Split-Dollar Loans Equity Collateral Assignment

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1 Split-Dollar Loans Equity Collateral Assignment Introduction A split-dollar arrangement in its various forms is typically used to help clients minimize income taxes and transfer taxes associated with the funding of large life insurance premiums and/or reduce the cash flow required to fund a needed life insurance death benefit. While the 2003 final split-dollar regulations (Final Regs.) changed the way split-dollar arrangements are treated from a tax perspective, a properly structured split-dollar arrangement remains a viable technique to consider. Split-Dollar Overview A split-dollar arrangement is an agreement between an owner and a nonowner (i.e., an employer and employee or a family member and a trust), where the parties agree to split the premium payments, cash value and death benefit of a life insurance policy that satisfies the following criteria: 1. Either party pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including a payment by means of a loan to the other party that is secured by the life insurance contract; 2. At least one of the parties paying the premiums is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and 3. The arrangement is not part of a group term life insurance plan described in Internal Revenue Code (IRC) 79 unless the group term life insurance plan provides permanent benefits to employees (as defined in Treas. Reg ). 1 Split-dollar arrangements attempt to place the majority of life insurance premium costs in the hands of the person(s) or entity with the ability to pay the premiums. White Paper

2 Use of Split-Dollar Loans Split-Dollar Loans The acquisition of a needed death benefit outside the client s estate often requires planning to reduce or eliminate potential transfer tax issues. Many clients find the premium costs for the death benefit needed exceed their gifting capacity (i.e., annual gift tax exclusion and/or remaining lifetime gift tax exemption amounts). 2 As a result, many clients use premium leveraging arrangements to facilitate funding their life insurance premiums with little or no cash flow and/or transfer tax impact. This article examines the use of split-dollar loans between the client, the client s closely held business or the client s employer (referred to collectively as lender ) and an irrevocable life insurance trust (ILIT) where the lender loans the premiums for a life insurance policy on the client s life to the ILIT. The loans are secured by a collateral assignment on the life insurance policy owned by the ILIT and are taxed under the loan regime of the Final Regs. The gift to the ILIT, if any, is equal to the amount of loan interest not the entire policy premiums. Loan interest can be paid current or accrued. Loan principal, including any accrued interest, may be repaid from the life insurance proceeds or from other sources during the client s lifetime. 3 Since the amount secured by the collateral assignment is generally only the premiums paid, a split-dollar loan is similar to equity split-dollar in that the third party owns any equity in the policy. Split-Dollar Post Final Regulations The Treasury and IRS issued Final Regs. on Sept. 11, 2003, creating two separate tax regimes for split-dollar agreements: the economic benefit regime and the loan regime. 4 Under the Final Regs. the actual or deemed owner of the life insurance policy determines the appropriate regime. 1. In a compensatory arrangement, where the employer is the owner of the policy, or a private arrangement, where the donor is the owner, the economic benefit regime applies. Any arrangement not covered by the economic benefit regime is governed by the loan regime. 2. Where a premium payer (e.g., an employer or donor) pays all or a portion of the life insurance premiums on behalf of the policyowner (e.g., an employee or trust) and is entitled to repayment from the policy s cash value or death benefit, the loan regime generally applies. In these cases, the premium payer is considered to have lent the premium payments to the policyowner. 5 Equity collateral assignment split-dollar arrangements entered into after Sept. 17, 2003, and arrangements entered into before Sept. 18, 2003, and materially modified after Sept. 17, 2003, are subject to the loan regime under the final regulations. 2 White Paper

3 Loan Regime (Collateral Assignment) Split-Dollar Loans The Final Regs. include regulations under IRC 7872 that provide a road map for structuring split-dollar loans used to pay for life insurance premiums. 6 Loans subject to these regulations are loans where: 1. The payment (of premiums) is made either directly or indirectly by the non-owner to the owner (including a premium payment made by the non-owner directly or indirectly to the insurance company with respect to the policy held by the owner); 2. The payment is a loan under general principles of federal tax law or it is not a loan under general principles of federal tax law (for example, because of the non-recourse nature of the obligation or otherwise); and 3. A reasonable person nevertheless would expect the payment to be repaid in full to the non-owner (whether with or without interest). 7,8 Directors and executive officers of publicly traded companies subject to the Sarbanes-Oxley Act of 2002 should avoid split-dollar loans; companies regulated by the Securities Exchange Act of 1934 ( 34 Act ) 9 and their subsidiaries are prohibited from directly or indirectly making any loans to a director or executive officer. Violation of this rule carries criminal penalties. An executive officer is defined as any person who leads a business unit, division or a major functional group, or who performs a policy-making function for the corporation. 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. Where the lender is a nonprofit organization and the borrower is an officer or director, consideration should be given to a number of factors, including: whether the organization s bylaws permit loans to officers and directors, whether state law expressly prohibits loans to directors and officers, and whether state law holds the nonprofit board members who approved the loan personally liable for repayment of the split-dollar loans. Taxation Under the Loan Regime (Collateral Assignment) The policyowner may either pay interest at the applicable federal rate (AFR) or be deemed to have paid the interest under IRC Loan interest paid by the policyowner is subject to income tax in the lender s hands. In a donor/trust situation, if the trust is a grantor trust for income tax purposes, loan interest should not be subject to income tax when paid or as accrued. Where no interest or less than the appropriate AFR rate is charged under IRC 7872, the policyowner is deemed to have received the proper amount of interest (i.e., the foregone interest) from the premium payer, and the premium payer will be deemed to have received the same amount back from the policyowner. The policyowner will thus be subject to federal income tax or gift tax (depending on the arrangement) on the deemed interest element. For instance, in a compensatory arrangement involving a trust as the policyowner, the arrangement will be subject to both federal income tax and gift tax. The employer is deemed to have paid the foregone interest to the employee and the employee is deemed to have made a gift of the foregone interest to the trust. Where the loan interest is subject to gift tax, it will also be subject to generation-skipping transfer tax. 3 White Paper

4 Term Loans or Demand Loans Split-Dollar Loans Split-dollar loans can be structured as either a term loan or a demand loan. The primary difference between the two is whether the loan has a set maturity date. The nature of the loan (term or demand) determines which AFR rate must be charged as well as the income tax consequences to the parties to the agreement. AFR rates are published monthly by the IRS and vary based on the duration of the note. Term Loans Where a repayment date is specified in the note, including a loan due at the occurrence of an event (i.e., date of death), the loan is a term loan. Term loans allow the parties to set the interest rate for the duration of the note at the appropriate AFR in effect at the time of execution of the note. Where premium payments are made annually, each premium payment is a new loan with its own terms (e.g., due date, interest rate, etc.). Loans payable at the insured s death are treated as term loans with a duration based on the insured s life expectancy at the time of execution of the note. See Hybrid Loans discussion below. For purposes of determining the appropriate interest rate, term loans fall into three categories: Short-term Duration of not more than three years Mid-term Duration of more than three years, but not more than nine years Long-term Duration lasting more than nine years Demand Loans Generally, demand loans are payable in full at any time on the demand of the lender. The interest rate for demand loans resets annually and is the blended AFR rate announced in July of each year (effectively the average of the prior 12 months short-term AFR rates). Annual premium payments are added to the loan balance and the current year s blended AFR rate is applied to the entire loan balance. Hybrid Loans As described above, the loan regime generally categorizes split-dollar loans as either term loans or demand loans. 9 However, special rules apply to loans payable on the death of an individual (i.e., loans for life). 10 Split-dollar loans payable on the death of an individual are split-dollar term loans for purposes of determining whether the loan provides for sufficient interest. To that end, the term of a split-dollar loan payable on the death of an individual is the individual s life expectancy as determined under the appropriate table in Treas. Reg on the day the loan is made. 11 The AFR in effect on the date the loan is made will constitute sufficient interest. 12 As with any split-dollar loan, the AFR used must be appropriate for the loan s term (e.g., short-term, mid-term or long-term). 4 White Paper

5 Split-Dollar Loans Documenting Split-Dollar Loans A split-dollar loan should be in writing. Depending on the relationship of the lender and the owner, the following documents may be required: 1. Split-Dollar Agreement Document memorializing the agreement between the lender and the owner (borrower) outlining each party s rights and obligations under the terms of the split-dollar arrangement. 2. Promissory Note Document detailing the agreement between the lender and the owner (borrower), containing the sum loaned, the interest rate and stated term of the note. 3. Corporate Resolution Where a corporation is the lender, a corporate resolution authorizing the split-dollar loan is likely required. 4. Collateral Assignment Where the life insurance policy is the security for the loan, a collateral assignment from the owner (borrower) to the lender should be filed with the insurance carrier to secure the lender s rights under the split-dollar agreement. 5. Representation on Tax Returns Where the split-dollar loan is non-recourse to the borrower, both parties to the agreement must attach statements to their federal income tax returns for the taxable year in which the lender makes the first split-dollar loan representing that a reasonable person would expect that all payments under the loan will be paid. The filing of this representation is necessary to prevent the contingent interest rules of IRC 7872 and a deferral charge from applying. The representation must include the names, addresses and taxpayer identification numbers of the borrower, lender and any indirect participants. Representation must be attached to the federal income tax return for any taxable year in which the lender makes a loan to which the representation applies. 13 Exit Strategies Certain risks exist with split-dollar loans, including interest rate uncertainty and the decreasing net death benefits due to the collateral assignee s increasing interest in the policy. In general, the longer the arrangement is in effect, the greater the risk to the client. As a result, a well-planned exit strategy should be in place from the beginning. A well-planned exit strategy provides clients an effective way to terminate a split-dollar loan by providing the funds necessary to repay the debt and maintain the client s desired level of insurance protection. Popular exit strategies to consider are grantor retained annuity trusts (GRATs), installment sale to an intentionally defective irrevocable trust (IDIT) and charitable lead trusts (CLTs). Generally, these techniques all provide for a future transfer of wealth at a reduced gift tax cost in an effort to provide the necessary funds to retire the debt associated with the premium leveraging arrangement at the appropriate time. By doing so, the client is able to utilize the split-dollar loan to acquire his or her desired level of insurance protection, while at the same time managing and mitigating the risks associated with the arrangement. Conclusion With a properly structured and implemented split-dollar loan, a client is able to acquire the death benefit needed with little or no transfer tax impact. Perhaps equally as important, split-dollar loans provide planning flexibility and certainty not found with other wealth transfer techniques. Split-dollar loans offer a number of advantages, including: Favorable loan terms not found with other arrangements (e.g., loan payable on death of insured, interest accrual for entire loan term (i.e., life)), and no collateral beyond the policy required even where the policy has no cash value). Unlike most intra-family loans, there is little concern that the IRS will argue a split-dollar loan is not a bona fide debt. Unlike an installment sale, no seed money is required. Endnotes 1 Treas. Reg (b)(1) 2 Under IRC 2503(b), the gift tax annual exclusion amount is $13,000 per recipient per year (2010) and $26,000 per year if a married couple splits their gifts under IRC 2513(a). The gift tax unified credit is $330,800 (2010), which translates into an applicable exclusion amount of $1,000,000 per individual. 3 Potentially, a return of premium rider can be used to repay the premium loan without diminishing the death benefit needed. 4 Treas. Reg (j); 68 Fed. Reg (9/17/03) 5 Treas. Reg (b)(3)(i) 6 Treas. Reg Commercial loans, such as premium financing loans from a commercial lender, are specifically exempted from the provisions of IRC 7872 under Treas. Reg (b). 8 Treas. Reg. Section (a)(2)(i) 9 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. 10 Treas. Reg (b)(2) and (3) 11 Treas. Reg (e)(5)(i), and (e)(5)(v) 12 Treas. Reg (e)(5)(ii)(B) & (C) 13 Treas. Reg (e)(4)(ii) 14 Treas. Reg (d)(2) 5 White Paper

6 About PartnersFinancial PartnersFinancial is a national community of industry-leading, independent life insurance and financial professionals. For more than 25 years, the organization has supported its members as they build insurance industry knowledge and expertise. In the process, PartnersFinancial members created a powerful culture of idea-sharing and collaboration all for the benefit of their clients. PartnersFinancial members take advantage of the organization s preferred market access and clout to offer clients a comprehensive selection of high-quality insurance and wealth transfer solutions. Members also have access to an extensive range of resources, technology, tools, and knowledge-sharing forums and events. As part of NFP, a national insurance, benefits and investments company, PartnersFinancial also offers members access to capabilities that go beyond an individual company s scope. For traditional insurance products only; may not be used with variable life policies. Riders are available for an additional cost. Any guarantees offered by life insurance products are subject to the claims- paying ability of the issuing insurance company. There are considerable issues that need to be considered before replacing life insurance such as, but not limited to; commissions, fees, expenses, surrender charges, premiums, and new contestability period. There may also be unfavorable tax consequences caused by surrendering an existing policy, such as a potential tax on outstanding policy loans. Please discuss your situation with your financial advisor. This material was created by NFP (National Financial Partners Corp.), its subsidiaries, or affiliates for distribution by their Registered Representatives, Investment Advisor Representatives, and/or Agents. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Neither NFP nor its subsidiaries or affiliates offer tax or legal advice. Securities and Investment Advisory Services may be offered through NFP Securities, Inc. member FINRA/SIPC. NFP Securities, Inc. and PartnersFinancial are affiliated. Neither firm is affiliated with any other entity listed on this document /10 (INS ) Copyright 2010 NFP. All rights reserved.