Competitive executive compensation planning in non-profit organizations is challenging. State and federal laws as well as public policy often limit the opportunities to offer compensation packages similar to those commonly offered in for-profit companies. This often skews the talent stream in their favor. The use of split-dollar life insurance as an executive benefit has become popular to provide a bridge over the compensation gap. It’s been used as a valuable employee benefit since the 1940s. Then and now, it’s used to recruit, retain and reward key employees with a tax-arbitraged plan. The arbitrage is using the nonprofit’s untaxed dollars to provide tax-advantaged benefits to key executives. Depending on the plan design, it can provide retirement benefits to the employee and golden handcuffs and cost recovery to the employer. Although this article is focused on executive benefit planning in nonprofits, split dollar as an executive benefit may also be effective in non-publicly traded, for-profit businesses. A split-dollar life insurance plan should always be considered when one party needs or wants a benefit, and the other party has the financial ability to pay for it.
Split-Dollar Plan Regulations
Prior to 2003, it was the wild west for split-dollar planning, meaning that many designs were developed that were eventually seen as abusive.1 The split-dollar regulations were enacted in 2003 to provide uniformity and a level playing field in split-dollar planning.2 The result of the implementation of the rules is to bring certainty to split-dollar planning and limit challenges when the rules and the spirit of the rules are followed.
The regulations provide two planning regimes: (1) economic benefit; and (2) loan. Both have beneficial applications in executive benefit planning. Because there can only be one title owner of a life insurance policy, the owner is often determined by the ownership desired on termination of the arrangement. Policy ownership is key to the type of plan chosen. With the endorsement method, the title owner of the policy owns the cash value and endorses the term portion to the other party. With the collateral assignment method, the title owner owns the term portion of the policy and collaterally assigns the cash value portion to the other party.
Once the ownership method is chosen, the regime must be determined. The economic benefit regime applies to both equity and non-equity split-dollar arrangements. Non-equity split dollar is used for endorsement method plans. The policy title owner endorses the term portion to the party receiving the benefit. Equity split dollar also uses the endorsement method. The difference is that the policy equity, above premiums paid, inures to the party receiving the benefit without any tax consequences. This type of plan design is no longer used because the regulations imposed tax on the policy growth.
Loan regime applies to collateral assignment method plans. The policy title owner is the party receiving the benefit. The party providing the benefit makes loans of the premium amounts to the benefited party. The prevailing applicable federal rate is used to calculate the loan interest unless a below market rate is used, in which case, interest will be imputed by Internal Revenue Code Section 7872. Current low interest rates favor the use of loan regime arrangements. To lock in the low rates, a single loan for a single premium policy may be particularly attractive.
Taxation of the Plan Regimes
When using an economic benefit regime, non-equity plan for an executive benefit, the employer pays the full premium. The employee is taxed on the economic benefit of the insurance protection received using the Table 2001 rates. The premiums paid by the employer generally aren’t deductible; however, the death proceeds are generally received tax free.3
When using the loan regime, the employee is the policy title owner, and the employer makes premium loans to the employee. The employee isn’t taxed on the loans unless they’re forgiven. The employer pays the interest on the premium loans, which is taxed to the employee as a compensation item.4 The employee isn’t taxed on the annual policy cash value growth, making the loan regime an alternative to the old equity split-dollar planning. The employer can’t deduct the loans made and if the plan is in a for-profit, must include the interest payments in taxable income. When the loans are repaid, neither nonprofits nor for-profits are taxed on the amounts.5
Famous LSDP Recovery Plans
Loan split-dollar plans (LSDPs) with cost recovery have become popular golden handcuffs for celebrity sports coaches. One of the most well-known cases is a benefit provided by the University of Michigan to its Wolverines football coach, Jim Harbaugh. To retain and reward Coach Harbaugh, the school adopted an LSDP to provide the coach with future tax-free income, while creating a golden handcuffs benefit and recovery of the plan costs. In this LSDP:
• The employee is the applicant and title owner of the life insurance policy.
• The employer loans the premiums to the employee. In this case, the loans totaled $14 million.
• The employee has no out-of-pocket costs and simply includes the loan interest imputed by Section 7872 in taxable income.
• The premium loans will be repaid to the employer from the tax-free death benefit at the employee’s death or from the policy cash value if the arrangement is terminated sooner. This is the cost recovery feature of the plan.
• If the employee ceases to perform the agreed-on duties, the employer stops making premium loans. This is the golden handcuffs feature of the plan.
• In retirement, the employee enjoys tax-free income through policy withdrawals and/or policy loans.
Due to the positive publicity surrounding the Coach Harbaugh LSDP, other schools have followed suit. Clemson University included a similar benefit in Coach Dabo Swinney’s latest contract extension. Louisiana State University also rewarded its winning coach, Ed Orgeron, with an LSDP. Recently, the University of South Carolina entered into a split-dollar arrangement with its women’s head basketball coach, Dawn Staley. It required Coach Staley to remain as the head coach for five years to receive the benefit.
Not-So-Famous LSDPs
A number of educational institutions have adopted LSDPs with cost recovery. In a recent case, a university wanted to provide an additional benefit to its president. It desired to retain her and reward her successes at the school. Because executive compensation in nonprofits can be statutorily and politically challenging, in this case, an LSDP was viewed as a beneficial way to meet the needs of both the university and its president. Here, as in many other cases, a critical component of the LSDP is the fully secured cost recovery feature.
LSDPs have also gained popularity in credit unions (CUs). One plan in a Texas CU was challenged by a member, claiming that the CU was making loans that it wouldn’t make to members. This CU had made loans of $36 million to its top executives to lock in these talented employees for the final 10-to-15 years of their careers. In dismissing the challenge to the benefit plan, the CU noted that executive loans are permitted under the National Credit Union Administration regulations6 and that the plan agreements were carefully drafted to protect the CU under all potential circumstances. The CU concluded that while a loan is involved, this was nothing more than a retirement plan, much like a pension plan, and the CU certainly wouldn’t offer a non-employee a pension plan.
An Alternative to DBO Plans
A death benefit only (DBO) plan provides a benefit to the employee’s designated recipient on the employee’s death. These plans are often used to provide for the employee’s family and for estate-planning needs. Because the DBO is a form of non-qualified deferred compensation, when the benefit is paid on death, it’s included in ordinary income for tax purposes as income in respect of a decedent.7
Economic benefit endorsement split dollar is a tax-advantaged possible alternative to a taxable DBO plan. In this plan, the employer is the policy owner and is entitled to the policy cash value. The employer endorses the term insurance portion of the policy to the employee, who’s responsible for the cost of the economic benefit of the coverage received, using the Table 2001 rates. Typically, the employer pays the premiums. The employee has no out-of-pocket costs but is taxed on the Table 2001 economic benefit annually. Although the premiums paid for the employer’s interest in the policy aren’t deductible, the death proceeds are received tax free.8 The value of using an economic benefit endorsement plan, when compared to a DBO, is the difference between the relatively small economic benefit cost of the term insurance coverage and the full benefit being taxed at death.
Nuts and Bolts of Planning
Choosing the appropriate life insurance product is important to the success of the plan. The choice depends on the plan design. Generally, the product should have enough cash value growth for lifetime access and sufficient death benefit for plan cost recovery. For this reason, permanent products, especially whole life and properly funded universal and indexed universal life products, are commonly used.
There are several additional IRC sections the planner needs to be aware of when designing an LSDP. Fortunately, the Internal Revenue Service has issued Notice 2007-34, which provides that IRC Section 409A doesn’t apply because these plans aren’t non-qualified deferred compensation. The Pension Protection Act of 2009 added Section 101(j) to the IRC. For the employer to retain the tax-free status of insurance it owns on employees, it must provide them with written notice of the coverage and get their consent to having the employer insure them. Failure to obtain the notice and consent makes the policy death benefit taxable above premiums paid by the employer. This provision was enacted in response to plans adopted by several of the country’s largest employers that purchased policies on many employees as a profit center. The employer received the tax-free death benefit while the employee’s family received nothing.
Although LSDPs aren’t subject to Section 409A regulation, care must be taken to comply with the Employee Retirement Income Security Act (ERISA) Top Hat rules. Top Hat plans are exempt from the ERISA participation, vesting, reporting and fiduciary requirements. To qualify for the exemption, the benefit must only be offered to a select group of management or highly compensated employees. The Department of Labor has concluded that the Top Hat exemption makes sense, because these individuals, by virtue of their position or compensation level, are able to affect or substantially influence the design and operation of the arrangement. They don’t need the substantive rights of Title 1 of ERISA.9
The Tax Cuts and Jobs Act of 2017 imposed a 21% excise tax on compensation exceeding $1 million.10 An LSDP may help mitigate the impact of this tax on executives by reducing the amount of compensation to the imputed loan interest, while providing a larger tax-free benefit.
All tax-exempt organizations are required to file a Form 990 annually with the IRS. They must report all compensation for officers and key employees on Schedule J. With LSDPs, only the imputed interest cost is reported. It’s important to note on Form 990 that the plan is designed for the recovery of the plan costs. This explanation may help prevent misunderstandings about the loans made.
Before adopting an LSDP in a nonprofit, the situs state’s statutes should be reviewed. A number of states prohibit loans to executives of nonprofits. Almost all of these states, however, have exceptions permitting split-dollar loans.
A final note on the applicability of LSDPs. Their usefulness in executive compensation planning isn’t limited to nonprofits. The benefit may be used in for-profits as well. To design a viable LSDP in a for-profit, a tax analysis should be conducted because the employer’s after-tax dollars will be used to pay premiums. If the economics work, an LSDP may provide an excellent way to recruit, retain and reward top talent. Of course, the Sarbanes Oxley Act of 2002 curtailed the use of LSDPs in publicly traded companies by prohibiting personal loans to directors and officers.
Endnotes
1. These designs include reverse split dollar, Internal Revenue Service Notice 2002-59; equity split dollar, Treasury Regulations Section 1.61-22; and economic benefit rate manipulation, IRS Notice 2002-8.
2. Treas. Regs. Section 1.61-22 applies to all shared benefit arrangements for life insurance entered into after Sept. 17, 2003 and to pre-Sept. 17 arrangements if materially modified.
3. Internal Revenue Code Section 101(a). Beware, however, of the transfer-for-value rule of IRC Section 101(a)(2).
4. Avoid below market interest rate arrangements to prevent tax disclosure reporting and the chance of causing original issue discount problems for term loans.
5. Section 101.
6. Code of Federal Regulations, Title 12, Chapter VII.
7. IRC Section 691.
8. Section 101(a).
9. Department of Labor Adv. Op. 90-144 (May 8, 1990).
10. IRC Section 4960.