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(Presentations in this Blog were created using the InsMark® Loan-Based Split Dollar System)

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Editor’s Note:  If you market executive benefits, or if you don’t but would like to, this Blog will be invaluable.  If you don’t and don’t plan to, you may want to skip this Blog.

Recently, there has been substantial publicity about the University of Michigan providing a high-end, split dollar plan for its head football coach, Jim Harbaugh.  So let’s review a similar arrangement for a major university to see how the concept works for Lee Sorensen, its winning head coach.

Background

Traditionally, many split dollar plans have involved bonuses to help offset the covered executive’s loan interest costs and/or repayment of the employer’s loans at “rollout” time.

Here is what the American Bar Association has to say about split dollar funded in part with bonuses:

If the employer has a plan to bonus the loan interest or the rollout to the insured executive, under the final split dollar regulations, such loans would be treated as an interest-free loan, subject to Section 7872.  The regulations disregard stated interest on a loan if all or a portion of the interest is to be paid directly or indirectly by the lender-employer so that the borrower appears to be taxed on both the imputed income as well as the actual income from the bonus.¹

¹Sophisticated Life Insurance Techniques (Sec. 4(a)(i), Pg. 25)

InsMark’s Loan-Based Split Dollar System allows the illustration of bonuses but includes this “be careful” note on the Preface, the System’s Guide to Marketing, and Guide to Operations.

Note: If a bonus is used to assist with loan interest payments (or repayment of the employer’s loans), care must be taken so as not to have the employer directly or indirectly make the loan interest payments (or loan repayments) on behalf of the executive.  The purpose of this is to comply with the prohibition against the employer making such payments as provided in the split dollar final regulations issued in 2003 (TD 9092, 9/11/03 and Rev. Rul. 2003-105).

An additional problem exists for tax exempt organizations like the University of Michigan due to Section 4960 of the Tax Cuts and Jobs Act of 2017.

For all taxable years beginning after December 31, 2017, Section 4960 imposes a new excise tax, at the rate of 21%, on tax-exempt organizations, including colleges and universities, and organizations that support them (e.g., most university athletic associations and foundations), to the extent that annual compensation paid to any of its five highest compensated employees exceeds $1,000,000.²

²How The New Excise Tax Impacts Coach Compensation

There are believed to be at least 240 football coaches and assistant coaches whose current compensation exceeds $1,000,000, not counting the hundreds more who are involved in other college sports such as basketball and baseball.  A 21% excise tax paid by the colleges and universities that employ them certainly discourages bonus benefit plans of any sort.

A plan like Exceptional Split Dollar which is based on loans, not compensation, that also eliminates the use of bonuses for loan interest and rollouts should be most welcome as preferred funding for high-end benefit plans for senior executives employed by tax exempt organizations like colleges, universities, and large charitable organizations.  Professional athletes are also likely candidates not only because of the benefits, but because the loans associated with Exceptional Split Dollar likely do not affect their team’s salary cap.

One last bugaboo: When loan-based split dollar is used to produce death benefits and supplemental, tax free, retirement cash flow, you do not want to use a modified endowment contract (MEC) where the tax free nature of policy loans is eliminated.  This, of course, means the policies used must have multiple premiums.  With a pattern of loans funding multiple premiums, the only known Applicable Federal Rate (AFR) that applies is attributable to just the first premium loan; the future AFRs are merely guesses as to what the AFR will be for subsequent premium loans.

The way to avoid this issue is to use a Premium Reserve Account (PRA) in which the employer makes a one-time loan to the insured of sufficient size to act as a sinking fund for all remaining premiums.  This way, the known current year’s AFR (the long-term AFR for June 2018 is a low 3.05%) is applied to the beginning loan and is locked in for the entire duration of the loan.  Obviously, a PRA is possible only for a substantial employer.

Note: The PRA should be reserved by the executive in a custodial account or trust that ensures the funds will be used solely for premium payments.

Imagine the arbitrage that can be obtained with a guaranteed 3.05% fixed loan rate supporting a max-funded Indexed Universal Life (IUL) policy that stretches out for as long as the loan remains in effect.  Accelerated arbitrage™ then occurs with the use of participating loans on indexed life insurance policies for retirement cash flow.

So let’s look at a split dollar arrangement for Coach Sorensen that avoids every one of the pitfalls noted above.

Case Study #1

The following split dollar design will accomplish its goal of rewarding and retaining Coach Sorensen, age 45, while also having a positive effect on the university’s balance sheet:

• Policy type: Indexed Universal Life (IUL) owned by Coach Sorensen.  (Increasing death benefit for ten years with level coverage thereafter reduced as much as possible in order to maximize policy cash values.)
• Premiums: $1,000,000 years 1 through 10.
• Initial face amount: $21,081,365.  (Minimum face amount for a non-MEC).
• The university’s one-time loan to the coach: $8,435,332.  This funds a PRA³ for the coach for the ten premiums (assuming a net yield of 4.00%).  Click here to review the Premium Reserve Account report.
• Loan interest: 3.05% accrued and added to the loan.  (Accrued loan interest is normally taxable, but the university is in a 0% tax bracket, so accruing it adds no tax to the transaction; instead, the full value of accrued interest adds to its balance sheet.)
• One participating loan in year 21: $16,883,748 allocated as follows: $15,383,748 used by Coach Sorensen to repay the outstanding loan (incl. accrued loan interest) plus $1,500,000 of tax free cash flow for Coach Sorenson at age 65.
• Annual, participating loans beginning in year 22: $1,500,000 for Coach Sorenson from age 66 to 95.
• ³Presumably, a single premium immediate annuity would make an excellent funding vehicle for the PRA.

Below is a graphic of the results which fully comply with the Final Split Dollar Regulations issued in September 2003 (68 FR 54336) by the U.S. Treasury Department.

Image 1

Exceptional Split Dollar for a Tax Exempt Organization

The plan produces $45,000,000 in after tax retirement cash flow for Coach Sorensen with cash values remaining in his policy of $18,727,260 at age 95 wrapped up in $20,625,821 of death benefit.  The cost for the coach is $0 in all years.

Click here to review the entire split dollar illustration.

Coach Sorensen has the opportunity for cash flow from the policy during pre-retirement years as the formal agreement allows him earlier access to cash values that exceeds the loan and its accrued loan interest.

If he dies while the agreement is in force, the university recovers its premiums and accrued loan interest through its share of the policy death benefit with the coach’s beneficiary(ies) receiving the balance.

Termination of the 20-year split dollar arrangement is subject to the terms of the agreement between Coach Sorensen and the university.  Two possibilities are:

• If he quits or leaves for any reason after the premium funding years (ten years in Case Study #1), he is entitled to keep the plan in force until retirement at which time the planned policy loan occurs for repayment of the university’s loan and accrued interest, and the collateral assignment expires.
• If he quits or leaves for any reason during the premium funding years, the university exercises the collateral assignment and receives its premiums and accrued loan interest through the policy’s cash value, the collateral assignment expires, and Coach Sorensen is entitled to the remainder values of the policy.

The cost to the university?  In all years, there is no cost, only a credit to earnings of the accrued loan interest.  By retirement, for example, this credit amounts to $6,948,416 (which is part of the loan repayment at the beginning of year 21).  There is, of course, a loss of use of money beyond the 3.05% loan interest rate; however, this is far offset by the financial value Coach Sorensen brings to the university.

Case Study #2
(C Corporation)

The split dollar plan developed for the university in Case Study #1 is easily adaptable to a profit-making C corporation.

In this example, you will see the same IUL policy design in Case Study #1 except the employer extending the premium loans is a large, private company extending loans for Exceptional Split Dollar to its Executive Vice President, Max Bracey.

The only difference in the illustrations for Case Study #1 and Case Study #2 is the tax bracket of the plan sponsor which, in this case, is a privately-owned C corporation in a 21% bracket, the new maximum corporate tax bracket for C corporations.  This added cost diminishes the return to the business due to the 21% tax on the loan interest each year as it is added to the loan; however, the benefits to Max Bracey are identical to those provided to Coach Sorensen.

Image 2

Exceptional Split Dollar for a C Corporation

By retirement, the C corporation’s negative cost (credit to earnings) is $5,489,249 compared to the tax exempt organization’s $6,948,416 in Case Study #1.  The decrease is due to the income tax on the loan interest as it is accrued by the C corporation.

Click here to review this entire split dollar illustration. 

Conclusion

Exceptional Split Dollar is a new strategy for providing tax free retirement cash flow for favored executives (including Jim Harbaugh-type coaches).  It is fully compliant with the 2003 split dollar regulations issued by the U.S. Treasury Department.

Exceptional Split Dollar provides favored key executives with a way to transform loans from an employer into substantial, tax free, retirement cash flow while producing a credit to earnings for the employer in all years.  Illustrated using new features in the InsMark Loan-Based Split Dollar System, it requires no payments or taxes from the insured executive.

Exceptional Split Dollar produces more favorable results than the equity split dollar and reverse split dollar strategies of the 1970s, 1980s, and 1990s, the designs of which were always somewhat speculative due to the lack of specific tax law and regulation for the favorite variations.

Note: Publicly traded companies cannot use Exceptional Split Dollar due to provisions of the Sarbanes-Oxley Act which makes it illegal to loan money to officers, directors, and certain other key employees.

S Corporations, LLCs, and Partnerships

Exceptional Split Dollar is highly appropriate for non-owner, key executives of S Corporations, LLCs, and Partnerships; however, due to the pass-through nature of profits, it is not particularly suitable for owners.  See InsMark’s Executive Trifecta® for owners of S Corporations and the Dual Security Plan for owners of LLCs and Partnerships, both of which are modules in the InsMark Illustration System.

Specimen Documents

InsMark’s Cloud-Based Documents On A Disk™ (“DOD”) has specimen documents for the Exceptional Split Dollar in the Business Owner Benefit Plans section.  (See the Loan Regime series of documents in the section entitled Employer-Sponsored Split Dollar Plans.)  In the same location, DOD also has several specimen document sets for Executive Trifecta as well as documents for the Dual Security Plan.

If you are licensed for DOD, go to www.insmark.com and select “My InsMark” from the home page for access to the full version of DOD.

If you are not licensed for DOD, this link will take you to the DOD product site for more information or you can contact Julie Nayeri at Julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.

Licensing InsMark Systems

To license InsMark’s Loan-Based Split Dollar System or Cloud-Based Documents On A Disk, visit us online or contact Julie Nayeri at Julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.

Creating Similar Presentations

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Digital Workbook Files For This Blog

Before downloading and reviewing any files, be certain you have installed the most current updates to your InsMark Systems.  Do this using Live Update available under Help on the main menu bar of the System or this icon on the main menu bar: Note:  If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark Systems.  Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed.

If you obtain the digital workbook for Blog #177, click here for a guide to its content.  It will be invaluable to you.

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Important Note #1:  The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years.  This is not likely, and actual results may be more or less favorable.  Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2:  The information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

Important Note #3:  Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.

This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

A tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability.  The foundation of this special treatment is IRC Section 101.  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

Can your clients remember these facts years into the future?  If they are incapacitated, will family members understand the issues?  It is probably best to file a short note with the policy – something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does this note make it harder or easier to deliver the policy?  It’s harder if you haven’t discussed it with your client; easier if you have.  And that’s the point – you should discuss it.

Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity.  To be effective regarding the tax bomb, such carriers need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.