This Step Can Prevent an Income Planning Nightmare for Wealthy Clients

What You Need to Know

Employers may use split-dollar to fund retirement benefits for highly paid executives.
One popular strategy involves policy loans.
If the IRS thinks disbursements are compensation, rather than loans, an executive client could face a nasty tax surprise.

One of Jack Elder’s favorite income planning ideas is checking to see whether one particular arrangement is working properly.

Elder, senior director of advanced sales at CBS Brokerage, likes to ask clients who are highly paid executives whether they have nonqualified deferred compensation arrangements. He then looks to see whether the NQDC retirement benefits are funded with split-dollar life insurance arrangements.

If a client has an NQDC plan funded with a split-dollar life insurance arrangement, Elder recommends an annual auditing process.

“Split-dollar is a powerful tool that can help the right client meet specific financial goals,” Elder said in an email interview last week. “Oftentimes, some form of split-dollar is the only way for a client to reach their objective tax efficiently.”

But, at the same time, Elder said, financial professionals have to help clients make sure the arrangements are operating properly.

“The tax consequences of a failed split-dollar plan can be severe,” Elder warned.

What It Means

One way to please clients is to help them make a lot of money.

Another way is to keep the IRS from sending them giant, unexpected tax bills.

Split-Dollar Arrangements

A split-dollar arrangement gives two or more parties a way to share costs, other responsibilities and benefits involved with owning a life insurance policy.

The arrangements are shaped by guidance from federal agencies over the years, including the preamble to a split-dollar arrangement final rule that the Internal Revenue Service released in 2003.

For retirement income planners, the arrangements that come up most often might be those used by employers to provide adequate retirement benefits for highly paid employees, through use of split-dollar arrangements to fund nonqualified deferred compensation plans.

Employers could also use split-dollar arrangements to provide ordinary life insurance benefits for key employees.

Estate planning clients could use private split-dollar arrangements to pay for trust-owned life insurance policies, to help children and other loved ones cope with estate tax and gift tax rules.

The parties can choose between an “economic benefit regime,” which might involve an employer or wealthy client paying for a life insurance policy, and another party receiving the death benefit protection, or a “loan regime,” which involves the party that owns the policy cash value borrowing the cash to pay the premiums from another party.

Split-Dollar Audits

When financial advisors perform split-dollar arrangement audits, they review the age of the arrangement, the specific accounting regimes used to set up the arrangement and how well the parties have met the requirements associated with the tax regime chosen.

The Thinking

Here are answers that Elder gave to 10 questions about split-dollar arrangement audits. The interview has been condensed and edited.

THINKADVISOR: How could a split-dollar arrangement run into trouble?

JACK ELDER: For example, consider this basic fact pattern: The employer lends $100,000 to a key executive for 10 years, but they never account for the $100,000 disbursements as loans — no note agreement or interest accounted for.

If the executive’s tax returns are audited, the IRS could reach the very logical conclusion that those $100,000 disbursements are compensation, not loans. You could have income taxes, plus underreporting penalties, plus interest.

A similar result could occur in the wealth transfer context.

Assume the family and trustee didn’t treat the $100,000 advances as loans — no documentation and no accounting. If the estate tax return is audited, the $100,000 annually look like gifts.

What could failure to audit a split-dollar arrangement mean for a client’s tax bills?

Those gifts would then reduce the family’s estate tax exemption on a dollar-for-dollar basis, potentially exposing the family to a 40% estate tax rate.

What background do people need to perform split-dollar plan audits?

Doing an audit doesn’t require specific credentials or education, per se, but providing the remedies might.

To audit split-dollar, you must be very experienced with split-dollar.