Every business owner has a short list of people they would hate to lose.
They're the ones who know the customers, understand the operation, anticipate problems, and make decisions without needing someone to look over their shoulder. Over the years, they've earned something that doesn't appear on a balance sheet: the owner's trust.
If you've built a business, chances are you can name a few of these people without giving it much thought.
Naturally, you want to take care of them. You also want to be thoughtful about how you use the financial resources of the business.
A split-dollar life insurance arrangement may offer a way to provide meaningful financial protection for a valued executive while allowing the business to retain certain rights to the policy's value.
A Bonus Doesn't Always Address the Bigger Picture
Most business owners are familiar with traditional ways of rewarding key employees. Competitive salaries, performance bonuses, retirement contributions, and equity incentives all have their place.
But what happens when an executive is already well compensated?
An additional bonus may be appreciated, but it doesn't necessarily address the financial concerns that become more important as an individual's wealth and responsibilities grow.
Perhaps an executive wants to provide greater financial security for a spouse. Maybe they're thinking about estate planning, protecting family wealth, or creating additional resources for the next generation.
Meanwhile, the business owner has a different set of considerations.
How much should the business commit to an executive benefit? Can those dollars eventually be recovered? What happens if the executive retires, leaves the organization, or passes away?
Understanding Split-Dollar Life Insurance
Despite the name, split-dollar isn't a particular insurance product. It's an agreement that determines how two parties share the costs and benefits of a life insurance policy.
In a typical business arrangement, the parties are an employer and a key executive.
The employer provides some or all of the premium funding. In exchange, the employer may retain certain rights to the policy's cash value or death benefit. The executive, or the executive's beneficiaries, receive other benefits specified in the agreement.
The arrangement establishes who owns the policy, who pays for it, what each party receives, and what happens when the agreement ends.
The costs and benefits don't have to be shared equally. The arrangement can be structured around the financial interests of each party.
Consider a hypothetical business owner who wants to provide a valued executive with $1 million of life insurance protection.
Rather than simply paying the executive additional compensation to purchase coverage independently, the business might fund a permanent life insurance policy through a split-dollar agreement.
Depending on the structure, the business could retain a right to recover specified amounts it contributed, while the executive's beneficiaries would receive the portion of the death benefit available under the agreement.
The actual amounts depend on the policy, the agreement, and the applicable financial and tax considerations.
The point is that the business and executive may be able to pursue complementary objectives without requiring the business to make an unrestricted compensation payment.
Two Common Ways to Structure the Arrangement
There are several ways to establish a split-dollar agreement, but two common approaches are endorsement arrangements and collateral assignment arrangements.
Endorsement Arrangements
Under an endorsement arrangement, the business generally owns the life insurance policy and pays the premiums.
The employer retains ownership and control while endorsing a specified portion of the death benefit to the executive's designated beneficiaries.
The executive receives life insurance protection, and the employer retains the policy interests not assigned through the endorsement.
The executive is generally subject to annual taxation on the value of the life insurance protection provided.
Collateral Assignment Arrangements
A collateral assignment arrangement takes a different approach.
The executive, or an appropriate trust, generally owns the policy. The business advances funds for premiums, often through a loan arrangement, and receives a collateral assignment securing its repayment rights.
The executive retains ownership interests subject to the employer's collateral rights and the terms of the agreement.
Depending on the structure, outstanding loans may be repaid from policy values, death proceeds, or other resources.
Split-dollar loan arrangements have their own tax considerations, including applicable interest requirements and the potential consequences of below-market loans.
Both approaches can provide benefits, but they create different ownership, taxation, cash flow, and administrative responsibilities.
Choosing between them is not simply a matter of preference. The appropriate structure depends on what the business and executive are trying to accomplish.
Why Would a Business Consider Split-Dollar?
For some businesses, the primary objective is retention.
A split-dollar agreement may include provisions that provide incentives for an executive to remain with the organization, although those incentives depend on the specific agreement and how benefits are conditioned.
For others, the ability to retain a financial interest in the policy is particularly appealing.
Consider the difference between paying an executive a $50,000 bonus and advancing $50,000 toward premiums under a properly structured loan arrangement.
A cash bonus generally becomes the executive's compensation, subject to applicable taxes. The business does not retain a contractual right to recover that payment.
With a split-dollar loan arrangement, the business may retain a repayment claim, although the timing and amount ultimately recovered depend on the agreement, repayment resources, and other factors.
The business still needs to consider the cost of tying up capital, administration, credit exposure, and tax treatment.
It is also important to understand that split-dollar premium payments are not automatically deductible business expenses. Their treatment depends on the arrangement and applicable tax law.
Still, for an owner interested in providing a meaningful executive benefit while preserving certain financial rights, the structure may deserve consideration.
For the Executive, a Different Perspective
Life insurance can serve several purposes in a broader financial plan. It may provide financial protection for family members, help address estate liquidity needs, or support wealth transfer objectives.
Through a split-dollar arrangement, an executive may receive life insurance protection without personally funding the entire premium obligation.
Depending on the structure, the executive may also have access to certain policy values, subject to the employer's rights and the policy's terms.
The executive may incur annual income tax obligations or interest expenses. Access to policy cash value may be restricted. And benefits may change if employment ends or the agreement is terminated.
Before agreeing, the executive should understand the potential tax costs, restrictions on accessing policy values, and what happens to the coverage if employment ends.
The Details Matter, Especially Over Time
A split-dollar arrangement may remain in place long after the executive's compensation, ownership structure, or retirement plans have changed.
The executive may retire. The business may be sold. Interest rates may change. The policy may perform differently than illustrated.
A well-designed agreement should anticipate these possibilities rather than assume everything will unfold according to the original plan.
Before implementing a split-dollar strategy, the parties should carefully consider:
- Tax treatment: Whether the arrangement is governed by economic benefit or loan rules, along with applicable employer-owned life insurance requirements.
- Policy performance: Premium commitments, policy charges, cash value assumptions, and the risk of lapse.
- Repayment obligations: How and when the employer expects to recover amounts advanced.
- Employment changes: What happens upon retirement, termination, disability, or death.
- Exit provisions: How the arrangement can be modified, terminated, or unwound, including potential tax consequences.
These arrangements require coordination among financial advisers, insurance professionals, attorneys, and tax advisers. Periodic reviews are also important.
The additional administration and long-term commitments should be weighed against the benefits the arrangement is expected to provide.
When Financial Interests and Personal Priorities Align
For many business owners, taking care of the people who helped build the company is personal. These are individuals they've worked alongside for years, people they trust and want to see succeed.
But a meaningful executive benefit also needs to make sense financially, both for the business providing it and the person receiving it.
Disclosures: This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please contact your Harbour Wealth Management Group Financial Professional. Information obtained from third-party sources are believed to be reliable but not guaranteed. The tax and legal references attached herein are provided with the understanding that Harbour Wealth Management Group is not engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Harbour Wealth Management Group does not replace those advisors. Securities and Investment Advisory Services Offered Through M Holdings Securities, Inc. A Registered Broker/Dealer and Investment Adviser, Member FINRA/SIPC. Harbour Wealth Management Group is independently owned and operated.