What is Loan-Based Split Dollar?
In loan-based split dollar, the corporation pays the premiums on a policy owned by the business owner or key person (the “insured”). Generally, this would be treated as a distribution from the corporation and income taxable. However, in this case the premiums payments are structured as individual loans from the corporation to the insured/policy owner that are collateralized by the cash value and death benefit of the life insurance policy. The principal of the loan is payable at the end of the loan period, with the insured being responsible only for payment of loan interest on an annual basis. If loan interest is not paid, it is treated as taxable distribution to the insured.
How Does Loan-Based Split Dollar Work?
Corporate funds are loaned to the insured to purchase a life insurance policy, and are not income taxable to the insured/owner at this point. If a cash value permanent life insurance policy is purchased, there is the possibility to accumulate cash values on a tax deferred basis. At some point, when cash values have accumulated safely beyond the outstanding principal of the loan (generally, premiums paid), funds can be taken out of the life policy on a tax advantaged basis to pay back the loan. The resulting policy, along with tax deferred cash value, will be owned free and clear by the insured. The policy cash values – net of loaned amounts used to repay split dollar loan – can then be borrowed out of the policy income tax free (as long as the policy remains in force) as needed.
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