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  A Valuable but Complex Business Arrangement for Physicians

 By Gary A. Cook; MSFS, CLU, RHU, CFP® CMP™

Split dollar arrangements can be a complicated and confusing concept for even the most experienced insurance professionals or financial advisors. 

Moreover, for most physicians and healthcare executives they seem to be fraught with even more confusion. 

The Basic Concept

This concept is, in its simplest terms, a way for a medical practice to share the cost and benefit of a life insurance policy with a valued physician employee. 

In a normal split dollar arrangement, the employee doctor will receive valuable life insurance coverage at little cost to them.  The medical practice business entity pays the majority of the premium, but is usually able to recover the entire cost of providing this benefit. 

Approaches and Structures [IRS Notice 2002-8 and 2002-59]

Following the publication of IRS Notices 2002-8 and 2002-59, there are currently two general approaches to the ownership of business split-dollar life insurance: Employer-owned or Employee-owned. (In addition, Proposed Regulation 164754-01, substantially changed split-dollar arrangements even further.  

Both the medical practitioner and his/her financial advisor should research this area thoroughly before proceeding or making any recommendations. Regardless of the method used, a written agreement must be prepared to spell out the rights and obligations of the parties.

[1] Employer-owned method [IRS Tables and PS38 Rates] 

In the employer-owned method the employer is the sole owner of the policy. A written split-dollar agreement usually permits the employee to name the beneficiary for most of the death proceeds. The employer owns all the cash value and has the unfettered right to borrow or withdraw it as necessary. 

At the end of the formal agreement, the healthcare business entity can generally (1) continue the policy as key person insurance, (2) transfer ownership to the insured and report the cash values as additional income to the insured, (3) sell the policy to the insured, or (4) use a combination of these methods. This is commonly referred to as “rollout.”

Medical practitioners, and their advisors, should be careful not to include rollout language in the split-dollar agreement. Many plans are set up with the intent—although not in writing—to transfer the policy to the insured after a certain number of years.

The reason the rollout should not be included is that if the parties formally agree that after a specified number of years—or following a specific event—related only to the circumstances surrounding the policy, that the policy will be turned over to the insured, the IRS could declare that the entire transaction was a sham and that its sole purpose was to avoid taxation of the premiums to the employee.  

If that happens, the IRS may deem that the premiums paid should be considered income to the employee when they were paid. If this comes up in an audit years after the inception of the agreement, it may generate substantial interest and penalties in addition to the additional taxes due. The death proceeds available to the insured employee’s beneficiary are considered a current economic benefit. Also called reportable economic benefit (REB), it is an annually taxable event to the employee.  

If an individual policy is involved, the REB is calculated by multiplying the face amount times government’s rate tables, or the insurance company’s alternative term rates, using the insured’s age.  

If a second-to-die policy is involved, the government’s PS38 rates or the company’s alternative PS38 rates will be used.

Any part of the premium actually paid by the employee is used to offset any REB dollar-for-dollar. 

The employer-owned method is primarily used when the employer wishes to maintain as much control as possible over the life insurance policy or for officers and executives of publicly-held corporations. This employee perquisite can be used to reward key employees with current inexpensive death protection and simultaneously provide a potential handcuff for them by informally funding a deferred compensation agreement. 

[2] Employee-owned method [Code § 7872] 

With the employee-owned method, the insured-employee doctor is generally the applicant and owner of the policy.  Any premiums paid by the practice are deemed to be loans to the employee and the employee reports as income an imputed interest rate on the cumulative amount of loan based on Code § 7872.

A collateral assignment is made for the benefit of the business to cover the cumulative loan amount.  In some cases, the assignment may allow the assignee to have access to the cash values of the policy by way of a policy loan. This method is unavailable for officers and executives of publicly- held corporations because of the current restrictions on corporate loans (the Sarbanes-Oxley Act). 

The employee-owned method is somewhat similar to the older collateral assignment form of split-dollar. The benefits for the employee are both the ability to control large amounts of death proceeds as well as developing equity in the policy.

Whether or not this new method catches on will depend greatly on the imputed interest rate published by the IRS every July. If set low enough, this may be an excellent opportunity for the employee to use inexpensive business dollars to pay for life insurance.  

Illustrative Example: 

Dr. Charles Tryon is a valuable member of a team of surgeons at St. Mary’s Hospital.  He has recently developed a new technique for treating brain aneurysms.  The hospital would like to keep him on staff for years to come. 

Dr. Tryon is married and has one small child and his wife is pregnant.  He has requested that the hospital provide him with more life insurance.  The hospital’s board of directors meets with a number of financial advisors to review their options and they settle on an employer-owned method split dollar arrangement. 

As a result, they will purchase and pay for a life insurance policy on Dr. Tryon, providing him the bulk of the death benefit for his family, as long as he is a member of their hospital staff.  They have also agreed to bonus Dr. Tryon the amount equal to the Reportable Economic Benefit, in order to keep his insurance cost at a minimum.

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Assessment

The above is not intended to be a complete treatise on the split dollar concept. There are many different variations that continue to change and develop daily.  Due to the complexity of split dollar and potential tax implications it is recommended that when considering a split dollar arrangement, an experienced team of advisors be consulted.

Conclusion

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