Split-dollar life insurance for key employees

Split-dollar life insurance isn't a type of policy. Rather, it's an arrangement under which rights and obligations relating to a cash value policy on your life are split between you and your employer. Depending upon the type of arrangement, the employer pays part or all of the premium and retains an interest in the policy's cash value and death benefits, so that it can recoup its investment in the policy at a later date. If your employer doesn't pay the entire premium, you would have to pay the balance.

There are different ways to set up a split-dollar arrangement. Your employer could own the policy, or you or a trust could own it and assign an interest in the policy to your employer as collateral for the obligation to repay the premium payments the employer will make. You might want the policy to be owned by a trust, so that its proceeds wouldn't be taxed in your estate. The exact form that you use will depend upon what you and your employer want from the arrangement. But the current income tax consequences to you are the same regardless of the form of the arrangement.

Under any split-dollar life insurance arrangement, you will be taxed each year on (a) the value of the death benefit protection you receive under the split-dollar arrangement-that is, the amount of life insurance protection that actually benefits you-minus (b) the amount you contribute to the premium. Value (a) is treated as equal to the cost of a one-year term life policy on your life, and is normally determined using IRS's so-called P.S. 58 rates. However, the actual cost of generally available term coverage from an insurer, if lower than the applicable P.S. 58 rate, can be used instead, but only if this is the insurer's current, published one-year individual term rate that is available to all standard risks. While commercially available term rates are generally lower than the IRS's P.S. 58 rates (and would provide for a lower taxable benefit to you for the same amount of coverage), IRS is very particular about what types of commercial term rates are acceptable P.S. 58 substitutes. As an example, IRS treated one insurer's term rate as not "available to all standard risks," and therefore not an acceptable P.S. 58 substitute, because, among other reasons, the rate was for non-smokers only. Therefore, we should review your employer's split-dollar arrangement to determine whether you must use the P.S. 58 rates to determine your taxes under the arrangement, or whether a lower rate is available.

In addition to the above, if your employer's split-dollar arrangement entitles you to a share of the policy's cash surrender value, you will be taxed on the annual increase in the value of that share. If your employer owns the policy, that value may not be taxed to you until some point when the policy is transferred to you; if the cash surrender value of the policy is subject to claims of your employer's creditors, that value may not be taxed to you until it is no longer subject to those claims. Otherwise, the increases in cash value that you are entitled to under the arrangement are generally taxed to you each year as they accrue in the policy. Therefore, to avoid any potential underpayment of tax on your part, and the resulting penalties and interest, we should review your employer's split-dollar arrangement to determine whether you (or your employer) own the cash value accumulation.

Finally, if you receive other benefits under the split-dollar arrangement-for example, dividends in the form of cash or additional life insurance coverage-you will be taxable on the value of those benefits.

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