Split-dollar plans are a sophisticated financial tool used to provide life insurance benefits to key executives while allowing organizations to recover their costs. Given the complexity and long-term nature of these arrangements, it’s crucial to understand the legal framework that governs them. This blog explores the critical elements of split-dollar agreements, including plan funding, interest rates, vesting, policy access and death benefits.
Understanding the Terms of the Split-Dollar Agreement
A well-drafted split-dollar agreement is essential, as these plans can last for decades, potentially outlasting the employment of the key executives they benefit. Clear, detailed documentation helps avoid future misunderstandings and conflicts, ensuring all parties are aware of their rights and obligations. The agreement should be specific and avoid ambiguity, especially since split-dollar plans are custom-designed transactions with various implementation methods.
Plan Funding
Split-dollar plans can be funded either fully at implementation or over a defined period. Each method has its advantages and disadvantages:
- Fully Funded at Implementation: This approach allows the Applicable Federal Rate (AFR) to be set and remain unchanged for the agreement’s life, reducing uncertainty and enhancing design flexibility. However, it requires a significant initial capital outlay, which might be challenging for cash-flow-sensitive organizations.
- Installment Funding: This method spreads the premium payments over several years, easing the immediate cash flow burden. However, it introduces variability in the AFR, as each premium tranche, or installment, will bear the rate in effect at the time of payment. Predicting future AFRs is challenging, necessitating conservative assumptions to maintain compliance.
Declaration of Interest Rate
Interest on a split-dollar loan can be accrued, paid or forgiven. The interest rate must be no less than the AFR at the loan’s initiation, based on the arrangement’s anticipated term. Fully funding the plan simplifies interest rate administration, as it locks in the rate at implementation. Occasionally, “demand” loans are used, allowing the organization to demand repayment at any time and often employing a lower short-term AFR. However, the annual fluctuation of the short-term rate and the uncertainty it brings can negate the plan’s benefits.
Vesting and Effect of Termination
Split-dollar plans are often used as retention tools, tying benefits to continued employment. Vesting schedules can be incremental or all at once, depending on specific employment conditions or milestones. Various events can affect vesting, including:
- Death: Typically results in full vesting.
- Disability: Usually leads to some level of immediate vesting, though not necessarily full vesting.
- Voluntary Termination: Often results in partial or complete forfeiture, depending on timing and the vesting schedule.
- Change of Control/Good Reason: Defined in many agreements, this can lead to partial or full vesting if the organization undergoes significant changes like a merger.
- Termination for Cause: Usually results in complete forfeiture.
Limitations on Policy Access
Access to the life insurance policy’s value by the key executive must be carefully negotiated and documented to avoid future conflicts. Access can be limited by timing and amount or granted more freely, provided it doesn’t jeopardize plan compliance or the organization’s ability to recover its costs.
Allocation of Death Benefits
A split-dollar plan must ensure that the life insurance policy maintains a death benefit at least equal to the amount owed to the organization. This often includes premiums paid plus interest. Designing a policy that precisely tracks the amount owed each year is challenging, so additional death benefits are often included to cover potential shortfalls. The remaining death benefit, after covering the organization’s obligation, can be substantial and should be carefully negotiated as part of the split-dollar agreement.
Successfully Navigating Terms and Conditions
Properly understanding and documenting the legal elements of a split-dollar plan are critical for its success. These plans involve complex financial and legal considerations, from funding methods and interest rates to vesting schedules and policy access. By carefully negotiating and documenting these terms, organizations and executives can create a robust and effective split-dollar arrangement that meets their mutual goals.
Call us today at 972- 318-1110 to schedule a consultation and take the first step toward a more secure financial future. Your peace of mind is worth the call.
