It’s never been more difficult for closely held businesses to recruit and retain top talent. While most think of stock options, synthetic stock plans, bonuses, company cars, health plans or qualified plans such as supercharged Internal Revenue Code Section 401(k) plans, a split-dollar program can achieve far more benefits for a lower cost. While a 401(k) plan or even a cash balance plan can provide meaningful benefits, those plans must be made available to all eligible employees. Further, employers face burdensome government regulations for those benefits, and for recipients, the distributions are 100% taxable, generally at a high tax rate. Not so with split dollar. More on that in a minute.
Some employers turn to non-qualified plans such as a supplemental executive retirement plan (SERPS), stock bonus plans and synthetic stock plans, but legislative changes have made those plans harder to implement under IRC Section 409A, which governs the timing of deferrals and the payment of benefits to terminated employees. Violation of these rules can result in a significant penalty for the employer. Further, owners of pass-through entities like S corporation or limited liability companies taxed as partnerships rarely use non-qualified plans. That’s because there’s no tax leverage for the owners like there is with split dollar.
Split-Dollar Advantages
Split dollar has long been used to compensate top executives, but after Congress passed The Sarbanes-Oxley Act in 2002, it prevented publicly traded companies from providing loans to their executives for split dollar. Then the Internal Revenue Service issued new regulations in 2003 that substantially increased the cost of using split dollar to retain key employees or privately held businesses. Referred to as the “loan regime,” loans for split-dollar programs required the employee to pay tax on an imputed income under IRC Section 7872, called the applicable federal rate (AFR) Table 6.
Companies faced three major challenges when evaluating non-qualified “top hat” plans for executives:
1. Contributions aren’t tax deductible to plan sponsor until benefits are paid.
2. Potential creditor risk for plan participants.
3. Reliance on the future sustainability of the corporation to pay the benefits.
In response, a new type of split dollar called capital split dollar (CSD) was modified to address these objections. Essentially, CSD is a financial arrangement in which an employer and employee (typically a key executive) share in the costs and benefits of a valuable insurance policy. The employer makes an interest free loan of premium to the executive. In return, the executive must pay tax on the value of the loan as determined by the AFR. Essentially, the corporation acts as a pass-through mechanism to help the executive build substantial wealth in what’s called the “tax-free zone.”
The employer retains an assigned interest in the insurance policy as collateral for the loan. This means the executive is unable to use the benefits of the policy cash values without the employer’s consent. Eventually, the employee must repay the loan to the employer.
What I like about CSD is that it has no creditor risk during the accumulation period and doesn’t rely on the corporation to pay benefits during retirement. All residual benefits are owned by the executive from Day One, subject to the loan being repaid. CSD isn’t subject to Section 409A issues. The corporation acts as a pass-through mechanism to help the executive build substantial wealth. CSD can be used as a substitute for stock ownership or alternative stock option plans. If the company doesn’t t want to tie up surplus capital, it can borrow from a bank to fund the split-dollar loan. If set up properly, the interest on the loan is tax deductible to the company.
Many practitioners will point out that because interest for financed life insurance is a consumer loan, it’s not deductible. True. But using the company to finance the CSD plan can avoid consumer loan status if set up properly. My firm has an opinion letter on that strategy if you’re interested.
How CSD works
The executive purchases a cash-rich life insurance policy. Any permanent life insurance policy can be used, but we favor the indexed universal life plans in which the annual crediting rate is based on an index such as the S&P 500. The employer then loans money to the employee who deposits it into the insurance company’s general account. This account guarantees the safety of the principal – it’s ideal as collateral for a bank loan. The interest payable by the carrier is then used to buy options on the index.
If the index is up one year, the account is credited with 100% of the upside subject to a maximum cap. This cap varies from year to year depending on interest rates. The higher the interest rates, the higher the cap. There may also be a participation rate that’s based on interest rates as well. This can multiply the crediting rate by a factor greater than 100%.
If the option is out of the money, there’s no negative impact on the cash value account. The option expires and the cost of the option is lost. By using an investment collar to protect the account on the downside, the owner of the policy can participate in the benefits of a rising market but will be protected from any losses. This is why we say the capital is guaranteed. There’s no way to lose capital. Only a few carriers offer a cash rich insurance product that can provide a guarantee of principal plus an equity-based return.
Once the policy is ready to be activated, the business will then loan the executive the first-year premium in a lump sum under Treasury Regulations Section 7872-15 (the interest free loan split-dollar regulations).
Example
Assume the total premiums are $1.5 million deposited over five years. Where does the company get the initial $300,000 premium? It could distribute money from retained earnings, but most companies won’t do this. Instead, we can arrange for a lender to lend $1.5 million to the business to make this program available. This loan can be renewed annually, assuming the corporation qualifies for the loan. The interest payment due from the corporation to the lender is paid upfront and is considered a normal business expense if structured properly. Then, at retirement, the loan is repaid from the cash values of the policy. The “profit”– any earnings in the policy over and above the loan amount – belongs to the executive. The executive can convert the cash value into a stream of income payments or tap the money in a lump sum. This determination is at the option of the policy owner.
Economics of CSD
There are two cash flow considerations with CSD. First, the employee must pay tax on the imputed Section 7872 interest attributed to this loan. The interest is based on the AFR which changes annually. The cost to the employee is their effective tax rate on this increased income. For instance, if the current AFR is 4.71% and if the loan is $1 million, then the imputed income would be $47,100. If the employee’s effective tax rate is 35%, the tax impact on the AFR imputed income for this policy is $14,200. Remember, this rate can rise and fall as interest rates fluctuate.
The second cash flow is the employer’s cost to the lender. The rate of interest is set by the bank and is based on the SOFR (Secured Overnight Financing Rate), plus a spread. If SOFR is 5% and the spread is 2.5%, the interest rate charged by the lender would be 7.5%. This amount is deductible to the business as an ordinary and usual business expense.
Split dollar falls under the Department of Labor regulations as an authorized fringe benefit program for closely held businesses. Structured as CSD, it:
- Is tax deductible to the business.
- Grows tax-free.
- Has tax-free distributions.
- Requires little or no collateral.
- Is exempt from creditors.
- Is exempt from multiple regulations and rules.
CSD provides meaningful retirement income that will be tax-free (under current law). It’s no more costly to offer than a qualified plan, but it can be limited to select employees. The assets are exempt from creditors and the loan is fully collateralized. All benefits distributed from the plan are considered tax free distributions if done properly. This plan is truly a win/win for all parties to the transaction.
Again, CSD overcomes the two biggest concerns most owners have about implementing a plan for their top people: tax efficiency and creditor risk.
Dr. Guy Baker, CFP, CEPA, MBA is the founder of Wealth Teams Alliance (Irvine, CA). He is a member of the Forbes 250 Top Financial Security Professionals List and author of Maximize the RedZone, a guide for business owners as well as The Great Wealth Erosion, Manage Markets, Not Stocks and Investment Alchemy.