Is loan regime split dollar snake oil or liquid gold? How is a board to know? If it works, LRSD is a powerful tool for compensating key executives and preserving credit union assets. If it doesn't work, the costs to the credit union and the participating executives are high.
The purported advantages over traditional nonqualified deferred compensation plans have led directors to consider LSRD. But boards can find LRSD due diligence daunting. However, like eating the proverbial elephant, the diligence due is more easily pursued in a series of small questions.
The questions and their answers are best processed with a general understanding of LRSD.
Split dollar refers to a wide variety of arrangements where an employer and employee split the dollars (cash value and/or death proceeds) in a life insurance policy. Loan regime split dollar (sometimes referred to as collateral assignment split dollar) takes its name from the IRS regulations that treat the employer's premium advances as loans from the employer to the employee.
Designers add bells and whistles, but the key elements of LRSD are: the executive acquires a cash value life insurance policy on the executive's life; the credit union pays premiums on the policy; the executive borrows against the policy's cash value to supplement retirement income; the credit union recovers its premium advances from the policy's cash value and/or death proceeds.
Against this backdrop, the following questions can guide the board through its due diligence. The easy answers are included. The harder answers depend on the specific facts, design and product selection and should be asked of the LRSD designer and the board's compensation, legal and accounting advisers.
What does the NCUA think? In 2007, NCUA stated in Opinion Letter 06-0924, "Split dollar life insurance is a valuable tool for funding employee benefit plans used to attract and retain senior managers and employees; the Office of General Counsel has stated FCUs may purchase split dollar life insurance for this purpose." In numerous discussions with the NCUA about LRSD over the past couple of years, we have heard nothing inconsistent with this published statement.
What do state regulators think? This varies from state to state, so the board should ask its state regulator. Some state regulators have required specific structures, but no state has prohibited all forms of LRSD.
Is LRSD subject to safety and soundness and liquidity risk analysis? Yes.
Is LRSD subject to concentration analysis? Yes. However, given the structural differences, concentration standards for LRSD may be more lenient than those for deferred compensation funding.
What are the federal income tax consequences? LRSD tax rules are clear. The employer premium advances are not taxable to the executive. The executive pays interest on the loan (during life or at death) or reports the interest in income each year. The executive's loans from the policy to supplement retirement income are not taxable. The death proceeds are not taxable. If the policy lapses, the executive is taxed on the supplemental retirement income borrowed from the policy and on any portion of the credit union's premium advances not repaid.
Will the policy perform as illustrated? Policy performance is critical. Key performance drivers are the interest on, and charges (mortality and administrative) against, the policy's cash value. The board should evaluate both elements to understand the likelihood of the policy under-performing. The policy should be stress tested to determine how it would perform in a prolonged period of negative market returns.
Is executive borrowing monitored and controlled? How, by whom, for how long, and for what fee? LRSD requires committed administrators experienced in monitoring and reporting on policy performance, accounting values, carrier stability and regulatory issues, among others.
In addition to the above, there are several difficult or complex questions that should be answered by the board's advisers.
Does LRSD provide a reasonable level of compensation?
How is the amount of interest the executive pays or reports in income determined?
Is the interest rate locked in or does it change with economic conditions?
Can and should the credit union charge a higher rate of interest on the premium advances to increase the return to the credit union?
How does the arrangement protect against the policy lapsing during the executive's lifetime?
If necessary, will the credit union be required to pay additional funds into the policy to keep it from lapsing?
Since policy performance depends on how much the executive borrows from the policy to supplement retirement income, how is the amount the executive can borrow determined?
What are the accounting implications of LRSD?
Is the credit union's funding commitment capped to avoid additional expense-liability reporting?
Armed with responses to these questions, the board will be better able to cut through the hype and howls and determine whether LRSD for its credit union is snake oil or liquid gold.
Kirk D. Sherman is a partner at the law firm of Sherman & Patterson Ltd.
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