Employer-Employee Split-Dollar Life Insurance Arrangements: How They Work and How They Are Taxed

When It May Not Fit: Conditions That Limit or Complicate the Arrangement

Complications tend to come from cash flow, tax cost and documentation:

• Premium funding. The employer may not be able to sustain premiums for the funding period, which raises the chance of lapse or forced termination.
• Employee tax cost. The employee may find it hard to absorb annual income tax on the economic benefit or on forgone interest.
• Missing notice and consent. If an employer-owned policy is an employer-owned life insurance contract and written notice and consent were not given before issue, section 101(j)(1) caps the exclusion at "the premiums and other amounts paid by the policyholder."
• Uncertain characterization. A design may not clearly fit either the economic benefit regime or the loan regime. A premium payment by the non-owner that is neither a split-dollar loan nor consideration for economic benefits is governed by general tax principles rather than by either regime.
• Unclear relationship. The relationship between the parties may not be clearly employer and employee, which leaves open which rules apply.
• Unreviewed pay. If total compensation has not been considered for reasonableness, the section 162(a)(1) deduction for any compensation element is uncertain.

Tax Treatment: Economic Benefit Regime and Loan Regime

Under 26 C.F.R. § 1.61-22(j), the regulation applies to a split-dollar arrangement entered into after September 17, 2003, and an arrangement entered into on or before that date is treated as a new arrangement entered into on the date of any material modification made after it. Section 1.7872-15(n) sets the same dates for the loan regime.

Premium deductions. Section 264(a)(1) states the starting rule: "No deduction shall be allowed for— (1) Premiums on any life insurance policy … if the taxpayer is directly or indirectly a beneficiary under the policy." Any compensation element can be deductible only within section 162(a)(1), which allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered."

Economic benefit regime. The non-owner is taxed each year on the economic benefits it receives, including the cost of current life insurance protection. Under 26 C.F.R. § 1.61-22(d)(3)(i), the amount of protection is the death benefit minus "the total amount payable to the owner," less certain cash value amounts. Under (d)(3)(ii), that amount is multiplied by "the life insurance premium factor designated or permitted in guidance published in the Internal Revenue Bulletin." Under § 1.61-22(d)(1), depending on the relationship between the owner and the non-owner, the economic benefits "may constitute a payment of compensation, a distribution under section 301, a contribution to capital, a gift, or a transfer having a different tax character." A transfer of the policy to the employee is addressed in § 1.61-22(g), which for a transfer in connection with the performance of services applies once the contract is taxable under section 83 (§ 1.61-22(g)(3)).

Loan regime. Section 7872(c)(1)(B) covers below-market loans "between— (i) an employer and an employee." Under 26 C.F.R. § 1.7872-15(e)(3), a split-dollar demand loan, meaning one payable whenever the lender demands it, is tested every year against "the blended annual rate." The IRS publishes that rate each July. If the loan's interest falls short, the forgone interest "is treated as transferred by the lender to the borrower and as retransferred as interest." That transfer generally occurs on the last day of the calendar year.

Death benefit. Section 101(a)(1) excludes amounts "paid by reason of the death of the insured," subject to limits. One limit is the transfer-for-value rule in section 101(a)(2). Another is section 101(j), which applies to employer-owned contracts. Its cap lifts only if a section 101(j)(2) exception applies and written notice and consent came before issue. The split-dollar taxation page covers the two regimes in more depth.

Potential Advantages: What the Arrangement Can Provide

For the employer, the arrangement is a selective benefit. It can be limited to chosen employees, and the agreement can give the employer a right to recover its outlay from cash value or the death benefit.

For the employee, the arrangement can support a larger death benefit than the employee could fund alone. In collateral assignment designs, the employee may have access to cash value above the employer's interest.

The arrangement can also be fitted to the employer's compensation approach and the executive's personal insurance need. These are structural features of the arrangement. Actual tax and financial results depend on the agreement, the policy and the facts.

Important Considerations: Compliance, Documentation, and Ongoing Obligations

Annual measurement. Under the economic benefit regime, 26 C.F.R. § 1.61-22(d)(1) requires the non-owner to take into account the full value of the economic benefits, less any consideration the non-owner pays for them, and requires the owner to do so for gift and employment tax purposes. The reporting mechanics are confirmed with a tax professional.

Notice and consent. For an employer-owned contract, section 101(j)(4) requires three things before issue:

• written notice of the intent to insure the employee and of "the maximum face amount";
• the employee's written consent, including consent that coverage "may continue after the insured terminates employment"; and
• written notice that the policyholder "will be a beneficiary."

The IRS instructions for Form 8925 add that consent is not valid unless the contract is issued "within a year after the consent was executed, or before the employee terminates employment," whichever is earlier. Notice 2009-48, A-13, describes limited relief for inadvertent failures. It also says a missing written consent "cannot be corrected after the insured employee has died."

Changes and termination. Under 26 C.F.R. § 1.61-22(c)(1)(ii)(B)(3), where the employer is treated as the owner only because current life insurance protection is the sole economic benefit, entering into a successor arrangement that has the effect of providing any additional economic benefit "is treated as a modification of the prior split-dollar life insurance arrangement." Under § 1.61-22(d)(5)(i), if the arrangement terminates during the non-owner's taxable year, the economic benefits for that year are valued on the day it terminates. Tax results at termination depend on the regime, the ownership and the policy's value at that time.

Tax and Legal Coordination: What Professionals Review

A split-dollar agreement is a legal document, and its terms shape the regime and each party's rights. Legal counsel commonly drafts and reviews it.

Tax advisers typically address three questions:

• whether section 264(a)(1) bars a premium deduction;
• whether any compensation element meets the section 162(a)(1) reasonableness standard; and
• how the arrangement fits the executive's total pay.

When the employer owns the policy, section 101(j) notice and consent is confirmed before issue. Form 8925 reporting is confirmed after issue. The business life insurance ownership choice affects which of these rules apply.

The tax treatment of a specific arrangement depends on facts this page cannot know. Structure, ownership and tax treatment are confirmed with qualified tax, legal and insurance professionals.

Alternatives: Other Structures That Address Similar Objectives

Several other structures serve similar goals:

• Executive bonus. The employer pays the premium as a bonus, and the employee owns the policy outright. The bonus is taxable compensation to the employee. The employer's deduction turns on section 162(a)(1) reasonableness.
• Group-term life insurance. Section 79(a) includes in an employee's income the cost of group-term coverage only to the extent it exceeds "the cost of $50,000 of such insurance" plus the amount the employee paid. Under section 79(c), cost is set by "uniform premiums (computed on the basis of 5-year age brackets)" prescribed by regulations.
• Nonqualified deferred compensation. This is an employer's promise of a future benefit, sometimes informally funded with life insurance. It is governed by its own federal rules.

Example (Hypothetical): How the Economic Benefit Regime Works in Practice

This example is hypothetical, uses round figures and illustrates the arithmetic only. It is not any reader's result.

Assumptions:

• The employer owns a $1,000,000 policy under the endorsement method.
• The employer pays a $10,000 premium each year.
• The agreement pays the employer the premiums it has paid.
• After 10 years, the employer has paid $100,000.
• The employee's beneficiary receives the rest of the death benefit.
• No cash value has been taxed to the employee or paid for by the employee, the employee has no current access to policy cash value, and the employee receives no other economic benefit.
• "F" stands for the premium factor per $1,000 designated in IRS guidance for the insured's age. The example does not state a factor.

Arithmetic:

1. Premiums paid by the employer: $10,000 × 10 = $100,000.
2. Current life insurance protection: $1,000,000 − $100,000 = $900,000.
3. Units of $1,000: $900,000 ÷ $1,000 = 900.
4. Cost of current protection: 900 × F. Under 26 C.F.R. § 1.61-22(d), with these assumptions, that amount is the employee's economic benefit for the year.

If F were $3, the cost would be 900 × $3 = $2,700. That figure shows the method only and is not a real factor. Actual amounts depend on the policy, the insured's age, the published factor and the agreement.