Over the last few years, private split dollar, a popular estate planning concept for wealthy families, has emerged as an interesting application for small business succession.
Private split dollar is a plan allowing the benefits of a permanent life insurance policy to be split between two parties. The split is generally outlined in what is known as a split dollar agreement. But in private split dollar, the arrangement is between individuals (usually family members) or trusts that benefit them, rather than between an employer and an employee.
Because the insured member owns the life insurance policy, he has lifetime access to the cash values and can take advantage of the tax-deferred accumulation.
The two objectives a prospect must have in order to be a candidate for a private split dollar plan are access to policy values to supplement retirement income, and exclusion of the net death benefit from the estates of both the client and spouse.
Private letter rulings from the Internal Revenue Service in 1996 (PLR 9636033) and 1997 (PLR 9745019) enabled the split dollar concept to extend to private arrangements, including the use of a second-to-die contract, and offer some attractive planning opportunities that are difficult, if not impossible, to achieve outside of private split dollar.
Estate tax exclusion for death proceeds, combined with lifetime access to cash surrender values. Through one insurance policy, private split dollar plans can provide both a source of supplemental retirement income for a husband and wife and a federal estate tax exclusion of the net death benefit from the husband and wife’s estates. This can be a powerful combination in many situations. For example, a relatively young professional couple who, although very successful, find the security of retaining access to cash values very important, would benefit from the estate tax exclusion of the net death benefit.
Significant gift tax and generation-skipping tax leveraging opportunities. In private split dollar, premium payments by the party retaining an interest in the cash value are not treated as gifts for transfer tax purposes. As a result, private split dollar can significantly reduce the amount of the gift required to put relatively large net death benefits into life insurance trusts. This transfer tax leveraging can also be important for generation-skipping transfer tax purposes. Reducing the amount of the gift to the trust effectively increases the leverage of a client’s $1,000,000 generation-skipping tax exemption, so more of the death benefit can be kept exempt.
Combination of benefits. In some cases, it is the combination of access to the cash values, the net death benefit exclusion, and the gift-tax leveraging opportunities that motivates a client to consider the private split dollar concept.
Finance a buy-sell arrangement for members of a limited liability company (LLC). This is an interesting and potentially useful application of private split dollar. The buy-sell obligation is a cross-purchase arrangement, where the surviving member agrees to purchase the interest of the deceased member. Each LLC member owns his own life insurance policy, and endorses the net death benefit proceeds to another member in exchange for payment of the term cost.
This design can accomplish multiple objectives. If the insurance policy is on a universal life chassis (fixed, indexed and/or variable), by electing Option B (the increasing death benefit), the insured member can build cash values and yet still provide a business partner with the necessary liquidity to cover the buy-sell obligation.
Under “check-the-box” regulations, an LLC is taxed as a partnership unless it specifically elects to be taxed as a corporation. The IRS has ruled privately on several occasions that members of an LLC are “partners” for purposes of the transfer for value rule (see PLRs 9625013 through 9625019). Violating the transfer for value rule means the death proceeds become income-taxable to the extent the benefits exceed what money the transferee has paid for the policy. The net effect of this position is that the death proceeds received by the non-insured member under the private split dollar arrangement remain free of income tax.
Because the insured member owns the life insurance policy, he has lifetime access to the cash values and can take advantage of the tax-deferred accumulation. The insured has incidents of ownership over the policy and the entire death proceeds are included in his estate.
However, IRC section 2053(a)(4) and the regulation promulgated thereunder (Treas. Reg. section 20.2053-7) allow a deduction for a liability “contracted bona fide and for adequate and full consideration in money or money’s worth.”
Arguably, the non-insured member’s interest under the private split dollar plan constitutes a liability against the policy which was “contracted bona fide and for adequate and full consideration in money or money’s worth.” Accordingly, the “at risk” portion represents such a liability (debt) and should be deductible from the deceased insured’s estate.
The benefits of using private split dollar to finance a buy-sell arrangement for members of an LLC can be summarized as follows:
- The insured member retains lifetime access to the cash values accumulated in the life insurance policy, which can be used to supplement retirement.
- Although the entire death proceeds are included in the insured member’s estate, the “at risk” portion payable to the non-insured member should be deductible.
- The non-insured member has purchased the necessary liquidity to perform his buy-sell obligation for a term premium.
- The death proceeds received by the non-insured member should be income tax-free.
Lawrence T. Jones, J.D., is second vice president, advanced sales, for National Life of Vermont. He can be reached by phone at 802-229-3460 or by e-mail at email@example.com.