SPLIT DOLLAR EXECUTIVE BENEFIT PLANS BECOMING DOMINANT IN CREDIT UNION LAND – THE CRUCIAL NATURE OF STRUCTURING IT RIGHT AND DOING IT WELL

It was twenty years ago in the fall of 2003 that the Internal Revenue Service (IRS) issued a ruling that split dollar executive benefits plans would not generally be considered compensation – if structured properly – for income tax purposes because the executive is essentially borrowing from the value of a life insurance policy which a business (in our case, a credit union) advanced funds to buy on the executive’s life and which the business (credit union) would be repaid upon his or her death with interest.

This ruling also exempted properly structured split dollar benefits from being considered compensation for 990 reporting by state-chartered credit unions.  With split dollar benefits not being considered compensation for the two above referenced purposes, a credit union does not have to count benefits from a split dollar plan as compensation for the excise tax imposed on compensation above $1 million at nor-for-profit entities as required under the 2017 tax act.

Basically, based upon the IRS ruling that had its 20-year anniversary just a few weeks ago, split dollar benefit plans became the emerging standard and benefit-plan-of-choice for most credit unions rather than the previously used defined benefit plans that were difficult to keep funded appropriately and 457f SERP plans that did not always cover the executive’s benefits fully after retirement.

For example, the number of credit unions using split dollar executive benefit plans grew since 2014 from 255 credit unions to just over 900.  The number of dollars invested in split dollar plans has increased from $670 million to over $6.8 billion.

That 1000% increase is telling.  First, credit unions are coming of age in recognizing that recruiting, retaining and rewarding quality executive talent requires more than just a good salary and bonus plan.  An executive retirement package that is more than just competitive, but one that rewards the executive for staying with the credit union rather than chasing every new job offer that comes his or her way, has become essential for growing and thriving credit unions.

Secondly, as credit unions mature in their utilization of executive benefits plans for their most crucial executives that they absolutely don’t want to lose and desire to reward sufficiently to keep them on the team, more and more of them are rejecting the somewhat outdated and out-of-vogue defined benefit plans that were the mainstay of the small number of credit unions offering executive benefits in past decades.

Even 457f SERP-type plans were beginning to viewed as less and less appealing since the value becomes viewed by the IRS as compensation upon the year of vesting – thus triggering tax ramifications potentially for both the executive and the credit union through the excise tax.

All of this has contributed to the growth of split dollar executive benefits plans.  Very likely your credit union has either put in place a split dollar plan(s) or is seriously considering doing so.

Even credit unions with existing defined benefit plans or 457f plans are looking to supplement with split dollar.

The key is, as mentioned several times earlier, making sure your split dollar plan is structured correctly.  If not, unexpected tax liability could accompany it.

We are quite high on, as are the growing number of credit unions, split dollar as being the Mercedes of the road when it comes to executive benefits.  And we are even higher on the necessity for credit unions that want to do more than survive – but to thrive – being able to hire, keep and benefit their key executives.

Because we are so high on split dollar and more of our clients are utilizing them every day and because how they are structured can possibly turn a very positive benefit into one with a significant tax bill accompanying it, we try to follow the latest developments and guidance in the split dollar marketplace.

Just this past week CU Today (www.cutoday.info) ran a very significant piece about the complexity of split dollar plans, the importance of due diligence in putting such plans into effect and the potential downsides of not structuring split dollar correctly.

The following link takes you to the CU Today article written by their outstanding reporter Ray Birch on the history of split dollar plans since the 2003 IRS ruling and quotes some experts on important due diligence steps to avoid disappointment in the executive benefits plan you select for your key executives.

https://www.cutoday.info/THE-feature/Ensuring-Retirement-Benefit-Benefits-the-Retiree

While we are not licensed financial advisors and certainly do not have the expertise to guide a credit union on every step it should take to make sure its split dollar plan is structured properly, we ourselves have advised our clients on some of the basic key due diligence steps on split dollar that we have learned from our other clients’ experience.

Even though we are incredibly positive on these plans as the best executive benefit option available in today’s market, there have been a few horror stories of credit unions taking bad advice from someone that is not an expert on split dollar and finding their programs in need of saving before a catastrophe befalls either the executive, the credit union or both.

For example, we have previously written about the importance of shopping a split dollar vendor.  Never use “our guy that handles insurance for us” without comparing his expertise, experience and pricing on split dollar versus some of the firms that either primarily or exclusively offer split dollar to not-for-profit entities such as credit unions.

We recommend at least three vendors be brought in to discuss your needs and abilities regarding executive benefits.  (And we are getting a number of reports that NCUA examiners are asking more and more – perhaps because of the significant dollars involved – about what process a credit union went through to select their split dollar executive benefits vendor.)

We also recommend that you include in those vendors at least two that work either exclusively or primarily with not-for-profits such as credit unions.  The tax treatment of a not-for-profit in structuring and funding a split dollar plan versus how a for-profit company does so is a major difference.

Another factor that we encourage our credit union clients to look at is whether the split dollar benefit plan being marketed to you has one policy backing it or two.  We have found that most vendors offer only one policy that tries to include both a death benefit and an income producing feature.

Almost inevitably trying to cover both the death benefit and income production in one policy will make the premiums higher than if a dual policy regime is utilized.

Only having a death benefit adversely impacts the return to the credit union for advance funding the policy.  Only having a policy that is more like whole life with income production as a key factor almost always results in the credit union paying too much for the death benefit.

We have seen our clients with split dollar perform best with dual policies that has one for the death benefit and the second one for income production.  The cost-benefit ratio is much stronger, normally, in the dual policy structure.

One last piece of recommendation for your due diligence on either your existing split dollar plan (which can be re-structured or supplemented if they were not structured well in the beginning) or one that you are considering is that the service-after-the-sale is more important on split dollar than any other type of benefits plan.

It is absolutely crucial that whoever you purchase your split dollar plan from be able to service the policy provisions for changing market conditions, interest rates, policy cash value earning, IRS reporting requirements on an ongoing basis sufficiently to provide your credit union and the executive you are providing the benefit to that everything is on track and he/she (or the credit union) is not going to end up disappointed when retirement comes.

Today’s interest rate environment is changing the split dollar market, just as it is many other insurance-related products and returns.  Make sure your chosen vendor can accommodate a changing interest rate environment with the structure and product he or she places you in.

The profits to companies selling split dollar are quite high.  In return, you should expect more than a “sell and disappear” relationship when it comes to ongoing support and compliance of your split dollar plan(s) with changing rules, laws and market conditions.

There are publicly traded companies offering split dollar, as well as private companies, mutuals and even a CUSO with multiple credit union ownership.  Don’t settle for hearing from one source only.

Your executive benefits may be the most important purchase you make as it relates to the amount of dollars involved, its impact on the lives of your most valued executives and the absolute essentiality of doing it right.

The credit union’s dollars of investment are at stake in properly structuring a split dollar plan.  But, even more importantly, doing right by the executives you trust to build your credit union into what it should and can become is on the line with how his or her plan is structured.

Doing right on your credit union’s executive benefits is doing right by your executives.

In the before referenced CU Today article, one of the nation’s most recognized and leading attorneys in the split dollar field was quoted extensively.

Kirk Sherman of Sherman and Patterson has set the standard for legal expertise on split dollar and is used by thousands of businesses offering split dollar executive benefits – including many credit unions.

In a recent conversation with Mr. Sherman, we discussed an article he wrote on the 20^th anniversary of the IRS ruling that opened the doors for split dollar to grow into the leading source of executive benefits that it is today.

At our request, Mr. Sherman gave us the authority to print his entire article in one of our Client Updates.

So, below I offer you the expertise of Kirk Sherman and his partner, James Patterson, on doing split dollar right and structuring it to make sure there are no surprises at tax time for the executive.

I know many of you utilize split dollar plans for your executive benefits.  I believe, from our experience, that you are indeed in the right ball park and playing on the best field for retirement and retention benefits for credit union executives when you are using split dollar.

But the old NCUA Chairman in me says, you still need to follow through on a good idea by making sure you do it in the right way.

So, I encourage you take a few minutes to read Mr. Sherman’s article below.  And please don’t hesitate to let us know if you have any questions that either we can answer or find someone who can answer for you.

 

Split Dollar 911

“When reality disappoints”

Kirk D. Sherman and James S. Patterson

Sherman & Patterson, Ltd.

 

“The number of credit unions sponsoring “loan regime split dollar” life insurance arrangements (LRSD)[1] and the dollars held in such arrangements have soared over the last 9 years – from 255 to 899 credit unions (350%), and from $0.67 billion to over $6.76 billion (1000%):

LRSD’s potential advantages drive this growth. For the executive it promises tax-free retirement income and death proceeds. For the credit union it promises executive retention, cost recovery, interest income, key-person life insurance and reduction or elimination of the excise tax on compensation in excess of $1 million.

LRSD’s outward shine is matched by its internal intricacy. These inner dials and knobs in the hands of qualified designers and administrators can keep LRSD running smoothly and meeting or exceeding expectations. When the unexpected happens, they can adjust to minimize down time and get back on track. In the hands of less qualified designers and administrators, LRSD can find itself being towed to the shop for major repairs.

Here we consider several common causes of LRSD difficulties and steps to maximize performance and minimize disappointments.

Design and IRS Rules

The LRSD difficulties and possible remedial actions require a brief review of the key elements of LRSD structure and the IRS rules.

Regarding structure:

• The credit union advances funds for acquiring one or more life insurance policies on the executive’s life.[2]
• Subject to vesting, the executive borrows tax free from the policy to supplement retirement income.
• At the executive’s death, the insurance proceeds repay the credit union’s advance plus interest. They may also provide additional death benefits for the executive’s beneficiaries and/or the credit union.

The 20-year-old IRS rules specify:

• If the executive is not personally obligated to repay the credit union’s advance (i.e., nonrecourse LRSD), the executive must file with his or her 1040 for any year the credit union advances funds a “written representation” stating that a reasonable person would expect the credit union to be repaid in full. The credit union, if state-chartered, must also file a copy with its Form 990. Failure to file causes the executive to be taxed on the entire advance.
• If the arrangement terminates before the executive’s death and the credit union does not recover its entire advance plus interest, the executive is taxed on (i) all amounts borrowed from the policy, and (ii) the principal and interest the credit union does not recover.

Difficulties and Remedies

Four difficulties that can require remedial actions are:

1. Under-performing economics;
2. Inadequate or unclear documentation;
3. Failure to file the written representation; and
4. Poor recordkeeping

Under-Performing Economics

Nearly all life insurance policies perform well in good economic times. But a variety of factors can stress even strong policies:

• Carriers reducing dividend rates (whole life policies)
• Carriers reducing the CAP rates (IUL policies)
• Indexes not performing well (IUL policies)
• Permitting aggressive borrowing in the early years
• Carriers increasing internal policy fees and charges
• Carriers increasing mortality rates
• The executive living longer than anticipated
• For LRSD using demand loans, an increasing AFR

Under-performing policies are the poster children for “an ounce of prevention is worth a pound of cure.” Prevention in LRSD includes:

• Having expert advisors. Life insurance policies are complex financial instruments requiring experienced hands to manage them safely.
• Diversifying policy investments
• In multiple policy arrangements, diversifying carriers and policies
• Monitoring executive loans and withdrawals
• Testing whether loans or withdrawals provide the most efficient access to the cash value
• Evaluating new and lower-cost policies

Arrangements that are already in distress require more drastic actions, some of which may be:

• Cutting back executive loans and withdrawals
• “Refinancing” the arrangement when the AFR dips
• Exchanging old policies for more efficient new policies (possibly without underwriting if the face amount does not increase and the exchange is with the same carrier)[3]
• Electing “paid up status” (hopefully after the executive has borrowed all amounts anticipated under the arrangement)
• Layering a new policy on top of the old (credit union infuses more cash; requires using the current AFR for the additional loan)
• Replacing the current policy with a joint survivor policy covering the executive and the executive’s spouse, subject to acceptable underwriting[4]

Documentation Failings

The next difficulty can be documents that are vague about how to calculate the amount the executive can borrow each year. The board wants to use conservative assumptions to protect its position. The executive wants more aggressive assumptions to maximize retirement income.

Rather than focusing on specific loan amounts, the credit union and executive should first focus on their common interests and then on process. The policy lapsing prior to the executive’s death would be very expensive for both sides. The credit union would suffer the loss of its advance plus interest. The executive would lose the retirement income and be taxed on any loans taken plus the advance and interest the credit union does not recover. Neither the credit union nor the executive wants the policy to lapse.

With this common interest, they should update the arrangement to provide a process for calculating annual loan amounts. A proper procedure will specify:

• The qualifications of, and the process for choosing, the third-party advisor.
• How long the executive is assumed to live (e.g., to age 99 or 3 years after calculation, whichever is longer).
• How to determine the assumed future cash value earnings/dividend rate (e.g., the lesser of a 3-year rolling average of actual policy performance or the maximum illustration rate the carrier allows).
• Whether the annual payments to the executive will be by borrowing or surrenders.
• If the executive will borrow from the policy, what loan interest rate to assume (e.g., the carrier’s current loan interest rate).

Such a process can give the parties greater confidence that their common and competing interests are being properly balanced.

Failure to File Written

Representation

If the executive or state-chartered credit union fails to file the written representation with their tax returns, remedial actions to avoid the executive having to pay taxes on the credit union’s advance, in decreasing order of levels of protection, are:

• Amended Returns – If the failure occurred in one of the three preceding tax years, the executive and credit union can file amended returns to submit the written representation.
• Private Letter Ruling – The IRS issued private letter rulings granting LRSD participants additional time to file the written representations. In these situations, the architect and installer of the arrangements either failed to tell the participants of their filing obligations, or failed to provide the written representation to be signed and filed. It is not clear how the IRS would respond if the executive and the credit union were provided the written representation and told to make the filings but failed to do so.
• Fresh Start – The parties could terminate the original arrangement and install a new arrangement (using the current AFR). The total principal and interest in the original arrangement becomes the beginning balance in the new arrangement. The parties then file the written representations for the new arrangement.
• Do Nothing – The parties could ignore the risks and do nothing, waiting for the statute of limitations (typically 6 years) to run. However, absent some notice of the issue to the IRS, the statute of limitations may not start running, making this an even more aggressive approach.

Poor Recordkeeping

Memories are short. Consider LRSD covering a former CEO that has been on the books for many years. The former CEO and the consultant that installed the plan work together, without the credit union’s input, to determine when and how much the former CEO can borrow from the policy. Meanwhile, the credit union’s board and senior leadership have turned over several times. Few of the current credit union leadership remember the former CEO, yet the financials continue to show a large and growing LRSD asset. The credit union would like to free up cash, and wonders if it can terminate the arrangement, surrender the policy and recover the book value.

The same as for economic under-performance, the best “cure” for poor recordkeeping is prevention – not only good tracking of policy performance, but also good and consistent communication among the credit union, the executive and the consultant about that performance. Best practices that can foster good recordkeeping and open communication include:

• Receiving annual (or semi-annual) reports from the consultant to the credit union’s board and/or current senior leadership team about the LRSD, tracking:
  • Policy cash value earnings
  • Loans taken
  • Current investment options (IUL or VUL policies)
  • Loan amount proposed for the coming year
• Establishing a process for requesting and approving loans each year, including:
  • A form for requesting loans
  • A list of information to accompany the loan request (e.g., in-force illustrations and illustrations projecting future policy performance after the loan)
  • A form for reporting the board’s decision on the loan request
  • A calendar specifying when the loan request will be submitted each year, how long the credit union has to act on the request, when the credit union will communicate its decision to the executive, and when the executive can access the funds
• Requiring certification from the consultant that the executive accessing the proposed amounts will not place the policy at risk of lapsing during the executive’s expected life expectancy.

Moving from poor recordkeeping and poor communication to good recordkeeping and communication can be difficult and raise issues of confidence and trust. However, the comfort of understanding the arrangement’s current status and likelihood of providing the intended benefits (or at least avoiding the disastrous consequences of a failure) can justify the effort.

In Conclusion

If LRSD fails, the only winner is the IRS. Credit unions and participating executives should insist on strong LRSD structure and process.  For struggling, LRSD, taking immediate action can minimize the risk of suffering the consequences of complete failure.”

Thanks to Mr. Sherman for allowing us to share his expertise and experience.  Again, don’t hesitate to reach out to us if we can provide further guidance on this crucially important issue for credit unions and their key executives.

Until next time.

Dennis Dollar