Gregory S. DuPont
Split Dollar Benefits for S Corporations
Although split dollar life insurance arrangements have merit as a supplemental benefit for many business owners and key executives, they are generally not viewed as a practical option for S corporations. This is due to the “pass-through” nature of taxation in an S corporation, under which premiums paid by the corporation are included in the insured’s income to the extent of the insured’s ownership of S corporation stock. (The value of the economic benefit (VEB) is also included in income if the plan is noncontributory.) However, when business success may lead to a substantial estate tax bill, an owner-employee of an S corporation may benefit from the use of split dollar life insurance as a creative estate planning strategy to help minimize taxable gifting.
Traditional Split Dollar
Under a traditional split dollar arrangement, a life insurance policy is purchased on the life of a business owner or key executive. Typically the insured owns the policy and assigns a portion of the death benefit to the corporation to cover the corporation’s total premium outlay over the life of the policy. The corporation pays a large part of the annual premium. The insured is responsible for paying only the portion of the premium equal to the economic benefit of the death proceeds to be received (as determined by the Internal Revenue Service Table P.S. 2001 or the insurer’s lowest published one-year term rate). In other words, the insured is paying term insurance rates.
Creative Use for S Corporations
At first glance, due to the pass-through nature of taxation of corporate-paid premiums in an S corporation, a split dollar arrangement may appear to have little benefit to the insured. However, if the owner faces a potential estate tax problem, using an irrevocable life insurance trust (ILIT) as a third-party owner under a split dollar arrangement can help minimize taxable gifting to the trust.
With this planning alternative, the split dollar arrangement is made between the S corporation and the ILIT, rather than the S corporation and the owner (with no collateral assignment to the S corporation if the insured is a majority shareholder). The ILIT beneficiaries are usually the insured’s children or grandchildren and ILITs are typically funded with gifts made by the insured (the donor). Gifts are made using the donor’s annual gift tax exclusion ($11,000 per person per donee for 2003). Because, in the case of a split dollar arrangement, the ILIT pays only a portion of the premium equal to the one-year term cost, it is possible to minimize gift taxation for the donor and, in addition, have the corporation fund a portion of the ILIT.
Even in an S corporation, where premiums paid by the corporation are included in the insured-owner’s taxable income (to the extent of the insured’s stock ownership), using a split dollar arrangement can create gifting advantages that may potentially outweigh the purchase of life insurance (either by the insured or an ILIT) independent of any agreement with the corporation. (Again, the VEB may also be included in income if the plan is noncontributory.) By taking advantage of the opportunities offered under the split dollar arrangement, the insured will pay a reduced portion of the premium (the economic benefit), thus enabling the insured to potentially minimize gift taxation.
A Valuable Estate Planning Technique
Contrary to what some may think, split dollar life insurance may offer benefits to S corporations. When used as a mechanism to help fund a business owner’s ILIT, a split dollar arrangement can be an attractive estate planning technique. However, as with all advanced planning issues, it is essential that the potential tax consequences be reviewed before implementing this strategy.