Part 2 Ins and Outs of Split-Dollar: Loan Rate and Product Risks

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1 Part 2 Ins and Outs of Split-Dollar: Loan Rate and Product Risks Chris Burns-Fazzi, Principal Burns-Fazzi, Brock Agenda Review of Split-Dollar Types of Split-Dollar Economic Benefit Regime Loan Regime Most Prevalent for Retirement Benefits Risks Associated with Loan Regime Split Dollar NCUA Views and Concerns Question and Answer 1

2 Split-Dollar Review Split-Dollar insurance policy Split-Dollar = method of owning insurance Rights to dollars in the policy are split between the employer and the employee Split-Dollar = popular way of providing: Death benefit protection Supplemental retirement income Split-Dollar History 1955 Split-Dollar is a loan from employer to employee Employer loans produced no taxable income 1964 Split-Dollar is not a loan, but a way for the employer to provide taxable economic benefits to the employee Term cost of the death benefit protection Rights to other values 1995 Private letter ruling Equity taxed as soon as it emerges 2003 Final Split-Dollar IRS regulations Taxation depends on ownership Executive owns policy/collaterally assigns it to employer = Loan Regime Employer owns policy/endorses rights to employee = Economic Benefit Regime 2

3 Post 2003 Types of Split-Dollar Economic Benefit Regime Primarily for Death Benefit Protection Executive Taxed on term cost of protection If Executive Has Cash Value Interests Taxed as deferred compensation Earlier of when cash value is accessible or when it is vested Loan Regime Also called Collateral Assignment SD Primarily for Cash Benefits Treated as two transactions Loan from employer to employee Must Charge Interest Employee uses proceeds to purchase an insurance policy to withdraw/borrow from on a tax-free basis Loan Taxation Executive is taxed on any forgiven principal or interest Loan Regime Modeling 3 Major Risks to Mitigate Interest Rate Risk Interest must be charged on loan balance Controlling the variable Product Risk Insurance policy performance Stress testing variables Flexible policy features Administration, Compliance, and Reporting 3

4 How the Model Is Built Financial Modeling for Split-Dollar is based on Interest Rate Arbitrage The difference between what you owe to the credit union and what your policy makes. is your benefit Benefit = Policy Performance Loan and Interest Risks that should be controlled or stress tested and reviewed Risk #1 Interest Treatment In Loan Regime Split Dollar interest MUST be charged; pay it, forgive it or accrue it IRS Applicable Federal Rate (AFR); type of loan determines AFR Type of Loan Demand loan Term loan 3 years Term loan > 3 years 9 years Term loan > 9 years Interest Rate Blended Annual Rate Short-term AFR Mid-term AFR Long-term AFR Best Option for Financial Modeling is to lock-in the interest rate One variable is controlled Model can then more effectively stress test other variables; loan amount, year of loan payback, policy performance 4

5 Risk #1 Loan Interest Rate Options Charge interest paid currently Bonus (expense) from CU or take from policy Forgive interest with/without bonus Current taxation to Executive TODAY - Make the Loan Once at a Fixed Rate for the Life of the Plan Charge interest accrued, compounded and paid at death No taxation to Executive and no expense to CU Historical AFR Rates Blended AFR Long Term (Annual) AFR 5

6 Historical AFR Blended Rates vs. Insurance Dividends NCUA Views Split-dollar life insurance is a valuable tool for funding employee benefit plans used to attract and retain senior managers and employees. (NCUA Opinion ) Split-dollar loans are not comparable loans restricted by the preferential loan rule 6

7 NCUA Concerns Interagency statement OCC Guidance for banks NCUA considering its own guidance Prudent Risk Management Board understanding Analysis of seven risks Board oversight annual reviews Investment Policy re: split-dollar Thorough pre-purchase analysis Effective ongoing management NCUA Concerns Pre-purchase analysis Identify need for insurance and quantify amount (25% / 15% standards?) Assess vendor qualifications (long-term commitment) Review characteristics of available insurance products Select carrier (strength and long-term commitment) 7

8 Questions? Chris Burns-Fazzi, Principal Burns-Fazzi, Brock ext. 201 Burns-Fazzi, Brock is the NAFCU Preferred Partner for Executive Benefits and Compensation Consulting Services. More educational resources are available at Important Disclosures: Split Dollar Disclosure for plans created prior to Sept : Split-Dollar Insurance is not an insurance policy; it is a method of paying for insurance coverage. A split-dollar plan is an arrangement between two parties that involves "splitting" the premium payments, cash values, ownership of the policy, and death benefits. Split dollar arrangements are subject to IRS Notice and Proposed Regulations that apply for purposes of federal income, employment and gift taxes. Split Dollar Disclosure for plans created after Sept : Split-Dollar Insurance is not an insurance policy; it is a method of paying for insurance coverage. A split-dollar plan is an arrangement between two parties that involves "splitting" the premium payments, cash values, ownership of the policy, and death benefits. These arrangements are subject to Split Dollar Final Regulations that apply for purposes of federal income, employment and gift taxes. The final regulations provide that the tax treatment of split-dollar life insurance arrangements will be determined under one of two sets of rules, depending on who owns the policy. The Sarbanes-Oxley Act of 2002 makes it unlawful for a company regulated by the Securities Exchange Act of 1934 ("34 Act") to directly or indirectly make loans to its directors or executive officers. This includes not only companies required to register their securities under the 34 Act, but also companies required to file reports (i.e. 10k and 10Qs) under the 34 Act. Please consult with your attorney before purchasing a life insurance policy that will be corporate/business owned or used in a split dollar arrangement to determine what restrictions may apply. This information is not intended to be tax advice. Please consult your tax advisor for more information regarding the tax implications of this policy. Split dollar agreements are complex and involve tax and legal considerations. Please consult with appropriate counsel before entering into such an arrangement. National Financial Partners Corp., its affiliates and subsidiaries do not offer tax or legal advice. This material neither constitutes nor is intended to constitute an offer or an agreement to provide insurance coverage; it is intended to provide general information and is not necessarily a complete descriptions of all terms, exclusions and conditions applicable to products and services. 8

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