Want to know when you're approaching the top of the corporate ladder? When your company starts talking to you about split-dollar life insurance. Employers use these fancy policies to protect, reward, and retain their best-paid employees. Split-dollar policies-- so called because the company and the employee each owns a share of the policies' benefits--have been around since the 1950s, but lately, they've been booming. Thanks to huge stock gains, execs increasingly discover that they have far more dough in retirement plans than they can ever hope to spend. Split-dollar insurance offers an almost tax-free way to pass along that excess wealth to heirs.
But the Internal Revenue Service may have defused the boom. On Jan. 29, the agency formally gave notice that it was scrutinizing the way companies and executives pay taxes on split-dollar policies--and its goal is not to ensure that they pay less. Now, high-end financial planners and their clients are ripping into the details of policies, trying to figure out where they stand. "Every policy is an individual transaction, so it's almost impossible to predict the impact," says Mike Walsh, an executive-benefits expert at consultant Watson Wyatt Worldwide in Boston.
No one's quite sure how large the split-dollar market is--but "you see these policies everywhere from the 100 largest corporations to the partnership that owns a corner restaurant," says Michael Harahan, a benefits expert at Mullin Consulting in Los Angeles and past president of the Association of Advanced Life Underwriting. The AALU, which represents life-insurance agents, is particularly upset that the IRS notice threatens to impose a new tax treatment on policies established under old rules.
It doesn't help that the IRS' guidance is temporary and unclear. "New policies are on hold, and some companies and executives are looking for exit strategies" from existing plans, says Jonathan Forster, director of wealth preservation at the Tyson Corner (Va.) office of law firm Greenberg Traurig.
Split-dollar policies owe their popularity in large part to IRS neglect: The agency's last serious look came in 1966. That inattention let insurers and planners design policies that could shelter huge sums, particularly from executives' excess retirement benefits.
Here's how a plan might work, based on an example laid out by Watson Wyatt's Walsh (table). Consider a 60-year-old executive who is retiring with several benefit plans, including a supplemental executive retirement plan (SERP)--a special pension, offered only to highly compensated employees, that pays fixed monthly or annual benefits. Thanks to rich returns on her other pensions, the executive might decide she can live securely without the SERP, which has a present value of $2 million. If she took the benefits and tucked them away for her heirs, she would pay $800,000 in taxes, plus 40% in tax on future earnings--and an additional 55% in estate taxes on what's left. "SERPs by themselves are very tax-inefficient," notes Andrew Liazos of Boston law firm McDermott, Will & Emery.
If, on the other hand, she can get the money into a life-insurance policy, she'll enjoy two big tax breaks. Inside buildup--cash value that grows from a policy's investments--isn't taxed. And if the death benefits go into a trust for her heirs, that money won't be subject to estate taxes.
So the executive and her company negotiate a "SERP swap." She gives up the retirement account in exchange for a split-dollar agreement--a whole- or universal-life insurance policy, either of which builds cash value, pledged to both the company and her beneficiaries. The company uses the account and its earnings to pay policy premiums. In this example, the company pays premiums for seven years. After 15 years, it reclaims its payments from the policy's cash value. After that, the company has no claim on the policy--it all belongs to the executive.
What about taxes? Since the executive gets a benefit, she has taxable income from the plan. Under the IRS' old rulings, that income was equal to the value of the life insurance she got while the company owned part of the policy. So she would have been taxed each year on the amount that the company would have spent to buy a one-year term-insurance policy. That's far less than what the company actually paid.
The old rules also allowed executives to base their tax tab on the cheapest term policy their insurer offers. To keep tax bills down, most insurers carry on their books a supercheap policy--so cheap that they would sell it only to Superman on a Kryptonite-free planet. Based on such low premiums, our executive would pay less than $140,000 in taxes over 15 years.
But the big tax break is still to come. Once the company reclaims its premium payments, the executive owns all the cash value inside the policy. Most insurers maintain that the 1966 ruling says there's no tax when the company lifts its claim on that asset. The IRS disagrees, saying the ruling applied only to an earlier form of insurance. But in practice, few executives have paid tax on huge sums transferred via split-dollar insurance.
Now, that's likely to change. The IRS notice says executives soon must start paying more taxes while their company is paying premiums. And the agency is studying just how the policy's cash value should be taxed when the employer gets its premiums back. "If an employer is transferring property to an employee, generally that will be taxable income to the employee," says an IRS official. The IRS says it won't tax cash values until it sets final rules--but it won't say whether the new rules will apply only to new policies or also to the billions of dollars in policies that are already in place.
What should you do if you have a split-dollar policy? If your employer hasn't yet reclaimed its premiums, get your accountant or lawyer together with the company's benefits experts. Make sure they agree on how to report your policy to the IRS, because both tax returns have to show the same numbers and details. If your policy is fairly new and hasn't yet built up a large cash value, have your accountant crunch the numbers to see whether it's worth keeping in the face of potential new taxes.
Split-dollar life insurance is likely to survive. But with a new tax treatment, it may no longer be right for you.