equal to the cash value increase. So, the total employer premium payments at any time are equal to the cash value.
If, in a traditional split dollar plan, the policy's cash value at the end of 10 years is $20,000, we know that the employer has made premium payments totaling $20,000. The level outlay split dollar plan simply takes that cash value and divides it by the number of policy years that have elapsed to calculate an average outlay per year. For example, by dividing the $20,000 cash value at the end of policy year 10 by the 10 years, we can see that the average premium per year paid by the employer was $2,000. Once the average employer premium per year is determined, that amount is paid by the employer each year, and the insured pays the balance.
This split dollar plan approach helps to overcome the two principal concerns of the traditional split dollar plan: high early premiums and no REB carry forward. Furthermore, the employer's premium can be leveled over 10 years, 20 years or even longer. The result, in most cases, is that the employer's portion of the premium tends to increase-and the executive's portion tends to decrease-as the duration increases.
Employer-Pay-All Split Dollar Plans
In the employer-pay-all split dollar variation, the employer pays the entire policy premium for as long as the split dollar plan is in force. The executive makes no premium payments and must include the entire REB in his or her income each year.
Since the rates that may be used to determine the REB are so low, the executive's total annual tax cost is likely to be lower than the premiums for a comparable amount of one year term insurance.
Executive Pays REB
When the employer owns the policy and pays the entire premium for it in a split dollar plan, the executive must pay the REB. The executive may eliminate the imputed income by paying a premium each year that is equal to the REB.
By doing that, the executive's premium tends to increase each year while the employer's premium tends to decrease. If the intention is to roll out the policy to the executive at some time in the future, this may be an appropriate plan design since it reduces the employer's interest in the policy. This reduced employer interest also reduces the amount paid to the employer when it is rolled out or when the death benefit is paid.
Bonused REB Costs
Rather than having the executive pay premiums equal to the REBA each year, a variation calls for the employer to bonus the REB to the executive each year. The amount bonused becomes the executive's premium payment for the year. As a result, the imputed REB cost is avoided as is any executive out-of-pocket premium payment, and the executive's cost is reduced to the income tax payable on the bonused REB.