In a competitive business landscape, attracting and, more importantly, retaining top-tier talent is a must for companies looking to secure their long-term success. One powerful tool that stands out is a split-dollar arrangement, which can be used as a “golden handcuff.” This approach provides a unique and attractive incentive for key employees and strengthens the employer-employee relationship by aligning their financial interests.
In this article, we'll delve into the intricacies of split-dollar arrangements, exploring how they can be a game-changer for advisors seeking effective ways to help their clients retain their most valuable assets – their talented workforce.
A corporate split-dollar arrangement is a strategy where the costs and benefits of a life insurance policy are shared between an employer and an employee. In this case, it’s used for executive compensation and retention.
Split-dollar arrangements are typically split into two tax regimes: economic benefit and loan regimes. Each arrangement is subject to different rules and regulations, and which will be used ultimately depends on who owns the policy.
With the economic benefit regime, the business owns the policy, and with loan regime, the employee owns the policy. This article will focus mainly on the economic benefit regime, also called an “endorsement split-dollar.” In nearly all cases, a permanent life insurance policy will be used to provide the benefit.
In an endorsement split-dollar arrangement, the company owns the life insurance policy and maintains control over the cash value during the employee's working years. It also retains ownership of the death benefit but will endorse a portion to the employee to benefit their heirs. The business can endorse any amount of the death benefit to the employee; however, it must retain at least the greater of the premiums paid into the policy or its cash value.
The employee must recognize and pay tax on the economic benefit charge each year, which is considered imputed income based on the death benefit amount endorsed to the employee. These charges are calculated using the IRS Table 2001 rates or, if available, the carrier’s alternative term rates. This must be paid annually as long as the arrangement is in place. Put simply, the employee is essentially renting the death benefit from the business.
One of the key advantages of this golden handcuff strategy is the potential for cash value accumulation within the life insurance policy. As the policy matures, it accrues cash value tax-deferred, presenting a valuable financial asset.
Some arrangements may incorporate an early cash value rider into the policy to expedite the growth of the policy's cash value, allowing for quicker accumulation in the earlier years. Notably, the cash value is recognized as a corporate asset, a factor that can be leveraged to secure credit lines for the company.
A pivotal component of the golden handcuff strategy includes a vesting period within the split-dollar arrangement, during which the employee must remain with the company to unlock the benefits of the life insurance policy.
Should an employee decide to depart prematurely, they will likely have to forfeit all benefits associated with the policy. In that case, the business can surrender or keep the contract in force. Vesting periods are thoughtfully designed, often aligning with retirement age, typically around 65, reinforcing the long-term commitment sought by the employer.
Notably, a split-dollar arrangement is a legally binding contract, and even in the face of business transitions such as a sale or closure, the company is obligated to honor the terms of the agreement.
When the split-dollar arrangement is fulfilled, and the employee has satisfied their service requirement, the company is obligated to transfer ownership of the policy to the employee. However, this transition from company-held policy to individual ownership isn't without its intricacies. Traditional deferred compensation plans may trigger the stringent IRS 409A regulations, necessitating strict annual reporting compliance by the company.
However, these regulations can be avoided if the employee is given the policy in one single transaction and the business provides no ongoing benefit. So long as the policy is transferred within 2 ½ months of the end of the calendar year in which the service requirement is satisfied, 409A compliance is avoided altogether.
This ownership transfer will keep the policy in force while giving the employee an immediate asset. However, it’s important to note that the employee must pay taxes on the policy's fair market value at the time of transfer. To manage this tax liability, the insured can withdraw the funds from the policy’s cash value to cover the expenses. Consequently, the business will enjoy an income tax deduction based on the same fair market value amount. Going forward, the (now former) employee can access the policy’s cash value income tax-free and provide a meaningful benefit to their heirs should they pass away prematurely.
Split-dollar arrangements are complex legal agreements, but advisors can utilize a tech-enabled brokerage, like Modern Life, to make the process of getting life insurance for their clients as simple and pain-free as possible. Here’s a closer look at how we can help your firm grow its life insurance business:
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