Split-Dollar Life Insurance Tax Guide

Split dollar life insurance is a versatile financial tool used by businesses and individuals to share the costs and benefits of a life insurance policy. However, the tax implications of these arrangements can be complex and vary depending on the structure chosen. This comprehensive guide explores how split dollar life insurance is taxed, covering both the economic benefit and loan structures. Whether you’re an employer considering this as part of an executive compensation package or an employee evaluating a split dollar offer, understanding the tax consequences is crucial for making informed decisions.

Understanding Split-Dollar Life Insurance Basics

A trust is a legal agreement where one party—the “trustor”—gives another party—the “trustee”—the right and responsibility to hold assets and property intended for the benefit of a third party—the “beneficiary.” Trusts are commonly used to dictate the management and distribution of the trustor’s assets after their death. The trust will provide specific terms for distributing the assets to the beneficiaries, which the trustee must abide by. Notably, other types of trusts exist to serve different purposes, such as charitable trusts, Totten trusts, spendthrift trusts, and others. This article focuses solely on family trusts.

Living versus Testamentary Trusts

A trust can either be a “living trust” or a “testamentary trust.” A living trust is created during the trustor’s lifetime and can be used to avoid probate court. A testamentary trust is a trust created by a will document and does not avoid probate court.

Revocability of a Trust

Additionally, a trust can be either revocable or irrevocable. A revocable trust is a trust that can be amended or completely revoked by the trustor after it is created. On the other hand, an irrevocable trust cannot be amended or revoked after it is created. A revocable trust generally becomes irrevocable once the trustor dies because the trustor is no longer alive to amend or revoke the trust.

The choice between a revocable trust and irrevocable trust often comes down to flexibility and tax benefits. A revocable trust offers the benefit of changing the terms of the trust at any time, whereas an irrevocable trust may offer additional tax benefits to the beneficiaries.

What is a “family trust”?

A family trust is a colloquial term used for a living trust that is created to pass on the trustor’s assets to their family members—typically the spouse and children of the trustor—upon the grantor’s death. When the trust is formed, the trustor specifies some or all of their assets to be transferred to the trust. The trustor retains control and use of those assets until their death, after that the assets are distributed per the terms in the trust documents to the beneficiaries. Like other trusts, a family trust can be either revocable or irrevocable. A family tax trust can provide tax and other benefits that individuals will want to consider when deciding whether or not to set up a trust.

How are family trusts set up?

To set up a family trust, the trustor should work with their attorney to determine if a family trust is suitable for their specific situation. If a family trust is determined to be the best course of action, the process will include determining:

Who is the trustee?

In a revocable trust, the trustee can also be the trustor. However, in an irrevocable trust, the trustor cannot be named as the trustee.

Is the trust revocable or irrevocable?

A revocable trust offers the flexibility to amend or revoke the trust later on. Individuals will want to discuss the revocability of the trust with their attorney before finalizing the trust documents.

Who are the beneficiaries?

The trustor is free to name who they wish as the trust’s beneficiaries. If the trust is revocable, other beneficiaries may be added or removed later on.  

What assets will go into trust?

There are a variety of assets that can go into a trust, including but not limited to: real estate, financial accounts and life insurance.

 How will the assets be distributed?

Trustors can decide that all assets will pass upon their death or they may choose for specific requirements to be met before assets are transferred to the beneficiaries. For example, a trust may dictate that half the assets be transferred upon the beneficiary’s 30th birthday and the other half upon the beneficiary’s 40th birthday. The trust will also dictate who receives what specific asset and the trust may differentiate, for example, what the surviving spouse receives versus what the surviving children receive.

What steps need to be completed to comply with federal, state, and local laws to form the trust?

The laws that dictate how a living trust must be formed will vary state by state. Individuals should consult their attorney and trust advisors to ensure all state laws and regulations are being met.

What are the benefits of a family trust?

A family trust provides several benefits that individuals will want to consider when deciding whether to form a trust. Below are a few important benefits a family trust can offer:

Flexibility and Control

First, a family trust offers significant control over the disbursement of assets. A trust can dictate who receives what specific assets, the timing with which they will receive the assets, and—if revocable—allows the trustor to make changes or completely revoke the trust before their death.

Avoidance of Probate Process

Second, the family trust, unlike a will, avoids probate court. The trust assets instead are distributed per the terms of the trust. While a will becomes a public record via the probate process, a trust remains private, and thus your assets remain private. Overall, the family trust simplifies distributing assets upon the trustor’s death because it avoids the timely process of going through probate and explicitly dictates where assets go.

Tax Benefits

Third, a trust may offer certain tax benefits depending on its structure. However, the taxation of family trusts is highly complex. While there are many general rules, each family’s situation is unique. Families will want to consult their tax advisor to weigh the tax benefits of the trust and their state’s specific trust requirements.

A family trust may save taxes by transferring the assets to a family member in a lower tax bracket. The transfer of the assets to a family member in a lower tax bracket may save a significant amount of tax. Additionally, if a trust is irrevocable, you may view the assets as having been transferred out of the trustor’s estate and thus provide certain transfer tax benefits.

Additionally, if the trust meets specific requirements, the trust may aid in avoiding some or all of the federal estate tax. However, this type of planning is usually only necessary for those families who surpass the estate tax exemption. For the 2022 tax year, the individual estate tax exemption is $12,060,000. Any estate under that value will not have to pay the estate tax.

Conclusion

Choosing whether to form a family trust or not is a complex process and will require an ongoing discussion with your tax advisor and legal counsel. The trust may be further complicated depending on the state and local requirements imposed on the formation and maintenance of the trust. Learn exactly how much a family trust, among 1,600 other tax-saving strategies can save you in taxes using Corvee today!