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(Presentations in this Blog were created using InsMark’s Loan-Based Split Dollar System and Wealthy and Wise®)
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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. In Blog #177 (Part 1 of 2), I presented a new approach to this concept (what we call Exceptional Split Dollar) for a major university to see how it would work for Lee Sorensen, its new head coach. In Blog #178, I will blend it into a retirement plan using Wealthy and Wise®, InsMark’s wealth planning system.
Coach Lee Sorensen has just been hired by this university. In addition to his multi-million compensation package, he has been offered the choice of a supplemental bonus payment of $1,000,000 a year for ten years. Unfortunately, as a tax exempt entity, each bonus has an additional $210,000 cost for the university.1
1For all taxable years beginning after December 31, 2017, Section 4960 of the Tax Cuts and Jobs Act of 2017 imposes a new 21% excise tax on tax-exempt organizations, including colleges and universities, to the extent that annual compensation paid to any of its five highest compensated employees exceeds $1,000,000. See How The New Excise Tax Impacts Coach Compensation.
As an alternative, the university has also offered Coach Sorensen a Harbaugh-type split dollar arrangement with premiums of $1,000,000 a year for ten years funded with a single loan of $8,435,332 designed to capture the long-term Applicable Federal Rate (AFR) of 3.05% for June of 2018 for all twenty years of the split dollar arrangement.
The advantage to the university using loans instead of bonuses is there is no excise tax associated with loans to highly-paid employees thus saving the university $2,100,000 in excise taxes ($210,000 a year for ten years) compared to the bonus plan.
The question for Coach Sorensen is whether he would prefer the bonus or the benefits of Exceptional Split Dollar. The split dollar plan involves no personal payments, no bonuses to help with loan interest or rollout, and no adverse tax consequences. The plan provides him with the personal use of $21,000,000 of death benefit (less the loan due the university) coupled with after tax, retirement cash flow of $1,500,000 annually from age 65 to 95. His residual cash value in the policy at age 95 is illustrated at $18,727,260 wrapped inside of $20,625,821 of policy death benefit.
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The university’s cost involves a single loan of $8,435,332 to Coach Sorensen. Invested at 4.00% net, for example, this is sufficient to cover the ten years of the premiums for the split dollar arrangement using what’s known as a Premium Reserve Account (PRA)2. Because of the single loan, it bears a level, long-term, applicable federal rate (AFR) of 3.05% (June 2018) which is scheduled to accrue for all twenty years of the loans. When repaid at the beginning of year 21 (the coach’s retirement), the university receives a compounded rate of return of 3.05% due to the accrued loan interest. |
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2The PRA should be reserved in a custodial account that ensures the loaned funds will be used solely for premium payments.
If you haven’t reviewed Blog #177, you may want to do so to acquaint yourself with the robust details of Exceptional Split Dollar.
Retirement Case Study
This Blog introduces how their financial adviser compares the results of both the bonus arrangement and Exceptional Split Dollar in an overall retirement plan for Lee and Jamie Sorensen. They are both age 45 and plan to retire at age 65.
| Current Net Worth |
| Lee and Jamie Sorensen |
3Continuing contributions of $18,000 increasing by 3.00% a year with a 25% match by the university.
Click here for comments regarding yields, sequence of returns, and Monte Carlo simulations
Retirement Cash Flow Goal
Considering the cash flow from their overall compensation package, Lee and Jamie would like to have $50,000 a month in after tax retirement cash flow starting at age 65 with a 3.00% cost of living assumption. Extending the analysis to their age 95 requires $18,000,000 of cumulative cash flow ($50,000 x 12 x 30 years). The 3.00% indexing increases the total cash flow to $53,331,604 between ages 65 and 95 – five years past their joint life expectancy. (Joint life expectancy indicates that at least one spouse is presumed remaining alive.)
Lee and Jamie would also like to provide $50,000 a year for six years of college and graduate school (indexed at 6.00% to account for educational inflation) for their three children, Tommy (age 10), Amy (age 8), and Jack (age 6).
But let’s see what happens if we take these objectives into account regarding the bonus offer of $1,000,000 a year for ten years or the Exceptional Split Dollar arrangement.
| Image 1 |
| Strategy 1: Bonus Plan |
| vs. |
| Strategy 2: Exceptional Split Dollar |
Not only is there a long-range difference in net worth of almost $29 million in Strategy 2, there is almost $22 million more cash flow. These results are impressively in favor of coordinating Exceptional Split Dollar with Wealthy and Wise as an extraordinary executive benefit package that is not apparent with just the split dollar illustration.
Strategy 1, the bonus plan, falls short with net worth and cash flow because all liquid assets are depleted by age 84. So not only is Exceptional Split Dollar the far better choice for Coach Sorensen, the university enthusiastically prefers this alternative since it avoids $2,100,000 in excise taxes that would accompany the bonus plan. ($210,000 a year for ten years.)
The bonus plan does have one short-term advantage over Exceptional Split Dollar. In the landscape area of the graph above, note how the values of the magenta area (the bonus plan) exceed the values of the blue area (Exceptional Split Dollar) in early durations. This is due to the presence of the split dollar loan that isn’t repaid to the university until age 65. After that loan is repaid by way of a policy loan, the blue area soars – due in part to the arbitrage inherent in participating policy loans associated with Indexed Universal Life that is a key component of Exceptional Split Dollar.
Wealth to Heirs
Not only are Lee and Jamie’s children assured of college and graduate school funds, notice in Image 2 below the effect of the life insurance death benefit associated with Strategy 2: Exceptional Split Dollar.
| Image 2 |
| Strategy 1: Bonus Plan |
| vs. |
| Strategy 2: Exceptional Split Dollar |
Click here to review all the Wealthy and Wise reports for this analysis.
This Wealthy and Wise analysis contains 38 reports covering 69 pages (with many reports extending to two pages). That is a large number; however, with a Wealthy and Wise evaluation, I recommend you have all applicable reports for a given case with you when visiting with a client or client’s attorney or CPA. Wealthy and Wise backs up every number shown, and you never know which report you’ll need to answer the inevitable question, “Where did this number come from?” That’s why I provide all of them so you can familiarize yourself with them.
Many Wealthy and Wise users select a few key illustrations in a main section, and put the balance in an Appendix. More elaborate report organization can be accomplished (e.g., Table of Contents, Section pages, etc.) which I used by selecting the following prompt available at the bottom right of the Main Workbook Window.
Conclusion
The coordination of Exceptional Split Dollar with Wealthy and Wise produces compelling retirement results. While any well-designed split dollar illustration can generate an interesting presentation, it is inadequate as a stand-alone retirement piece. The results can be effectively presented only by coordinating them with an overall retirement analysis. The graphics alone in this Blog – as opposed to those in Blog #177 – should prove that to you.
Pairing Wealthy and Wise with Exceptional Split Dollar introduces a new strategy for providing tax free retirement cash flow for favored executives (including Jim Harbaugh-type coaches as well as high-end executives of large charitable organizations as well as executives of private companies4). It provides senior 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.
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.
4Publicly traded companies cannot use loan regime 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. Here is the relevant section: Section 402 of the Act amends Section 13 of the Exchange Act to prohibit U.S. and non U.S. public companies from directly or indirectly extending or arranging for an extension of credit in the form of a personal loan to a director or executive officer (or the equivalent thereof) on or after July 30, 2002.
C Corporations
Case Study #2 in Blog #177 (Part 1 of 2) shows the results of Exceptional Split Dollar for an executive of a large, private C corporation. Interestingly, the same-age executive’s results are identical to Coach Sorensen’s. A Wealthy and Wise analysis using the same Exceptional Split Dollar assumptions used in this Blog will provide a same-age executive with similar benefits as provided for Lee and Jamie Sorensen.
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
New Zip File Downloaders
Watch the video.
Digital Workbook Files For This Blog
(Zip file also includes Digital Workbook file “Exceptional Split $.!LS” from Blog #177.)
Experienced Zip File Downloaders Download the zip file, open it, and double click the Workbook file name to open it in your InsMark System.
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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 #178, click here for a guide to its content. It will be invaluable to you. There is a similar Guide in Blog #177 for the split dollar illustrations.
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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.