If you’re a high-net-worth individual who desires to exclude the net death benefits of an insurance policy from your estate while still having access to the policy’s cash value to fund personal retirement income needs, consider setting up a private split-dollar insurance program.
Here are the basics.
In a private split-dollar arrangement, the ownership rights in the life insurance policy will be split between two parties — a subject addressed in IRS Private Letter Ruling 9636033. In that ruling, a taxpayer created an irrevocable trust naming his brother as trustee. The taxpayer retained no powers or authority over the trust property. Furthermore, the trust agreement specifically precluded him and his wife from acting as trustees.
The trust provided that, during the lifetime of the taxpayer, the net income and principal of the trust were to be paid, at the discretion of the trustee, to the taxpayer’s children. At the taxpayer’s death, the trustee could, at his discretion, distribute income and principal to the taxpayer’s wife and his issue. The trust was to terminate at the later of either the death of the taxpayer’s wife or when all the taxpayer’s children reached the age of 25.
Initially the taxpayer contributed cash to the trust, which was used to purchase a life insurance policy on his life. The trustee then entered into a collateral assignment split-dollar agreement with the taxpayer’s wife. Under the agreement, the trustee was designated as the owner of the policy and was to pay the cost of the pure life insurance coverage, as determined by various published insurance rates and tables.
From her separate property, the taxpayer’s wife was to pay the remaining portion of the annual premium, which would be added to the cash value or investment component of the policy.
To secure the wife’s interest in the policy, the trustee assigned certain rights to her and agreed to execute a promissory note evidencing the trust’s indebtedness to her. Under the agreement, the rights assigned to the taxpayer’s wife were: (1) the right to receive a portion of the proceeds payable on the taxpayer’s death equal to the wife’s interest under the split-dollar agreement; (2) the right to receive the cash value of the policy, if the policy was surrendered by the trustee, less any outstanding loans made from the policy to her; and (3) the sole right to borrow against the policy.
The IRS in its ruling determined that the payment of the policy premiums by the trustee and the taxpayer’s wife pursuant to the split-dollar agreement would not result in a gift to the trust by the taxpayer’s wife, and the insurance proceeds payable to the trust would not be included in the taxpayer’s gross estate.
The benefits of this split-dollar arrangement are:
1. The taxpayer’s wife has access to the policy’s cash value during her lifetime through tax-free withdrawals or loans. As long as the taxpayer and his wife remain married, the taxpayer, indirectly through his wife, may use the policy’s cash value to fund his personal retirement income needs.
2. At the death of the taxpayer, the net death benefit of the policy will not be included in his estate and may be used to benefit his wife and children.
3. The amount of the gift to the trust by the taxpayer is small, so only a correspondingly small portion of his annual gift tax exclusion ($10,000 per year per person) is used. Use of the annual gift tax exclusion does not reduce the applicable federal credit ($650,000 in 1999) available to each person.
There are, however, some disadvantages of a private split-dollar arrangement. Consider the following:
- If the parties to the arrangement divorce, the noninsured wife has, as an asset, the cash value of the policy, which may or may not, depending on state law, be equitably distributed between them.
- If the noninsured wife dies before the insured does, the policy’s cash value will be an asset in her estate. This asset must be considered when planning the noninsured wife’s estate. In particular, her estate-planning documents must restrict the insured’s (her husband) rights with respect to such cash value. Otherwise, the policy’s death benefits might be included in his estate.
While you can’t rely on Private Letter Rulings since they are relevant only to the specific facts upon which the ruling is based, the ruling discussed above, and other subsequent rulings, provide considerable comfort that private split-dollar arrangements will be honored by the IRS.
John Houston is a shareholder and John Hartzell is an associate attorney with Houston Harbaugh, a Pittsburgh-based law firm. Reach Houston by e-mail at [email protected] and Hartzell at [email protected].
