Many wealthy individuals consider purchasing a life insurance policy as part of their overall estate plan. In order to avoid estate inclusion (which could result in estate taxation) [1] of the death benefit, the life insurance may be purchased in an irrevocable life insurance trust (ILIT).
However, the value of the gifts that would need to be made to the ILIT in order to pay the premiums for the life insurance death benefit can exceed the individual’s available annual gift tax exclusions [2] and/or remaining lifetime gift tax exemption [1] amounts. Individuals in such a situation may believe that their only options are to either purchase a smaller life insurance policy, which may not meet their estate planning needs, or pay gift tax on funds gifted to the ILIT in order to pay the premiums. There is, however, another option to consider: A private split-dollar arrangement may allow individuals to fund the appropriate amount of ILIT-owned life insurance while minimizing the current gift tax consequences.
A Premium-Sharing Arrangement
A private split-dollar arrangement is not a special type of life insurance policy but, rather, a premium-sharing arrangement entered into between private parties. In a private split-dollar arrangement, one party pays most of the life insurance premiums in exchange for an interest in the policy equal to its cash value. The other party pays a relatively smaller cost for death benefit protection.
MAXIMIZING DEATH BENEFIT
The insured should discuss with his or her legal and tax advisors whether or not a private split-dollar arrangement is appropriate given his or her overall estate plan. If so, the insured, with the help of an attorney, establishes an ILIT. Typically, the insured and/or insured’s spouse enters into a private split-dollar arrangement with the ILIT. The ILIT will be the owner and beneficiary of the life insurance policy on the insured, but most, if not all, of the premium payments will be made by the insured and/or the insured’s spouse — known as the premium payor. In exchange for paying all or most of the life insurance premiums, the premium payor will be assigned an interest in the life insurance policy equal to the policy’s cash value. [3] Any life insurance death benefit above the policy’s cash value belongs to the ILIT. Since the ILIT benefits from the death benefit, the ILIT must pay for the cost of the life insurance protection, which is measured by the Reportable Economic Benefit (REB). [4] The REB cost is typically much less than the initial life insurance premium; however, it does increase annually.
Because the premium payments made by the premium payor are pursuant to the split-dollar arrangement, they are not gifts to the ILIT. In some cases, however, the insured may wish to make gifts to the ILIT so that the ILIT has the liquidity needed to pay the REB cost.
Upon the death of the insured, the private split-dollar arrangement will terminate and the premium payor will receive death benefit proceeds in an amount equal to the cash value. If the premium payor is also the insured, this amount will be includable in his or her estate for estate tax purposes. The ILIT’s portion of the death benefit may pass estate tax-free to the ILIT. The trustee may use the remaining death benefit proceeds to either buy assets from, or loan money to, the executor of the insured’s estate. The executor may then use the cash to pay any estate taxes.
Private split-dollar arrangements are governed by the split-dollar final regulations and modeled on two private letter rulings (PLRs). [5] They take three basic formats:
Single life private split-dollar — married insured (PLR 9636033)
Single life private split-dollar — single insured
Second-to-die private split-dollar (PLR 9745019)
Single Life Private Split-Dollar — Married Insured
1. Creation of ILIT and Gifts
The insured, with the help of an attorney, creates an ILIT to purchase and own life insurance on his or her life. The insured gifts funds to the ILIT. The gifts may be gift tax-free depending on the insured’s ability to use annual exclusion gifts [2] and/or lifetime gift tax exemption1 amounts.
2. Premiums and Collateral Assignment
The non-insured spouse enters into a private split-dollar agreement with the ILIT trustee and agrees to pay all or most of the premiums. In return for premium payments, the spouse, as premium payor, is collaterally assigned an interest in the policy equal to the entire cash value. As assignee, the spouse can access the policy’s available cash value. The ILIT trustee agrees to pay premiums equal to the REB.
3. Purchase Life Insurance
The ILIT trustee purchases a life insurance policy on the insured’s life. The ILIT becomes the owner and beneficiary of the policy.
4. Death of Insured
At the insured’s death, an amount equal to the cash value will be paid to the spouse
pursuant to the split-dollar agreement. The remaining death benefit will be paid to
the ILIT free from estate1 and income tax [6] and may be distributed to the ILIT
beneficiaries.
Single Life Private Split-Dollar — Single Insured
1. Creation of ILIT and Gifts
The insured, with the help of an attorney, creates an ILIT to purchase and own life
insurance on his or her life. The insured gifts funds to the ILIT. The gifts may be gift
tax-free depending on the insured’s ability to use annual exclusion gifts [2] and/or
lifetime gift tax exemption [1] amounts.
2. Premiums and Collateral Assignment
The insured enters into a private split-dollar agreement with the ILIT trustee and
agrees to pay all or most of the premiums. In return for premium payments, the
insured, as premium payor, is given a restricted collateral assignment over the
entire cash value. The restricted collateral assignment limits the insured’s right over
the policy to reimbursement upon the termination of the private split-dollar
arrangement, with no current access to the cash value. The ILIT trustee agrees to
pay premiums equal to the REB.
3. Purchase Life Insurance
The ILIT trustee purchases a life insurance policy on the insured’s life. The ILIT
becomes the owner and beneficiary of the policy.
4. Death of Insured
At the insured’s death, an amount equal to the cash value will be paid to the
insured’s estate pursuant to the split-dollar agreement. The remaining death
benefit will be paid to the ILIT free from estate [1] and income tax [6] and may be
distributed to the ILIT beneficiaries.
Second-to-Die Private Split-Dollar
1. Creation of ILIT and Gifts
The insureds, with the help of an attorney, create an ILIT to purchase and own life
insurance on their joint lives. The insureds gift funds to the ILIT. The gifts may be
gift tax free depending on the insureds’ ability to use annual exclusion gifts [2]
and/or lifetime gift tax exemption [1] amounts.
2. Premiums and Collateral Assignment
The insureds enter into a private split-dollar agreement with the ILIT trustee and
agree to pay all or most of the premiums. In return for premium payments, the
insureds, as premium payors, are given a restricted collateral assignment over the
entire cash value. The restricted collateral assignment limits the insureds’ right
over the policy to reimbursement upon the termination of the private split-dollar
arrangement, with no current access to the cash value. The ILIT trustee agrees to
pay premiums equal to the REB.
3. Purchase Life Insurance
The ILIT trustee purchases a life insurance policy on the insureds’ lives. The ILIT
becomes the owner and beneficiary of the policy.
4. Death of Insured
After the death of both insureds, an amount equal to the cash value will be paid to
the estate of the last insured to die. The remaining death benefit will be paid to the
ILIT free from estate [1] and income tax [6] and may be distributed to the ILIT
beneficiaries.
ADVANTAGES INCLUDE:
An amount gifted to an ILIT may be less than the current life insurance premium.
Gifts to the ILIT may qualify for an annual gift tax exclusion. [2]
A private split-dollar arrangement generally requires no IRS pre-approval.
If the premium payor is not an insured, such as where a single life policy is used for a married couple and the non-insured spouse pays the premiums, the premium-paying spouse may have tax-free [7] access to the cash value through the collateral assignment on the life insurance policy (as long as his or her separate property is used to fund premiums).
The ILIT can purchase the necessary death benefit needed for estate liquidity while minimizing the gift tax cost of funding the premiums.
DISADVANTAGES INCLUDE:
Payment of the REB cost by the ILIT may be taxable to the premium payor unless the ILIT is drafted as an intentionally defective grantor trust for income tax purposes.
Payment of the REB cost by the ILIT does not give the ILIT cost basis in the policy and does not reduce the amount owed to the premium payor.
If the premium payor is also the insured, such as where a single individual enters into a private split-dollar arrangement with his or her ILIT, access to the life insurance policy’s cash value could cause estate inclusion of the entire death benefit. Therefore, a restricted collateral assignment should be used and the premium payor should have no access to the cash value. The cash value will only be paid to the premium payor upon termination of the private split-dollar agreement.
The benefit of the life insurance policy equal to its cash value is includible in the premium payor’s estate for estate tax purposes.
At termination of the private split-dollar arrangement, the ILIT should give an amount equal to the cash value to the premium payor. If policy cash values are used to repay the collateral assignee, then, without proper planning, the policy will likely lapse if rollout occurs during the insured’s lifetime.
The REB cost does increase each year and must be paid even if the life insurance policy does not require a premium payment to maintain coverage.
Private Split-Dollar Key Elements
Life insurance premiums and benefits are divided among private parties.
The premium payor pays all or most of the premium in exchange for an interest in the policy equal to the cash value.
The ILIT pays a relatively small portion of the premium (the economic benefit amount) to receive a portion of the life insurance death benefit.
The insured’s gift to the ILIT may be as little as the economic benefit amount.
At the insured’s death, the premium payor receives a life insurance death benefit equal to the cash value of the policy.
At the insured’s death, the ILIT receives the life insurance death benefit in excess of the policy’s cash value.
[1] According to the Tax Cuts and Jobs Act of 2017, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts are all $10,000,000 per person (indexed for inflation, effective for tax years after 2011); the maximum estate, gift, and GST tax rates are 40%. In 2026, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts are scheduled to revert to $5,000,000 per person (indexed for inflation for tax years after 2011).
[2] As of January 1, 2023, the annual gift tax exclusion is $17,000 per donee (indexed for inflation).
[3] The premium payor must be assigned the entire cash value to qualify under the split-dollar economic benefit regime as defined in Treas. Reg. Sec. 1.61-22(d)(1) pursuant to the special rule in Treas. Reg. Sec. 1.61-22(c)(1)(ii)(A)(2). The split-dollar regulations provide that cash value is determined disregarding surrender charges or other similar charges or reductions and no artifice or device may be used to understate the cash value. The client’s independent tax advisor should be consulted for help determining the appropriate measure of the cash value. If the premium payer is an insured, then a restricted collateral assignment should be used to avoid estate inclusion. This gives the collateral assignment only the right to be repaid in the event the arrangement is terminated or upon the death of the insured(s) and prevents the insured(s) from having any other rights in the policy, such as the right to borrow or withdraw from the policy cash value.
[4] Treas. Reg. Sec. 1.61-22(d)(3)(ii) reserved the issue of the cost of current life insurance protection (i.e. REB) for future guidance. Until such guidance is issued, Notice 2002-8 states that taxpayers may continue to use the insurance carrier’s published one-year term rates or the Table 2001 rates for arrangements entered into prior to January 28, 2002. For arrangements entered into after that date, taxpayers are generally limited to the Table 2001 rates.
[5] Private letter rulings cannot be cited as precedence and are only binding upon the Internal Revenue Service as to the individuals and facts specifically set forth in the rulings.
[6] For federal income tax purposes, life insurance death benefits are generally received tax free by beneficiaries pursuant to IRC Sec. 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to, the transfer of a life insurance policy for valuable consideration, unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e., the “transfer-for-value rule”); arrangements that lack an insurable interest based on state law; and an employer-owned policy, unless the policy qualifies for an exception under IRC Sec. 101(j).
[7] For federal income tax purposes, tax-free income assumes, among other things, that (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) the policy remains in force until death; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC Secs. 72, 7702(f)(7)(B), 7702A. Any policy withdrawals, loans, and loan interest will reduce policy values and may reduce benefits.
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