Many business owners enter into "split-dollar" life insurance arrangements, in which the employer and employee share the cost of life insurance. But the IRS recently changed the rules, making those plans less attractive.
The good news: Some tax benefits still remain under existing policies. The IRS handed special status to split-dollar deals in effect before Jan. 28, 2002. (IRS Notice 2002-8) If you own a split-dollar policy, here are your three options for securing your tax breaks before year-end:
Option 1: Terminate the deal
If you hold equity in the life insurance policy, terminating the arrangement may make sense. Suppose your company paid $100,000 worth of premiums for a policy on your life, over several years. Now you own $140,000 worth of cash value in the policy.
The $40,000 excess cash value is considered equity in the policy. The IRS says that equity may be considered taxable income. So unwinding the arrangement by Dec. 31 is a savvy move. You could repay the $100,000 worth of advanced premiums to your company, perhaps by borrowing from the cash value.
Even if you borrow the $100,000, you'd still have $40,000 in equity in the policy. This equity is untaxed, under the grandfather rules, so you'd wind up with a policy worth $40,000 in cash value, yet you'd never owe income tax on the previous buildup.
Key point: Remember to terminate the split-dollar arrangement, not the policy itself. Canceling the policy may immediately subject all the tax-free buildup to income tax.
Option 2: Switch to a loan
Changing the split-dollar agreement terms to a loan may make sense in these low-interest-rate times.
Say your company paid $80,000 in premiums for a $1 million policy on your life. It now carries a cash value of $90,000, so your equity in the policy is $10,000.
If you convert the arrangement to a loan by Dec. 31, you'll never pay interest to your company on a $90,000 loan (on the premiums already paid).
If interest rates are only 4 percent today, you'd owe $3,600 on a $90,000 loan in the first year. You can lock in low-rate loans now, based on current rates published by the IRS.
What's more, you'll be paying interest to your own company, so the only actual cost would be any corporate income tax owed by your company on the interest payments it receives.
If you convert to a loan, you'll never pay tax on the growth of the cash value, as long as you don't cancel the policy. The cash value grows untaxed inside the policy. Eventually, you can roll out the policy, tax-free, and perhaps tap the cash value via tax-free withdrawals and loans.
Option 3: Leave the plan in place
You can also choose to leave your split-dollar arrangement in place. Especially if your policy is relatively new, you may not have any equity in it, now or for several years in the future.
Assuming the plan was established before Jan. 28, 2002, you won't pay tax on any equity buildup while the split-dollar arrangement remains in effect.
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