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Throughout my Blog series, I’ve written a lot about Loan Regime Split Dollar (See Blog #177 and Blog #178 for example).  I haven’t addressed the several variations of employer-owned Endorsement Split Dollar that we also illustrate.  This Blog features one of them.  It involves an employer owning a life insurance policy in certain pre-retirement years during which the covered executive names personal beneficiaries for a large percentage of the death benefit.  The employer, who owns all cash values, has the option to transfer the policy to the covered executive at any time, and this case study will illustrate that transfer occurring at the beginning of year 11.

Before the final split dollar regulations in 2003, these plans were known as Endorsement Split Dollar with Contractual Transfer.

Why did “Contractual” become “Optional”?  Thanks to the U.S. Treasury Department that issued the regulations for all split dollar plans in 2003, it ruled that the “Contractual” feature makes all cash value taxable to the covered executive as it accrues from day one, thus effectively eliminating this strategy as a generous executive benefit.  Imagine a benefit where each increase in cash value is taxable to the executive, but there is no cash flow provided to pay the tax.  What executive would be content with a provision where the company has the voluntary option – but not the obligation – to transfer the policy?

There is one executive who would not be concerned with “optional”, namely a chief executive officer who is either a sole or majority shareholder who can turn “optional” into “actual” with the stroke of a pen.

Thus was born Endorsement Split Dollar with Optional Transfer, a special benefit plan for owners.

So let’s talk about Ben Davidson, age 45, the President, CEO, and sole shareholder of Davidson Windows, Inc., a national manufacturer of industrial windows.  Davidson Windows is a family-owned C corporation in a 21% income tax bracket, and Ben wants to take personal advantage of all tax-favored executive benefits.

Here are the details of Ben’s plan:

• Policy: Indexed Universal Life (IUL);
• Face amount: $2,200,000 increasing for ten years; level after that;
• Annual premium: $100,000 for ten years (paid by Davidson Windows, Inc.);
• Policy owner: Davidson Windows, Inc;
• Ben’s endorsed share of the policy death benefit for ten years: $1,500,000 with the balance of the death benefit to the company; after ten years all of the death benefit to Ben’s family;
• Cash value of the policy: Owned by Davidson Windows, Inc. for ten years; after that owned by Ben Davidson;
• Taxable benefits to Ben in years 1 - 10: Ben recognizes the plan’s economic benefit¹.  Davidson Windows pays a small gross-up bonus to Ben to cover the income tax cost of the economic benefit;
• Policy transferred to Ben²: Beginning of year 11 (Ben’s age 55);
• Ben’s out-of-pocket personal cost in all years: $0;
• Annual, participating, tax free, policy loans of $70,000 for Ben begin at age 65: increasing with 3.00% indexing for $3,330,277 in total retirement cash flow by age 95.

¹The taxable income is measured on each $1,000 of the death benefit payable to personal beneficiaries times a term-type rate table issued by the government (Table 2001 rates).

²Ben takes a participating, tax free, policy loan of $260,269 in year 11 (after the transfer) to offset the income tax on the accumulation value of the transferred policy.

Below is a graphic of the overall results of the plan:

Image 1

Endorsement Split Dollar

with Optional Transfer

Click here to review all the reports for Ben’s plan.

Conclusion

An offer to have a business owner’s company pay for all the costs of a large amount of personal, cash value, life insurance coverage can be appealing.  This is particularly advantageous for an owner of a C corporation due to the new 21% corporate income tax bracket.  That 21% produces a significant amount of “found” dollars available for such benefit plans.  Endorsement Split Dollar with Optional Transfer is a good one for you to consider and a good one for Ben to have.  It works best for owners of C corporations.

Note:  In Blog #182 scheduled for mid-October, we will examine Endorsement Split Dollar with Salary Continuation.

Specimen Documents

InsMark’s Cloud-Based Documents On A Disk™ (“DOD”) has specimen documents for Endorsement Split Dollar with Optional Transfer in the Employer-Sponsored Split Dollar Plans section of documents in Business Owner Benefit Plans.  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 the InsMark Illustration System, 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.

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 #181, 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.