Jim Harbaugh was recently named as the head coach of the Los Angeles Chargers. Prior to that, he had served as head coach of the University of Michigan Football team, and, in addition to leading the team to a national championship, had been the face of split-dollar arrangements for high-earning employees at non-profit organizations for the past few years.
His departure from Michigan to join the NFL raises the question of what happens to that arrangement and the related life insurance policy?
Let’s take a quick overview of how split-dollar works and then examine the options available to employees and their employers when they find themselves in a situation like Harbaugh and the Wolverines.
A Split-Dollar Primer
Since the enactment of the Tax Cuts & Jobs Act of 2017, tax-exempt organizations have been subject to an excise tax equal to 21% of taxable compensation above $1 million or excess parachute payments paid to certain highly compensated employees. As a result, many tax-exempt organizations, including colleges and universities, have increasingly been employing split-dollar life insurance arrangements as alternatives to traditional non-qualified deferred compensation plans.
As coaches at top college football and basketball programs often have contracts in excess of this $1 million level, incorporating split-dollar planning into their compensation packages is an attractive option.
Split-dollar arrangements allow for the sharing of the cost and benefits of a permanent life insurance policy. In such an arrangement, the employer makes loans to the employee to pay the premiums of a permanent life insurance policy. To secure these loans, a collateral assignment of the policy is made to the employer.
Over time, the cash value in that policy increases and can later be accessed by the employee in retirement tax-free as withdrawals and/or policy loans. The tax-exempt employer recovers their loans, plus accrued interest, from the death benefit of the policy. Any remaining proceeds are paid to the employee’s beneficiaries.
The Employee is Leaving. Now What?
When an employee leaves the employer, that will generally lead to the “exit” of any split-dollar arrangement. An exit refers to the unwinding of the arrangement during the insured’s lifetime (before the payment of any policy death benefit) and generally involves two components:
Repayment of the employer’s interest in the underlying policy, which can be either the total premiums loaned/paid or the policy’s cash value; and
A release of the business’s interest in the policy and a transfer of the policy to the employee or other third-party owner (such as the employee’s ILIT).
When determining how to address these two components, there are several factors that both the employee and employer must consider:
Who actually owns the policy?
Does the employee still need the insurance?
How has the policy performed?
What type of policy is involved and are there other product options that might be better for the employee?
How friendly is the employment separation and is there (either from goodwill or contractually) any willingness to forgive any repayment obligations?
If a trust is involved, are there any fiduciary obligations or considerations?
You will see how the answer to these questions play out in the next section as we walk through the actual mechanics of an exit.
How Does This Play Out?
There are generally three ways that an exit can work:
The employer forgives the loans and the employee takes the policy.
The employee pays back the loans and takes the policy.
The employee gives the policy back to the employer.
Employee Gets the Policy
When the employer is either repaid or forgives its reimbursement right under the arrangement, that is referred to as a “rollout.”
If the employer chooses to waive the repayment obligation, the parties need to consider potential accounting issues related to such a forgiveness. For example, if the forgiveness takes the form of a bonus arrangement, that bonus will be taxable to the employee as income. If the policy is owned by an ILIT, there will also be a corresponding taxable gift.
Furthermore, the forgiveness may subject the employer to the excise tax it was attempting to avoid by implementing this split-dollar arrangement in the first place. Effectively, rather than avoiding the tax, in this situation the employer has effectively deferred the excise tax payment. Though we imagine Michigan fans will argue their recent national championship made the deferral worth it in the Harbaugh case!
In the event there is no forgiveness and the employee must reimburse the employer for the outstanding premium loans, there are two main scenarios that can be followed:
If the policy has cash value, that may be accessed in order to pay the outstanding loans. There may be income tax consequences to this option (if the policy is a modified endowment contract, or MEC) and withdrawing those funds from the cash value may hinder the ability of the policy to meet the estate planning goals for which it was intended.
The employee can use outside, non-policy related funds from other sources to repay the loans. If, as is likely, the policy is held by the employee’s ILIT, the funds for the repayment can be provided to the ILIT via taxable gifts. If the ILIT is a grantor trust, the employee may be able to make loans to the trust to provide it the necessary capital. Assuming the structure involves an ILIT, this could be accomplished with taxable gifts.
With regard to either of the above options, another set of tax issues will arise for the parties if the cash value in the policy exceeds the total amount due as repayment for premium loans. This amount is sometimes referred to as “policy equity.”
If the policy has equity at the time of the rollout, it will be treated as compensation to the employee for tax purposes. While the employer should receive a deduction for any amount treated as compensation, it may face limitations if this imputed compensation (from either the policy equity or any forgiveness amount) is deemed not reasonable.
One final consideration for the employee. Once all loans have been repaid or forgiven and the employer has terminated its interest in the policy, the policy then belongs solely to the (now ex) employee. Often the policy will need additional premium payments to remain in force, and those payments are the responsibility of the employee. This is especially true if the policy’s cash value was used to fund the repayment.
If the employee does not have the means to pay these premiums, or does not want to, there are options available. They can work with a life insurance professional to determine whether decreasing the policy’s death benefit in exchange for lower premiums would be feasible and would still meet the individual's planning goals. It also may be possible to exchange the existing policy for a new product that better matches the employees needs and desired capital outlay. There is even the possibility of entering into a private split-dollar arrangement between the employee and their trust.
Employer Gets the Policy
Another option is for the employee (or their ILIT) to transfer the policy to the employer and then the employer terminates the split-dollar arrangement. Like the scenarios above, there are considerations, particularly tax-related, for the parties involved.
A transfer of the policy in exchange for releasing the employees repayment obligations may constitute a transfer for value. This would mean the amount equal to the excess of the policy’s death benefit versus the amount forgiven would be subject to taxation.
As you can see, when a highly paid employee of a non-profit organization, such as a coach of a university sports team, leaves their employment, the unwinding of any existing split-dollar arrangement is going to be a slightly complicated process.
In this piece, we attempted to make the explanation as straightforward as possible, but clearly there are many tax and planning considerations that must be taken into account. Any individual or organization in this position should work with their legal, tax, and insurance advisors as early in the process as possible to ensure all parties end in a good place.
At Robin Glen, we use our expertise in income and estate tax, private capital, and insurance analysis and design to create unique solutions that deliver impactful results for our clients and advisor partners.
As your life and the world changes, we are there every step of the way to ensure your planning evolves to always support you, your family, and your business.