Family Split-Dollar Insurance Plans As an Estate Planning Tool

by Charles Epstein, CLU, ChFC

In 1996, the IRS issued a favorable Private Letter Ruling (PLR) to taxpayers asking about the use of a split-dollar arrangement in a nonemployer situation. In 1997, the IRS followed that with another favorable ruling in the split-dollar area involving second-to-die insurance, again in a nonemployer situation. These two rulings (PLRs 9636033 and 9745019) provide a roadmap to solving many estate planning problems.

What Is a Split-Dollar Arrangement?

Many people mistakenly assume that “split-dollar” refers to a type of insurance. It does not. It merely refers to a technique by which the ownership of a life insurance policy is split between parties who will pay the premium. A life insurance policy typically has two components:

  1. The insurance portion, which is the amount of the death benefit in excess of the cash surrender value of the policy, and
  2. The cash value, which represents the investment part of the contract.

In a split-dollar arrangement, one party usually owns the insurance portion and the other party owns the cash-value portion. When the premium is due, each party pays its portion.

To determine how much each party owes, it is easier to determine how much the insurance portion of the contract costs. This can be done in one of two ways:

  1. Use IRS tables &emdash; Table PS 58 for a single life policy and Table PS 38 for a second-to-die life policy. The IRS tables have been an accepted method of valuing the insurance portion of a life insurance pol-icy for more than three decades.
  2. Use the lowest one-year term insurance premium available from the insurance company issuing the policy.

Once you have determined the cost of the pure insurance, you can subtract that from the total premium. The difference will equal the cost of the investment portion of the contract. The premium is then split accordingly, and each party pays the portion attributable to the part of the policy it owns.

What is a Family Split-Dollar Arrangement?

Until these two recent rulings, the IRS only officially sanctioned split-dollar arrangements in employer/employee settings. Revenue Rulings 64-328 and 66-110 provided the roadmap that has now been used to expand this concept to nonemployer situations. In the employer setting, the employer typically owns the policy and collaterally assigns the insurance portion of the policy to the insured. The employer typically pays the entire premium, and the value of the pure insurance portion is taxed to the employee/insured as compensation.

In the family setting, an irrevocable life insurance trust is often the policy owner, and the spouse of the insured is entitled to the cash value, upon the insured’s death. The cash value portion of the policy is collaterally assigned by the trust to the insured’s spouse to secure the spouse’s interest. This arrangement could also be used when the policy is partly owned by a family partnership or by another family member instead of a trust. In any event, the trust will receive the pure insurance portion of the policy if it ever pays off or is surrendered. The insured’s spouse will receive the cash value of the policy.

Before death, the insured’s spouse pays the lion’s share of the premiums. The trust pays its portion by receiving gifts from the insured. These gifts are much smaller than if the trust had to pay the entire premium. Therefore, the split-dollar arrangement reduces or eliminates the need to make taxable gifts (those in excess of $10,000 per donee) and reduces the necessity of using of the

$1 million generation-skipping transfer (GST) tax exemption if the trust is a GST trust.

Using Second-To-Die Insurance

Married couples often use second-to-die insurance to pay the estate tax on the death of the survivor. They also may use it if one spouse, typically the breadwinner, is not insurable. Finally, many use second-to-die insurance because it is less expensive.

Whatever the reason behind the use of second-to-die insurance, PLR 9745019 warns taxpayers to be careful. Nevertheless, a family split-dollar arrangement with second-to-die insurance is certainly now an option if desired, but care must be taken in setting up the plan. The split-dollar agreement should allow either party to terminate the agreement as long as the value of the trust assets equal or exceed the insured’s interest in the policy. Since the insured and his or her spouse will not have the power to terminate the policy, the face value of the policy is not included in the estate of the second spouse to die and the cash value of the policy is not included in the estate of the first spouse to die. Also, the insured and the spouse should have no incidents of ownership in the policy. Incidents of ownership include the right to borrow on the policy, change beneficiary and generally have access to the policy’s cash value.

Control Issues

You may not want to use an idea like this one because you like to maintain control over your assets. But removing life insurance from your estate is usually advisable. and doing so usually involves giving up control over the policy.

With single life policies, your spouse can maintain access to the cash value of the policy, the right to execute policy loans, the right to surrender the policy and the right to change the dividend option without causing the value of the policy to be included in your estate. These conditions should be written into the collateral assignment document but cannot be used with second-to-die insurance since the spouse is one of the insured.

Existing Policies

A split-dollar arrangement can also be used with an existing policy &emdash; but only with care. Your spouse must not be deemed a grantor of the trust with which the split-dollar arrangement is being made. Transferring ownership of the cash value of the policy to your spouse using a split-dollar arrangement before the transfer of the pure insurance portion of the policy to the trust is usually best.

The split-dollar arrangement also reduces the gift element of paying the premium. Therefore, when the premiums already paid by an existing life insurance trust have used a lot of the individual’s GST tax exemption, a family split-dollar arrangement can help avoid GST tax liability.

Getting Down to Basics

Please feel free to consult with one of our professionals if you have any questions or concerns about split-dollar arrangements. We would be glad to tell you more about how they might help you achieve your estate planning goals.