TAX EXEMPT ORG’S | Attracting & retaining winning talent
April 7, 2023
4 minute read – In 2016, the University of Michigan kicked off a trend of using split-dollar plans to attract head coaches for sports teams. As a means to attract and retain head football coach, Jim Harbaugh, the university offered him such a plan (loan regime split-dollar life insurance arrangement) as an alternative to deferred compensation. Since then, other colleges have followed suit, including Clemson, Louisiana State University, and the University of South Carolina.
A review of the features of a loan regime split-dollar arrangement reveals further why tax-exempt entities might prefer this method as a funding option:
Since Sections 457 and 4960 do not apply, both parties have more flexibility to design the program with reasonable vesting, creditor protection, key-person coverage, and the avoidance of the 21% excise tax.
There are various types of policies that can be utilized that provide the executive with numerous investment choices similar to 401(k) or 403(b), 457(b) options.
The organization records a premium expense as well as a receivable for the loan, often making this a neutral expense on the income statement and balance sheet.
Since all life insurance policies allow the insured to withdraw cash value basis first (the sum of premiums) and then tax-free loans, these plans can often produce lifetime tax-free income to the executive.
Tax-exempt organizations can struggle in competing with for-profit companies for top talent due to fewer executive benefit retirement options. Loan regime split-dollar plans help level the playing field by allowing tax-exempts to offer a substantial executive retirement benefit while also adhering to IRC Section 457. If properly structured, a loan-regime split-dollar plan can provide executive retirement benefits while simultaneously protecting the interests of the organization.
While the loan regime split-dollar approach can be very attractive for non-profits, there are risks that need to be addressed and monitored. In addition to having a properly drafted agreement between the parties, the success of the arrangement will be largely dependent on two factors: loan rates and the performance of the policy’s cash value.
Loan rates are determined by the AFR rate in effect in the month the premium payment is made. The U.S. had been in a period of very low interest rates, similar to home mortgages. If there will be 10 years of premium payments, then there will be 10 separate rates that make up the overall loan rate, as each premium payment is its own loan. As interest rates fluctuate (Up or down), more interest could be due—reducing available cash value for the executive to draw upon. Once all premiums have been paid, then the full loan rate is locked in.
One solution is to lock in all future premiums at the current rate. This can only be accomplished if the full value of future premiums is considered. To accomplish this, carriers offer a premium deposit account that can hold the sum of future payments and deduct from this account on an annual basis when premiums are due. There is also the possibility to renegotiate the loan in the future if rates go down, provided there is value to both parties to do so.
Carriers offer various options, including dividend-paying whole life, universal life, indexed universal life polices as well as variable policies. Because of the different types of market and interest rate risk inherent in these policy types, each of these approaches has positives and negatives that need to be discussed based on the client’s risk tolerance.
When designing a proper split-dollar arrangement, it is critical to use AFR rates and policy crediting assumptions that reflect all of the feasible scenarios that could occur. This allows for a beta test of the likely outcomes of the arrangement.
What If We have a 457 Plan Now?
IRC Section 4960 applies a 21% excise tax to tax-exempt organizations that pay an executive total compensation in excess of $1 million annually. When base, bonus, and payments from a 457(f) plan are included, this can easily occur. So, if a tax-exempt institution wants to provide benefits above and beyond what this combination provides, then they need to follow the rules of 457(f), which allows for any amount of compensation to be deferred for an executive. However, 457(f) has some onerous requirements:
Amounts deferred are subject to creditors.
If the executive voluntarily leaves the organization, the account balance will most likely be forfeited.
Most importantly, as soon as any amount deferred becomes vested to the executive, it is taxable.
The IRS has said that if an organization is paying the premiums on a policy owned by an executive, those premiums will be treated as taxable income to the executive unless certain conditions are met. In order for the premium payments not to be taxable income to the executive, those payments need to be considered loans to the executive, hence “loan regime.”
The mechanics of this approach is that the policy is owned by the executive, but the premiums are paid by the organization in the form of a loan to the executive. There is a split-dollar agreement between the parties that spell out the loan terms—including the loan rate, recovery either at a specific age or death of the executive, vesting, and provisions for early retirement. The insurance company provides a form that allows the executive to collaterally assign the policy to the organization in order to protect its interests.
Lastly. An important factor in the success of these arrangements is the way the loans are structured, which determines the chargeable interest rate (Remember: Each executive can have their own arrangement). The premium advances can be structured as either a demand or term loan:
Demand loan—the interest rate to be applied is based on an annual blended rate published by the IRS—the AFR.
Term loan—the appropriate AFR is determined based on the term of the loan (short-term, mid-term, or long-term) and the AFR of the month in which the loan is made.
The 457(f) plan has withstood many years of up’s and down’s in the market as well as guideline changes. Not a bad plan, and worthy of continual considerations. The Split Dollar approach is similar in purpose with one or two differences, taxes due upon distribution, as well as the organization having access to ‘repayment’. Each case is different, as well as the executive in mind.