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

Editor’s Note:  This blog presents a sizzling loan-based split-dollar plan.  This executive benefit will be difficult to justify if interest rates increase considerably. Still, such a strategy can look terrific if you know how to use a Premium Reserve Account.  If split-dollar does not interest you, consider skipping this blog — maybe forward it to a producer friend who serves this market.

In the past few years, 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 another significant Tax Exempt University to see how the concept works for attracting Roger DeWitt Thompson, H’94 ’95 ’98. Roger is the University’s top candidate for President.

Background

Traditionally, many split-dollar plans have involved bonuses in helping offset the covered executive’s loan interest costs and 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 the both the imputed income as well as the actual income from the bonus.

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 assists 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.  This restriction is to comply with the prohibition on 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 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 whose pay to its five highest-compensated employees exceeds $1,000,000.¹

¹How The New Excise Tax Impacts Coach Compensation

A 21% excise tax certainly discourages high levels of compensation.

A plan like Exceptional Split-Dollar which is based on loans 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.

One last bugaboo: With loan-based split-dollar, you do not want to use a modified endowment contract (MEC) where the tax-free nature of policy loans disappears.  Life insurance policies must have multiple premiums to avoid classification as a MEC. With multiple loans funding a stream of premiums, the only known Applicable Federal Rate (AFR) applies to just the first premium loan; all future AFRs projected are merely guesses.²

²With loans that extend for several years for a plan activated in March 2022, the only reasonable AFR to use is the March 2022 long-term rate of 2.14%.  But how should you estimate future AFRs since they fluctuate year-to-year?

The way to avoid unknown future AFRs 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 premiums.  This way, the known current year’s AFR is applied to the beginning loan to the PRA and is locked in for the entire duration of outstanding loans. 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.  A single premium immediate annuity could also be appropriate for the PRA.

Imagine the arbitrage that can be obtained with a guaranteed 2.14% 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™ can occur with the use of participating loans on IUL policies for retirement cash flow.

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

Case Study

The following split-dollar design accomplishes its goal of rewarding and retaining Roger, age 45, while also having a relatively low effect on the university’s balance sheet:

• Policy type: Indexed Universal Life (IUL) owned by Roger.
  (Increasing death benefit for ten years with level coverage after that.)
• Premiums: $1,000,000 in years 1 through 10 (a “ten and done” plan).
• Initial face amount: $15,000,000.
• The university’s one-time loan to Roger: $8,107,822.
  This funds a PRA for Roger for the ten premiums (assuming a net yield of 5.00%).  Click here to review the PRA.
• The imputed loan interest rate is 2.14% (the March 2022 long-term AFR).  Roger’s income tax on the imputed interest is paid via a bonus from the university (instead of a gross-up bonus, an alternate approach which can also be illustrated).
• One participating policy loan of $8,707,822 is made at the beginning of year 21, which repays the outstanding premium loan of $8,107,822 plus $600,000 of tax free retirement cash flow for Roger.
• Annual, participating loans begin in year 22: $618,000 including a 3.00% cost of living adjustment (COLA) for Roger with the same COLA increasing yearly from age 66 to 95.  This produces final after-tax cash flow to Roger of $1,413,939 at age 95.  The total after-tax retirement cash flow generated is $28,545,249.

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.  In this example, loan interest rates are imputed to Roger.

Image 1

Exceptional Split-Dollar

for a Tax Exempt University

Single Bonus for the Tax on the Imputed Income

This executive benefit produces $28,545,249 in after-tax retirement cash flow for Roger, with cash values remaining in his policy of $7,196,432 at age 95 wrapped up in $8,215,636 of death benefit.  All this develops for a cost to Roger of $23,753 a year for 20 years.

Click here to review the entire split-dollar presentation.

Click here to analyze Roger’s share of the plan.

Roger has the opportunity for cash flow from the policy during pre-retirement years.  (Example: Educational funds for his children.)  The formal agreement between the university and him can allow him early access to cash values that exceed the plan’s premium loans.

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

• If he quits or leaves for any reason after the ten years of premium funding, he can keep the fully funded plan.  At retirement, the planned policy loan occurs to repay the university, the collateral assignment expires, and the participating policy loans of $600,000 begin subject to the 3.00% COLA.
• Suppose he quits or leaves for any reason during the ten premium funding years.  In that case, the university receives its loan repayment from the policy cash value and PRA³, and Roger is entitled to any remaining policy values.

3There are three likely sources of loan repayment in years 1 and 2 when there are insufficient cash values and residual PRA to fully repay the university’s loan:

• The university includes provisions in the agreement to absorb the difference;
• A high early cash value IUL is utilized that provides the difference;
• The executive pays the difference.

The expense to the university?  The only direct costs are the bonuses paid to Roger to cover his income tax.  There is, of course, a loss of the use of money on the recoverable loan made to Roger.  However, Roger’s financial value to the university should more than offset this loss, assuming he is a “Jim Harbaugh” of the executive suite.

Options

Several other funding mechanisms in the InsMark software allow you to illustrate effective alternatives.  They are:

My favorites are the 1st, 4th, and 5th selections.  If you want no out-of-pocket cost for the executive, choose the 5th one.  It increases the employer’s costs, but providing a benefit such as Exceptional Split-Dollar for $0 personal cost is a powerful fringe benefit for an important officer like Roger.  It costs the university $2,038,040 instead of $1,283,960 ($754,080 more) and saves Roger spending $475,060.  That is a 58.73% increase for the university (plus foregone interest on the loans), but a 100% decrease in Roger’s costs.  Is he worth it?  Definitely, if he’s a “Harbaugh” clone.

Below is the graphic for this gross-up variation.

Image 2

Alternative Exceptional Split-Dollar

for a Tax Exempt University

(Gross-up Bonus for Executive’s Income Tax)

Click here to review the Summary pages of this variation with the gross-up bonus.

Conclusion

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 utilize Exceptional Split-Dollar due to provisions of the Sarbanes-Oxley Act, which make it illegal to loan money to officers, directors, and certain other key employees.  Consider Controlled Bonus (see Blog #218) for an alternative that works under Sarbanes with split-dollar-type funding.

C and S Corporations, LLCs, and Partnerships

Exceptional Split-Dollar is highly appropriate for all executives of C Corporations and non-owner, key executives of S Corporations, LLCs, and Partnerships.  It is not particularly suitable for owners of pass-through organizations due to the way profits are individually taxed.  See InsMark’s Executive Trifecta® for owners of S Corporations and the Dual Security Plan™ for owners of LLCs and Partnerships.  Both Executive Trifecta and Dual Security Plan can be illustrated in the InsMark Illustration System.

Licensing InsMark Systems

To license InsMark's Loan-Based Split-Dollar System visit us online or contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries — contact David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.

Specimen Documents

InsMark’s Cloud-Based Documents On A Disk™ (DOD) has specimen documents for Exceptional Split-Dollar in the Business Owner Benefit Plans section.  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.  (See the Loan Regime series of documents in the sections entitled Business Owner Benefit Plans and Key Employee Benefit Plans.)

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 go 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

Click on Blog 219.zip to download the Digital Workbook File used to prepare this presentation. 

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

If you download the Digital Workbook File for Blog #219, click here  for a Guide to its content.  It will be invaluable to you as you design similar 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.