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Private Split Dollar Arrangements– Not Splitting Hairs, It Can Be Good For Your Heirs!

July 8, 2024

A private split dollar arrangement is an estate planning strategy that allows individuals to set up an Irrevocable Life Insurance Trust (ILIT) providing money for heirs while minimizing gift and estate taxes. It is one of many tools that allow wealthy individuals to provide for future generations in a tax-efficient manner.  

How Does a Split Dollar Arrangement Work?

Life insurance is frequently part of estate planning because it provides liquidity to beneficiaries, allowing them to pay expenses, replace lost income, defray estate taxes, or provide an inheritance. An ILIT is one way to maximize the benefits of a life insurance policy while minimizing the impact the value of this asset will have on an individual’s taxable estate as the policy is not counted as part of the gross estate. The ILIT owns the policy and must pay the premiums and a split dollar plan is one way to fund these payments.

In a split dollar arrangement, a grantor first establishes an ILIT for future generations. The ILIT applies for life insurance on the grantor’s life or the grantor’s and spouse’s lives with a second-to-die policy. Premiums are the responsibility of the ILIT but if there aren’t sufficient funds, the ILIT will need to obtain the money from the grantor. Rather than making a gift to the ILIT of the premium payments, the trustee can enter into a split dollar agreement with a payor (which can be another trust or an individual)  whereby the payer advances the money for the premium secured by a collateral assignment on the policy. The agreement sets forth payment responsibilities, policy benefits, and repayment terms. Depending on which is the most beneficial, the premium advance can be treated as an economic benefit-cost or a loan for tax purposes.

When Should You Choose Economic Benefit Cost vs. Loan Regime?

Under the economic benefit cost regime, the payor is deemed to have given an annual gift to the ILIT to pay their premium. However, the value of the gift is calculated by looking at the economic benefit cost associated with the death benefit provided to the ILIT. This amount is either the cost of term insurance determined by the premium rates published by the IRS (Table 2001) or the qualifying one-year term rates published by the issuing insurer, whichever is lower. This amount is typically lower than the actual amount of the premium. However, it is important to note that since the economic benefit cost is determined based on the cost of term insurance on the insured’s life, that amount increases every year as the insured person ages.

Under the loan regime, the grantor’s premium advance is treated as a loan and the ILIT pays interest on the loan at an appropriate interest rate (typically, the long-term Applicable Federal Rate or AFR). The grantor gifts the amount required to pay interest on the premium loan balance. The gift is valued at the interest amount for gift tax purposes. When low interest rates prevail, this may be the better option. 

How Is the Advance Repaid?

During the grantor’s life, repayment can be made using GRATs, CLTs, gifts, or other wealth transfer strategies.

After the death of the grantor, the gift or loan (plus interest) can be repaid from the policy’s death benefit. 

Under the economic cost regime, the estate receives an amount equal to the greater of premiums paid into the policy or the policy’s cash value at that time of death. With the loan regime, the estate receives a portion of the life insurance proceeds equal to the outstanding loan amount at the time plus any interest accrued. 

What Are the Benefits of Private Split Dollar Arrangements?

Private split dollar arrangements are useful when the grantor does not want to utilize gifting. . A grantor can gift money to an ILIT to pay premiums without a split dollar arrangement. This works well if the premiums are less than the annual gift tax exemption (currently  $18,000 per year for individuals; $36,000 for married couples). However, if the premium is higher than the exemption or the grantor wants to use the exemption for another gift, a split dollar arrangement may be beneficial because it reduces the value of the gift which minimizes gift taxes and protects more of the grantor’s wealth.

Under the economic benefit cost regime, the ILIT may also pay the economic benefit cost if it has the funds to avoid a gift, further decreasing the chance that the grantor will exceed the lifetime gift exemption and have to pay gift taxes.

Split dollar arrangements also provide a lower-cost option for funding life insurance than private financing techniques, especially for second-to-die policies.

A benefit of the loan regime is that it allows the grantor to retain control over funds advanced for premiums. The grantor can demand the ILIT repay the loan. The ILIT would have to seek a loan from another source to repay the grantor but it may be worth it if the grantor needs the money.

Finally, if the cash value of the policy is less than the premiums paid, the estate will still get back the premiums. It just won’t receive an additional payout. If the cash value is higher, that money doesn’t go back to the grantor’s estate and will be paid to the beneficiaries directly.

Should You Use a Split Dollar Arrangement?

Private split dollar arrangements aren’t right for everyone. However, it can be a valuable strategy to fund life insurance planning.

Our attorneys provide comprehensive estate planning advice customized to our client’s unique needs and goals. Contact us to discuss creating or updating your plan.

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