Exit from the Business - Split Dollar Insurance

We've looked at eliminating risk if your key person becomes disabled (key person disability insurance) and if they pass away prematurely (key person life insurance). The last risk we can mitigate is a key person leaving for your competition. While we can't entirely eliminate this risk, we can use life insurance to provide a substantial financial benefit to staying with the corporation until roughly retirement. The basic idea is that the corporation purchases a life insurance policy for use as key person life insurance but they purchase a policy that is lifetime insurance and develops substantial financial benefits over time. No benefit is provided to the key person in the short term – the benefits are all 10 or 20 years in the future. During their working years, the corporation keeps the policy as key person insurance. If the key person stays, at the end of the 10 or 20 years the life insurance policy is transferred to them – with all the associated financial benefits. If they leave, there's no transfer of the policy. It's a substantial financial golden handcuffs benefit, only realized to their benefit if they stay with the corporation.

The reason it's called split dollar insurance is because both the premiums and the benefits are split between the corporation and the key person. The corporation receives the life insurance benefit should the key person pass away while still working there. The key person receives the life insurance policy – and the associated cash surrender value – when they retire. The premiums are split accordingly.

Set up properly, these policies can provide very attractive retirement benefits to your key person. Due to the way life insurance policies are taxed, the long term financial benefits can become very attractive to high income earners who have need to mitigate their tax obligations in retirement.

Here's the Basics of How It Works

We determine the amount of premium the corporation wants to contribute to the policy over the next 10 or 20 years.

We use this premium amount to determine the amount of coverage. This coverage amount is then used to reduce the amount of the 10 year term policy (i.e. if the key person needs $2MM of key person life insurance, and the premiums on this policy produce a $500,000 policy, then only 1.5MM of term 10 life insurance is needed).

We purchase a quick pay participating whole life policy (explanation below).

The corporation pays the portion of the premiums related to the insurance. They then bonus the key person the amount of the premiums related to the financial benefits (cash surrender value) of the policy, and the key person pays that portion. Thus the split dollar moniker – the corporation pays the insurance portion, the key person pays the financial portion of the premiums.

Upon retirement, the policy is now fully paid up – no more premiums ever. The policy is transferred to the key person as they exit into retirement. The policy provides life insurance for their estate to pay capital gains and other taxes, and it also provides substantial cash value financial benefits that can be used for retirement income (this specific strategy isn't covered here, but I can explain the mechanics in detail. It's very tax beneficial).

The end result? The employee is incentivised financially to stick around – they know they will be exiting with a large life insurance policy that is fully paid up, that will also contribute to their retirement income, and allow them to spend even more retirement income because they don't need to preserve their estate – the life insurance does that.

So in short, the corporation buys a whole life policy for the purposes of key person life insurance. They split the premiums with the key person, but bonus them to cover the cost. If the employee stays 10 or 20 years, they can leave with a substantial life insurance policy and a substantial additional source of retirement income. It's a compelling reason for them to stay on as a key person.

With split dollar insurance, we normally would recommend a participating whole life policy. Rather than selecting the coverage amount and calculating the premium, we instead fix the premium (i.e. how much you want to provide as a benefit) and have that determine the coverage amount. Then we top it up with 10 year term life insurance. So if we determined that the key person needed $2,000,000 of total coverage, and the split dollar premiums produced $500,000 in life insurance, we would then add on 1,500,000 of 10 year term.