Exit strategies for split dollar agreements
- February 9, 2009
John P. Dedon
In a previous column, I discussed the advantages of private split dollar for business owners to transfer wealth to future generations. This article discusses the exit strategy and the effect of the increasing “economic benefit” value.
In brief, Part 1 presented this example: Generation 1 (“G1”), which typically would be Mom or Dad, pays a life insurance premium insuring the life of their child (“G2”). The life insurance policy is owned by an Irrevocable Trust and would pass tax free to the grandchildren (“G3”) upon G2’s death. Assume G1 makes a one-time premium payment of $2 million. Upon G2’s death, insurance proceeds ranging between $11 million and $23 million would be available to the grandchildren estate tax free. Because G1 is taxed on the “economic benefit,” G1’s gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy. Thus, the $2 million premium is removed from G1’s estate; the gift tax is insignificant (at least in the early years); and substantial tax free death benefit is provided.
The advantages described above are derived from structuring the split-dollar arrangement as non-equity split dollar U.S. Treasury Regulations. There must be a contract between, in this example, G1 and the Irrevocable Trust, requiring that G1 is repaid the greater of the insurance premium ($2 million) or the cash value of the policy. The only “economic benefit” the Trust receives is the death benefit. Hence, the Trust does not have any “equity” in the policy.
Because the equity belongs to G1 in the form of the greater of the premium payment or cash value, there is a receivable due G1. The split dollar contract provides that the receivable is due upon G2’s death — the insured. And every year that the split dollar arrangement is in effect, the economic benefit increases. Thus, it is desirable to have an exit strategy in place to terminate the split dollar arrangement upon death or perhaps earlier when the premium has been fully paid. Here are various exit strategies:
1) If G2 dies first, G1 receives the greater of the policy cash value or the premium and a large amount of life insurance is inside the Irrevocable Trust tax free for G2’s family.
2) More likely, G1 dies first. Because the receivable is not due until G2’s death, which may be many years into the future, the receivable may be substantially discounted. G1’s estate includes the value of the receivable. The value may be absorbed by G1’s exemption. G2’s death terminates the split dollar agreement and the receivable.
3) A third alternative is that, prior to either G1’s or G2’s death, the receivable is sold for its fair market value, which again, may be subject to discount. The Irrevocable Trust or a new Trust purchases the receivable and the split dollar arrangement is terminated. The source of the payment has come from gifts by G1 or G2. Often times the source comes from gifting strategies such as GRATS or gift/sale techniques involving intentionally defective trusts.
The key is to plan for the termination prior to later years where the economic benefit begins to grow.
John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedononestateplanning.typepad.com.