In 2016, college football coach Jim Harbaugh received attention from the financial world due to the inclusion of a split-dollar life insurance contract as part of his compensation to coach the University of Michigan Wolverines. The execution of this strategy is not unusual; Penn State, Clemson and Louisiana State universities also have leveraged the split-dollar concept to both protect their investment and offer an attractive deferred compensation plan to their highly paid employees.
In uncommon circumstances, financial heuristics often leave a void, and due to income-based participation phaseouts, as well as contribution limits and tax implications, business owners, executives, and other highly compensated employees may face investing limitations for their retirements; as a result, incorporating life insurance to fill that void can be attractive.
While you may be familiar with the terms that follow, many professionals who have not been provided adequate information may miss out on opportunities to protect their business, create higher tax efficiency and increase compensation in retirement.
Here are two things to remember while exploring these concepts:
- The following terms are not specific products; rather, they are strategic functions of life insurance that can be deployed to address a specific set of circumstances.
- These definitions, while accurate, are also limited. They outline the basic tenets of each subtopic, but additional circumstances exist for which these subtopics may also be appropriate – circumstances not addressed in this column. If the concepts below spark interest, it is incumbent on the reader to speak with a reputable, licensed financial professional, tax professional or attorney.
- Buy-sell agreement. This legal contract outlines how shares of a business will be reassigned if a partner leaves the business or passes away. They often dictate the shares to be sold to the remaining partners or partnership, and life insurance can be used to fund this buyout to prevent the remaining partners from having to reallocate large amounts of capital in a short period of time.
- Cross-purchase plan. Life insurance policies can be purchased by each owner of a business on the other owners. For example, assume there are three partners: Partner A buys policies on partners B and C; partner B buys policies on A and C; and partner C buys policies on A and B. Upon the death of a partner, the proceeds can be used as either income replacement or – more often – to purchase back the shares of the deceased partner; this is referred to as a cross-purchase buy-sell agreement. While a cross-purchase plan is not 100% synonymous with buy-sell, the two often work in conjunction when multiple business owners are involved.
- Split-dollar insurance. This is not a specific type of insurance but a method for dividing the premiums, ownership interests and benefits of a permanent life insurance policy between two parties – such as an employer and highly compensated employee. There are two basic forms of split-dollar taxation: economic benefit regime and loan regime. Split-dollar plans may be sponsored by an employer in a work setting or by an individual or trust in a private setting. A split-dollar strategy can be an effective way to retain talent, as well as diversify retirement benefits for the employee.
- Nonqualified deferred compensation. This is a strategy for executives and other highly compensated employees to defer taxes on their income until a later date – when they are presumably in a lower tax bracket. Employers fund these future compensation payments via a general asset reserve required by generally accepted accounting principles and can use investment vehicles, such as stocks, mutual funds and life insurance, to fund future income payments. In this example regarding life insurance, an employer might choose to pay premiums into a permanent policy. If the employee passes away before retirement, the employer uses the death benefit to fund the promised retirement payout; however, if the employee survives to retirement, they could receive outright ownership of the policy, in addition to the compensation they deferred during their working years.
Ryan J. Hurn is an agent with New York Life Insurance Co. and a financial services professional for NYLife Securities LLC. He can be reached at firstname.lastname@example.org.