Split dollar life insurance plans are a popular option for businesses and executives, offering flexibility and shared benefits. However, understanding the tax implications of these plans is crucial to making the right decision. Depending on how a split dollar plan is structured—whether it’s a Collateral Assignment Split Dollar Plan or an Endorsement Split Dollar Plan—the tax treatment can differ significantly for both the employer and the employee.
This article will break down how each type of split dollar plan is taxed and explore key IRS rulings that impact how these plans must be reported.
How Split Dollar Life Insurance is Taxed
The taxation of split dollar life insurance depends on how the plan is structured and which party (employer or employee) holds ownership of the policy. There are two main taxation regimes that the IRS applies to split dollar arrangements:
- Loan Regime: If the employer’s premium payments are treated as loans to the employee, the employee may have to pay interest on those loans, or the interest may be imputed (taxed).
- Economic Benefit Regime: Under this regime, the employee is taxed based on the economic benefit they receive each year, which is generally the cost of life insurance protection minus any contributions they made.
The IRS guidelines, particularly Revenue Rulings 64-328 and 66-110, help determine whether a split dollar plan falls under the loan regime or economic benefit regime.
Taxation of Collateral Assignment Split Dollar Plans
Under a Collateral Assignment Split Dollar Plan, the employee owns the policy while the employer has a collateral interest. The way taxes are applied differs for both parties.
Tax Treatment for the Employee
- Economic Benefit: Each year, the employee is taxed on the economic benefit they receive, which is usually calculated using IRS Table 2001 rates. This amount represents the cost of life insurance protection, and it is considered taxable income to the employee.
- Access to Cash Value: If the employee accesses the policy’s cash value, they may be subject to taxation based on the policy’s growth and their contributions (policy basis). Withdrawals that exceed the amount of premiums paid are taxed as ordinary income.
Tax Treatment for the Employer
- Premium Payments: The employer’s premium payments are generally not tax-deductible because they are viewed as compensation to the employee.
- Reimbursement at Death: Upon the employee’s death, the employer is reimbursed for the premiums they have paid. This reimbursement is typically not considered taxable income, as it is treated as a return of capital.
Taxation of Endorsement Split Dollar Plans
In an Endorsement Split Dollar Plan, the employer owns the policy and endorses a portion of the death benefit to the employee’s beneficiaries. Here’s how taxes apply:
Tax Treatment for the Employee
- Economic Benefit: The employee is taxed on the economic benefit they receive each year, similar to the collateral assignment plan. The cost of the life insurance protection is taxable income, calculated based on IRS tables.
- Death Benefit: Generally, the death benefit paid to the employee’s beneficiaries is tax-free, as long as the policy qualifies under IRS rules for life insurance policies.
Tax Treatment for the Employer
- Premium Payments: The premiums paid by the employer are usually not deductible as a business expense, because the payments are part of the employee’s compensation.
- Employer Control: The employer retains control over the policy’s cash value, which may grow over time. Any withdrawals or loans taken by the employer may have tax implications.
Comparing the Two: Key Tax Differences
- Taxable Income for Employees: In both plans, the employee is taxed on the economic benefit they receive from the policy each year, but the amount may vary based on the structure of the plan and the value of the life insurance protection.
- Deductibility of Premiums for Employers: Employers cannot deduct premium payments as a business expense in either type of plan. These premiums are typically considered part of the employee’s compensation.
- Reimbursement and Death Benefit Treatment: In a collateral assignment plan, the employer is reimbursed for premiums upon the employee’s death. In an endorsement plan, the employer retains control of the policy’s cash value, but the employee’s beneficiaries receive the death benefit, which is generally tax-free.
Gift and Estate Tax Implications
Gift Tax Considerations: If an employer transfers ownership of the policy to the employee or a family member, this transfer may trigger gift taxes. The value of the policy or the economic benefit provided each year may need to be reported for gift tax purposes.
Estate Tax: Split dollar life insurance can have significant implications for estate taxes. Without proper planning, the death benefit from a policy owned by the insured may be included in their taxable estate. However, if the policy is placed in an irrevocable life insurance trust (ILIT), it can help keep the death benefit out of the taxable estate.
IRS Regulations and Compliance
The IRS has specific guidelines that must be followed when implementing and reporting split dollar life insurance arrangements. The two primary rulings—Revenue Ruling 64-328 and Revenue Ruling 66-110—provide the framework for determining whether a split dollar plan is taxed under the loan regime or the economic benefit regime.
Failure to comply with these regulations can lead to penalties and back taxes. It’s essential for businesses and employees to work closely with a tax professional to ensure proper reporting and adherence to IRS guidelines.
How to Choose the Right Plan Based on Taxation
When choosing between a collateral assignment or endorsement split dollar plan, taxation should play a key role in the decision-making process. Factors to consider include:
- Taxable Income: Employees in both plans are taxed on the economic benefit they receive, but the structure of the plan may impact how much income is reportable.
- Premium Payments: Employers cannot deduct premium payments in either plan, so it’s important to weigh this cost against the potential benefits.
- Estate Planning: If estate taxes are a concern, using an irrevocable life insurance trust (ILIT) can help shield the policy’s death benefit from estate taxes.
Consulting with a tax advisor can help determine the best plan for your specific needs and minimize potential tax liabilities.
Conclusion
The tax implications of split dollar life insurance plans can be complex, but they are an essential part of the decision-making process. Whether you choose a collateral assignment or endorsement plan, it’s crucial to understand how the economic benefit is taxed and how IRS guidelines affect both employers and employees. Working with a tax professional is highly recommended to ensure compliance with IRS regulations and optimize your tax situation.
Frequently Asked Questions
What is the economic benefit regime in split dollar life insurance plans?
The economic benefit regime taxes the employee on the value of the life insurance protection they receive each year. This is calculated based on IRS tables, such as Table 2001. The economic benefit represents taxable income for the employee. You can learn more about how split dollar plans work in our types of split dollar plans article.
What is the loan regime in split dollar life insurance?
In the loan regime, the premiums paid by the employer are treated as loans to the employee. The employee may have to pay interest on these loans, or interest may be imputed and taxed.
This structure differs from the economic benefit regime, where the employee is taxed on the value of life insurance protection. For more information on plan structures, read about collateral assignment split dollar plans.
Are premiums paid by the employer tax-deductible in split dollar life insurance plans?
No, the premiums paid by the employer in both collateral assignment and endorsement split dollar plans are typically not tax-deductible. These payments are considered part of the employee’s compensation. However, upon the employee’s death, the employer can be reimbursed for the premiums, which is not considered taxable income. Find out more about how these plans work in our endorsement split dollar plan guide.
How does split dollar life insurance affect estate taxes?
If a split dollar life insurance policy is owned by the employee at the time of their death, the death benefit may be included in their taxable estate. To minimize estate taxes, some policyholders set up an irrevocable life insurance trust (ILIT), which can help keep the death benefit out of the taxable estate. For more information, you can explore our guide on using life insurance in estate planning.
What are the gift tax implications of split dollar life insurance plans?
Gift taxes may apply if the employer transfers ownership of the life insurance policy to the employee or their family members. The value of the policy or the economic benefit provided to the employee may need to be reported for gift tax purposes. It’s important to consult a tax professional when structuring a plan to understand the potential gift tax consequences. For more insights, you can review our article on estate and gift tax implications in split dollar life insurance.
