For many business leaders, life insurance is thought of as unidimensional, providing short-term protection against tail risks, such as losing a key employee. 

In many scenarios, however, life insurance can be a more versatile tool, helping to not only protect a business, but also provide benefits to employees that can contribute to a successful retirement, reduce taxes, aid in estate planning and encourage longer company tenures. 

Managing double taxation for C-corporation owners

In forming a C-corporation, the business entity is distinguished from its owner,  which protects the personal assets of the owner and shareholders from the debts and liabilities of the corporation. Because of this division, C-corporation owners face the possibility of double taxation, where profits are taxed at the corporate level, and the business owner is taxed again at the personal level when they receive dividends or take profits as compensation.

In order to partially mitigate the issue of double taxation, business owners may establish a loan regime split dollar strategy. In this arrangement, the business loans the owner money to pay premiums on a life insurance policy, which is not taxed as income. Rather, the business owner is only responsible for paying interest on the loan based on the published Applicable Federal Rates (AFRs). If forgiven, the loan interest is typically tax-deductible for the corporation and is considered taxable income for the business owner. However, the interest payments are generally lower than the taxes that would be incurred if the business owner took the profits as compensation.

Exiting the loan regime split dollar arrangement

Eventually, the loan from the business must be repaid or forgiven. If the loan is forgiven by the business, the owner is no longer required to repay the loan, but must pay income tax on the forgiven amount.

If the policy is max-funded or overfunded, the owner can also withdraw funds to finance the loan repayment or rollout. This approach minimizes the tax implications associated with loan forgiveness, as the loan is repaid rather than forgiven.

Case study: Investment vs. split dollar

Consider a 40-year-old male business owner who is in good health and a 25% personal income tax bracket. Faced with a surplus profit of $14,000 per year for 10 years, he must decide whether he should withdraw profits from his business to invest in a taxable account or take out a split dollar plan.

If the owner takes the $14,000 as compensation and pays 25% in income tax, he is left with $10,500 to invest. Assuming that he invests the money somewhat conservatively, after taxes, he places the funds in an account yielding 4.31%. At retirement (age 66), he would have about $251,000 in the fund, providing him an income of $23,000 from ages 66 to 80, with no residual death benefit.

Were the owner to take the $14,000 as loans through a split dollar arrangement, he could utilize the entire amount without taxes. He pays loan interest back to the business each year but has the loan forgiven at age 65, when he takes a withdrawal from the policy to pay the tax on the loan forgiveness. In this scenario, the owner would have $369,000 of cash value at age 66, yielding $40,000 of tax-free income from ages 66 to 80. The policy would also pay a  residual death benefit of $350,000 to his heirs at age 90.

Mitigating key employee risk while incentivizing retention

It is more challenging than ever for business owners to retain top talent. SHRM estimates that the combined hard and intangible costs of hiring an employee can amount to as much as three- to four-times the salary of the position. Given the costs, many business owners are keen to explore strategies to protect their investments in key employees. 

One such approach utilizes a permanent life insurance policy to combine the benefits of key person insurance and an endorsement split dollar plan. This strategy not only safeguards the business in the event a key employee unexpectedly passes away, but also serves as a powerful retention tool to incentivize the employee to remain with the company. This approach offers businesses an avenue to achieve cost recovery on life insurance premiums while providing a tax deduction when the employee reaches the end of their tenure with the company.

Traditional uses of key person insurance

Key person insurance is commonly used to safeguard a business in case a crucial employee, such as an executive or revenue leader, becomes disabled or dies. The purpose of a key person arrangement is to provide the business with financial resources to maintain business operations, hire an appropriate replacement, and satisfy creditors and clients.

In a typical key person arrangement, a term insurance policy is taken out on the life of the employee. The business acts as both the owner and beneficiary of the policy. 

A business generally opts for term insurance for this policy as it is designed to address key person risk. However, since a term policy only pays out if the insured individual dies, the business is highly unlikely to ever recover the costs of insuring that specific employee.

Using a split dollar plan to improve employee retention

Generally, if an employee is important enough to a business to justify the purchase of key person insurance, the business also has a vested interest in encouraging the employee to remain with the firm. Because of this, it often makes sense for the business to combine the aforementioned key person policy with a traditional split dollar plan to help encourage employee retention. 

In such a scenario, during the employee’s agreed-upon term of service, the business would both own and be the beneficiary of a permanent life insurance policy. However, unlike a traditional key person arrangement, the business would endorse a portion of the death benefit to the employee during his or her working years. 

Should the employee pass away prematurely, his or her heirs would receive the agreed-upon portion of the death benefit tax-free. The company would receive the other part of the death benefit to help mitigate the loss of the employee. 

At the end of the employee’s tenure with the company, the business would transfer the policy to the employee, which could then be used to supplement retirement savings or as an estate planning tool. Were the employee to leave the company prematurely, he or she would not have any right to receive the policy.

Tax considerations and compliance

Throughout the employee’s tenure, he or she would be required to pay taxes on the Reportable Economic Benefit on the portion of the death benefit that he or she “rents” from the company.

Section 409A of the Internal Revenue Code imposes strict rules on nonqualified deferred compensation plans, making it crucial to structure split dollar life insurance plans carefully to avoid costly consequences. One way to avoid running afoul of 409A compliance is to utilize the short-term deferral exception, which allows businesses to transfer the entire life insurance policy to the key employee in one transaction within two and a half months of the end of the calendar year in which the vesting requirement is met.

At the time of the policy transfer, the employee is required to pay taxes on the fair market value of the policy. Businesses can structure the plan to allow the employee to take a withdrawal from the policy to cover the tax liability. The business can also claim a corresponding tax deduction based on the same fair market value, providing them with a financial benefit for offering the incentive to their key employees.