When Split Dollar Agrement Makes Cents
There is a lot of talk running around social media about split dollar agreements (SDA) which means there are a lot of misconceptions. Here is what I think you should know about a SDA.
A SDA in brief is a way for employers to compensate an employee with little to no risk and no loss of money. For the employee it is a way to get more benefit and money at a very small cost.
If you represent a company that will outlast the employee (the company doesn’t close if the employee leaves) or if you are an employee looking for more benefits keep reading. If you are an entrepreneur skip to the bottom and I’ll give you a secret to tax free money.
“If you are an entrepreneur skip to the bottom and I’ll give you a secret to tax free money”
So what is a SDA? A split dollar agreement is simply that, an agreement. A legal document (you need a lawyer) stating clearly how an employee will be compensated, when they will take ownership of that compensation, performance requirements, and how the agreement will be funded. There is no limit (for all practical purposes) as to what the requirements can be or what the compensation can be. The funding vehicle can also be diverse. It can be funded with life insurance (the most common), company shares, stock portfolio, or any other thing with financial value really. Again, I am not a lawyer so please consult a competent attorney for specifics in your area.
Here is an example and I’ll try to keep is simple (a difficulty because there are so many different ways to do this so talk to a good lawyer). Company Inc. wishes to retain a Rachel, a top manager at their office. Instead of just increasing her salary (directly resulting in a higher tax burden) they offer to fund a life insurance policy on her behalf. They would be the owner of that policy for 10 years. Rachel would be the life the policy is based on and she would get to pick the beneficiaries. Company Inc. would fund the policy with $100,000 each year for 7 years. At the end of 10 years Rachel would take ownership of the policy. She then would take a loan or withdraw from the cash value of the life insurance to pay back the $700k the company paid (sometimes the company gets interest back as well). Because there was so much money going in for the first 7 years the cash value grew to much more than $700k. Lets assume its $k currently, growing by $50,000 each year. After paying back the company, Rachel would have a life policy that pays her, tax free, for the rest of her life or she has a wonderful Long term care policy (it’s a free rider) or a great boost to her estate when she passes.
Tax Responsibility
There are some tax burdens for Rachel through all this. The amazing thing though, is that Company Inc. can give Rachel a bonus (a write off) to cover the added tax burden throughout this whole process. Make sure its in the agreement! She would be responsible to report as compensation A)any part of the cash value she can access B) the death benefit she could receive C) any part of the payment considered a loan and the ensuing interest. Before you think that that makes it unattractive to her, I can tell you that the end result is that she will end up with more compensation for very little cost. I recommend digging into this further at Cornell Law’s website, specifically section (d).
If I told you, I would give you a dollar but you had to pay $.25 you would take it hands down, every day and ask for more. That is what this is like for the employee.
For the employer it is even better. They can give an employee a great benefit, give themselves a tax write off, recover all expenses, and even make some interest if they want.
A SPA can be a great tool for companies that need to offer more than just money to an employee. It can be a way of ensuring that top people stick around, feel valued, and have a say in their compensation. In the end this is a legal agreement that is part of the employee/employer relationship and can be real benefit to all parties.
I promised that I would give entrepreneurs or small business owners a tip on how to get tax free money from their company. Now remember I am not a CPA, CFP or Tax lawyer. This is simply an encouragement to focus your research.
That being said, if you file as an S-corp (either as an LLC taxed as an S-corp or an actual S-corp) you can give yourself money from the company that is not taxable income. Look into “distribution of basis”. Find a good CPA or CFP that understands that and you will be able to skip the whole SDA and just fund a life insurance policy using your new tax-free money.
If you would like more information about using life insurance to fund an SDA or using it as an asset for yourself or your company reach out through the link below.