Have you accidentally created a split dollar life insurance arrangement?
TAX BLOG |
Businesses normally know when they have created a split dollar life insurance arrangement. However, sometimes these arrangements happen accidentally. When a company buys a life insurance policy on the life of an employee, but allows the employee to name another person as beneficiary (usually a spouse or other family member of the employee), the arrangement is a split dollar life insurance arrangement. In most cases, a company will have intentionally created a split dollar arrangement at the time it bought the policy. However, sometimes split dollar arrangements happen accidently.
For example, a company may have bought a key person policy on an executive’s life, but now the company is well established and no longer needs the death benefit, so it decides to change the beneficiary from the company to the executive’s spouse. This simple change in beneficiary creates a split dollar life insurance arrangement. We have seen situations where this has happened, and the tax result is very bad.
Why does it matter? It matters because while historically death benefits received from a company-owned life insurance policy were tax-free to the employee’s beneficiary that is no longer the case unless the company takes certain steps to ensure that income tax-free treatment.
In the case of a split dollar arrangement, depending on the particular facts and when the split dollar arrangement was established, the value of the current life insurance protection must be reported annually as compensation to the employee (subject to tax withholding) or the employee must pay (or reimburse the employer) that portion of the premium. By doing so, the death benefits can be entirely tax-free to the beneficiary. Otherwise, all or a portion of the death benefit may be taxable to the recipient.
As mentioned above, normally the company is aware that it created a split dollar arrangement requiring annual reporting of income to the employee. However, when the company originally purchased the life insurance policy for another purpose such as a key person life insurance policy securing a loan or as a funding vehicle for a deferred compensation plan and then it decides to repurpose the policy that is where there is a risk.
Whether the company created the split dollar arrangement intentionally or accidently it is critical that the company carry through with the employee payment or income inclusion requirements applicable to these arrangements.