Private split dollar: solving estate problems for wealthy business owners

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John Dedon

Enough about 2008:  let’s start 2009 with a positive planning option for business owners still in need of planning. One strategy worthy of consideration is split dollar life insurance, allowing business owners to pass significant wealth to family members free of the estate tax with relatively minimal gift consequences. 

The explanation is at the “30,000 feet level” due to space limitations.  Notwithstanding, it is a worthy topic because of the substantial advantages split dollar life insurance can provide to a business owner.  Although there are many variations of split dollar, this article discusses “private split dollar” — the parties being just family members and a Trust for family members — versus traditional split dollar where the business is also a party.  According to Jorge Fuentes, vice president of Wachovia Insurance Services Inc. in McLean, this strategy has been used for several clients nationwide with a number of different insurance carriers.

Legal assumptions:

 There is a current $3.5 million exemption that protects an individual from estate tax (with proper planning, $7 million for a married couple).  However, in 2011, the exemption amount is only $1 million, $2 million for a married couple, and the estate tax rate is 55 percent.

 Annual exclusion gifts are currently $13,000. Gifts in excess of these amounts erode the exemption amount available upon death.

Factual assumptions:

 Mom and Dad, now in their mid 60s, ran a successful real estate company.  Their 45-year-old child was not interested in the business, so they sold the company and netted $22 million after tax. Their total estate is $30 million.

 Their child is financially secure.  Therefore, Mom and Dad are not concerned about her, but they do want to provide for their four grandchildren and future generations.

 Upon the second of their deaths, estate tax could be anywhere between $6 million to $14 million, even without asset appreciation.

Solution: Private split dollar

Mom and Dad (collectively Generation 1 or “G1”) pay the premium insuring the life of their child (“G2”).  To remove the death benefit from the taxable estates of Mom, Dad and the child, the owner of the policy is an Irrevocable Trust.  The Trust beneficiaries are Mom and Dad’s grandchildren (“G3”).  (If there was more than one child, there could be more than one policy and more than one Trust.) 

Applying numbers to the facts above, 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.  The death benefit depends on the age of G2, the type of policy, and the year of G2’s death.  The Trust could be designed as a dynasty trust, meaning the proceeds are estate tax free in perpetuity. 

And here is a major advantage of private split dollar:  the gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy.  According to Fuentes, this is because the IRS taxes G1 on the “economic benefit” of the premium payment, which is substantially less than the premium payment.  “Current IRS rules and IRS tables indicate that private split dollar may be an effective way to preserve exemptions for other planning,” Fuentes commented.

In this example, absent the IRS rules, virtually all of Mom and Dad’s $2 million premium payment would reduce what they can otherwise protect from estate tax upon their deaths.  Instead, because the gift tax value (economic benefit) is so low, the $2 million premium payment can be absorbed by annual exclusion gifts to the Trust.  What have Mom and Dad accomplished?  At a financial cost of $2 million, which after tax is worth roughly $1 million, they provided $11 million to $21 million of proceeds free from estate taxes for their grandchildren and future generations. These proceeds can also be protected from their grandchildren’s creditors and divorce. And they did so with minimal gift tax consequences. 

As stated above, this is a dramatic simplification of how private split dollar works.  There are also different variations of private split dollar.  Follow this link for information on how to terminate the split dollar arrangement.

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.

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