Split-Dollar Life Insurance Plans- A New Form is Taking Shape

Take-Away: While highly regulated, split-dollar life insurance plans for key employees and executives are finding more creative approaches like loan split-dollar plans, which gained attention and some notoriety, University of Michigan’s football coach Jim Harbaugh’s contract. Apparently a $8.05 million annual salary was not enough for Jim and he needs tax-free income in retirement.

Background: Before 2003 many split-dollar life insurance plans were so aggressive as to be viewed as a tax abusive. That caused there to be a new regime to regulate, and tax, split-dollar life insurance plans intended to provide some level of uniformity and certainty in how those plans were taxed to the insured. These split-dollar rules are highly complex to understand with several buzz-words or descriptions, some of which follow.

Policy Ownership: Because there can be only one title owner of a life insurance policy, the owner of the policy is often determined by the ownership that is desired upon the termination of the split-dollar arrangement. Restated, policy ownership drives the type of split-dollar plan that is selected.

Endorsement Method: With the endorsement method, the title owner of the insurance policy owns the policy’s cash surrender value, who then endorses the term death benefit component of the life insurance policy to the other party to the split-dollar agreement.
Collateral Assignment Method: With the collateral assignment method, the title owner of the policy owns the term death benefit component of the life insurance policy, who collaterally assigns the cash surrender value portion of the life insurance policy to the other party to the split-dollar agreement.

Split-Dollar Regime: Once the ownership of the policy is identified, only then is the split-dollar regime selected. The split-dollar Regulations provide two separate regimes for the taxation of a split-dollar plan that benefits an employee: (i) the economic benefit regime; and (ii) the loan regime.

Economic Benefit Regime: The economic benefit regime applies to what are called either equity or non-equity split-dollar arrangements. Non-equity split-dollar is used for endorsement method plans, where the policy title owner endorses the term insurance portion of insurance policy to the party who receives that benefit. Equity split-dollar also uses the endorsement method. The difference is that the policy equity, above the insurance premiums paid, inures to the party that receives the benefit without any tax consequences. However, this type of split-dollar plan design is no longer used because of the 2003 Regulations impose a tax on the policy’s growth in value.
Loan Regime: The loan regime applies to collateral assignment split-dollar plans. The policy title owner is the party that receives the benefit. The party providing the benefit makes loans of premium amounts to the benefited party. The prevailing applicable federal rate (AFR) is used to calculate the loan interest rate, unless a below market rate is used, which will then cause interest to be imputed under IRC 7872. The historically low AFR rates we now have favor the use of loan regime split dollar agreements. To lock in the low interest rate, a single loan for a single premium policy may prove to be most effective exploitation of the currently low AFR rate.

Taxation of Plan Regimes:

Economic Benefit Regime: When using an economic benefit regime non-equity split-dollar plan as an executive’s benefit, the employer pays the full policy premium. The executive is taxed on the economic benefit of the insurance protection received under the policy. That economic benefit is calculated using what are known as the Table 2001 rates- the value of being provided a death benefit for one year. The premiums paid by the employer generally are not tax deductible, but the death benefit paid to it will generally be received income tax-free.[IRC 101(a)(1).]
Loan Regime: When using the loan regime, the employee is the owner of the life insurance policy, and the employer makes premium loans to the employee. The employee is not taxed on the loans unless the loans are later forgiven. Interest paid on the premium loans is taxed to the employee as compensation. The employee is not taxed on the annual policy cash value growth, making the loan regime an alternative to the ‘old’ equity split-dollar arrangements of the past. The employer cannot deduct the loans made and must include the interest payments in its taxable income. When the loan is repaid the employer is not taxed on the repaid amount.

Something New: The Loan Split-Dollar Recovery Plan: Football coach Jim Harbaugh is famous for? (i) always wearing khaki pants? or (ii) never winning a game against Ohio State?; or (iii) losing his touch in developing quarterbacks?; or (iv) a trend-setter in the realm of executive compensation? Surprise, all of the above.

It seems that ‘Harbs’ was the first to negotiate what is called a loan split-dollar recovery plan with his employer, the University of Michigan. To retain and reward the Coach, the University of Michigan adopted a loan split-dollar plan to provide to Coach Harbaugh with future tax-free income (as if he actually needs more income earning $8.05 million a year to coach 14 football games a year and repeatedly end each season with a 9 win, 4 loss record, but I digress.)

Harbaugh’s Deal: Under his ‘new’ executive compensation arrangement: (i) Harbaugh is the applicant and title owner of the life insurance policy that insures his life; (ii) the University of Michigan loaned, or will have loaned, Harbaugh cash in the amount of $14 million for policy premium payments; (iii) Harbaugh has no out-of-pocket costs; (iv) Harbaugh includes the loan interest imputed by IRC 7872 in his taxable income for the year; (v) the premium loans Harbaugh receives will be repaid to the University of Michigan from the tax-free death benefit paid at Harbaugh’s death, or from the life insurance policy’s cash surrender value if the arrangement terminates sooner (such as the perennial December sports twitter-world claims that Harbaugh will return to a pro coaching position after yet another disappointing 9-4 season, ending with an Ohio State blow-out.) This is the ‘cost-recovery’ feature of the loan split-dollar recovery plan; (vi) If Harbaugh ceases to perform his agreed-upon duties as head football coach, the University stops making the premium loans, i.e. the ‘golden handcuffs’ feature of the loan split-dollar plan; and (vii) when Harbaugh retires, apparently not having saved any of his $8.05 million annual salary over the years, he can then enjoy tax-free income through policy withdrawals or policy loans from the policy that he owns.
Trend-Setter: While it is pretty hard to swallow a college football coach earning $8.05 million a year, because presumably that was not enough, and the University had to loan him another $14 million in premium payments. Apparently that opened the eyes of a handful of other ‘successful’ college football coaches, a couple of whom earn even more than Harbaugh (though they do seem to win a few more games each year!) Dabo Swinney (who names their kid Dabo?) picked up a similar deal with Clemson University when his contract was extended, and Ed Orgeron just negotiated one with Louisiana State University, having just won the National Championship earlier this year.
Excise Tax Avoidance?: It is probable that this interest in the loan split-dollar recovery plan is a response to the 21% excise tax imposed on executive compensation in excess of $1.0 million under the 2017 Tax Act. [IRC 4950.] A loan split-dollar recovery plan mitigates the impact of this excise tax on an executive level employee by reducing the amount of compensation to the imputed loan interest while, as noted, providing a potentially large tax-free benefit when the executive retires.
Sarbanes-Oxley Act: It should be noted that the availability of a loan split-dollar recovery plan is gaining traction in the world of non-profit, or tax exempt entities, e.g. public universities. While a loan split-dollar recovery plan can also be used by for-profit corporations as well, but in that situation, care needs to be given to the Sarbanes Oxley Act of 2002, which curtailed the use of loan split-dollar plans in publically traded companies by its prohibition of personal loans to directors and officers.

Conclusion: Since the SECURE Act’s passing, there has been a lot of commentary about the renewed need to acquire life insurance, if for no other reason than to have the liquidity to pay the accelerated income tax liability on retirement plan distributions over a shortened 10 years. Many executive employees may have jettisoned their life insurance, initially acquired to pay federal estate taxes, after the federal estate tax exemption ballooned to $11.85 million per person in 2018. If those favorable transfer tax exemptions are rolled back with a new administration in Washington D.C. there may be yet another reason to consider acquiring life insurance. Thus, some new interest in exploring split-dollar life insurance arrangements between employees and their employers.

Postscript: This morning’s news indicates that Coach Harbaugh will be taking a 10% pay cut this fiscal year due to the pandemic’s impact on the UofM’s athletic budget (projected to be a $26 million deficit.) The 10% cut will offset the 10% increase in salary he was scheduled to receive.