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How is Split Dollar Life Insurance Taxed?

Split dollar life insurance taxed

Split dollar life insurance is an agreement between two or more parties who agree to share in a life insurance plan’s cost, cash value, death proceeds, and/or other policy benefits. A split dollar life insurance agreement is most commonly seen between an employee and employer, often for a key employee such as a CEO or business partner in a partnership agreement. The purpose of this type of contract is to protect both the individual and the business in case of an unexpected death that would have an adverse impact on the business. This is only one of the many scenarios where a split dollar life insurance arrangement would be beneficial.

Split Dollar Life Insurance Structures

Split dollar life insurance agreements generally fall under one of two categories: 

  1. the economic benefit structure (sometimes referred to as the endorsement method)
  2. the loan (or collateral assignment) structure

These two structures are mutually exclusive; a split dollar life insurance agreement cannot be both an economic benefit structure and a loan structure. Under the economic benefit structure, the policy owner (often the employer) pays some or all of the premium for the benefit of the non-owner (i.e.,  the employee). The benefits and responsibilities of the policy are divided between the two parties as part of the agreement. Under the loan structure, the employee owns the policy and the business pays the premiums and is assigned some of the policy benefits.. The loan structure essentially provides the employee with an interest-free loan from the employer and assigns the policy as the collateral for the loan.

Split Dollar Life Insurance Taxes Depend On The Structure

The tax impact depends on the structure of the agreement: economic benefit or loan structure. Under an economic benefit structure, the policy owner is providing the benefits of the policy to the nonowner. The provision of the policy benefits can be considered compensation, a section 301 distribution, a capital contribution, or a gift depending on the facts surrounding the agreement. In an employer-employee arrangement, the economic benefits provided to the employee are reported by the employer as compensation for the year in which the benefits are provided. With this arrangement the employer receives a business expense (i.e., tax deduction) and the employee is taxed because they are receiving the economic benefit (i.e., compensation).

Under the loan structure, the owner and nonowner are treated as borrower and lender, respectively. Suppose the split dollar loan provides either below-market interest or no interest. The loan is  subject to the Applicable Federal Rate (“AFR”) interest rate, though below market rates may be used. If the split dollar loan provides sufficient interest, then it is likely subject to the general rules for loans. Generally, interest on split dollar loans is taxable as income to the policy owner or lender (i.e., employee).

Split dollar life insurance agreements can provide several benefits to the parties subject to the agreement, such as additions to a compensation package for executives, loans and withdrawals may be made tax-free, cash values may grow on a tax-deferred basis, and business operations are protected. The parties will want to be aware of the structure of the agreement and the ensuing tax consequences that will occur due to the agreement. Learn more about taxes and how you can save clients money on taxes by signing up for a demo today!

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