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Split-dollar Life Insurance – A Tax-Leveraged Derivative for Hedge Fund Managers

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The Emergency Economic Stabilization Act of 2008 ended the not so discrete secret of hedge fund managers, the deferred compensation arrangement with their offshore funds or as the New York Times described, “an unlimited Super IRA for the super-wealthy.”

As Judge Learned Hand (of blessed memory to tax attorneys) once said:

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934).

The addition of IRC Sec 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017. IRC Sec 457A effectively eliminates the ability of investment managers to enter into deferred compensation arrangements with their offshore funds going forward.

IRC Sec 457A really deals with two problems. Problem #1 deals with existing deferrals that must be repatriated and Problem #2 deals with the inability to no longer defer the carried interest. A number of large accounting firms and law firms have proposed an option strategy that is similar to non-qualified stock options that are taxed as ordinary income once they are exercised. Presumably, the proceeds would be included in the hedge fund manager’s taxable estate, but the options issued in lieu of payment of the carried interest would provide for ongoing deferral.

This article will introduce an old concept that was effectively utilized by senior executives in Fortune 500 companies that participated in their company’s Supplemental Executive Retirement Plans (SERP). The senior executives in many cases were already wealthy and did not necessarily need any additional retirement income considering the SERP benefit was subject to both income and estate taxation, a “haircut” of 70-80 percent of the benefit. The senior executives opted to exchange their existing benefit for participation in a company-sponsored split-dollar life insurance plan. The benefit exchange was known as a “SERP Swap”.

In many respects, this technique is a better planning technique than the existing deferred compensation planning arrangement. After all, deferred compensation arrangements have tax problems, namely income and estate taxation that impose a whopping 70-80 percent “whack” on the deferred compensation assets. Life insurance is very tax-advantaged – (1) Tax-free accumulation of the cash value; (2) Income tax-free death benefit and (3) Estate tax-free death benefit. Under the split-dollar arrangement, the executive would be minimally taxed for both income and gift taxes.

The article will outline a technique that has been used for over sixty years in corporate America and how this “old school” life insurance technique may be more powerful than any derivative trading strategy in its ability to create and preserve wealth for a hedge fund manager. The strategy is far less complicated (to me at least!) than derivatives or hedge fund trading strategies, but probably “Greek” to the investment manager.

What is a SERP?

A SERP (Supplemental Executive Retirement Program) is a non-qualified deferred compensation plan where the executive and employer enter into an agreement in which the employer agrees to pay the executive a certain amount in the future. Actual money is not distributed until distributions are made according to the contractual terms of the deferral agreement. Under the “swap”, the participant and the employer agree to “swap” potential benefits under the SERP for a split-dollar life insurance arrangement.

The typical hedge fund deferred compensation program involves an agreement between the investment management firm and the hedge fund’s offshore fund, a foreign corporation. The agreement typically provided for the deferral of the offshore fund’s carried interest for a ten year period. As a result, many hedge funds tended to pursue and push investor funds into the offshore fund. Furthermore, most institutional investor funds such as pension, endowment and foundation funds are invested into the offshore fund due to tax issues related to Unrelated Business Taxable Income (UBTI).

The problem with the typical hedge fund deferred compensation arrangement is the same problem that any deferred compensation or pension arrangement faces – (1) taxation at ordinary rates on distributions: (2) Estate tax inclusion and (3) Income tax taxation on the plan balance at death. The combined taxes erode 70-80 percent of the benefit. The Strategy provides the ability to transfer of offshore carried interest income and estate-tax free at a minimal tax-cost. This result is superior to the prior deferred compensation arrangement and the current option strategy used by hedge funds.  More importantly, it is completely legal. Keep reading!

Split-dollar Life Insurance

Split-dollar is a contractual arrangement between two parties to share the benefits of a life insurance contract. In a corporate setting, split-dollar life insurance has been used for 55 years as a fringe benefit for business owners and corporate executives. Generally speaking, two forms of split-dollar arrangements exist; the endorsement method and the collateral assignment method. Importantly, IRS Notice 2007-34 provides that split-dollar is not subject to the deferred compensation rules set out in IRC Sec 409A. See § 1.409A-1(a)(5).

The IRS issued final split-dollar regulation in September 2003. These regulations were intended to terminate the use of a technique known as equity split-dollar. The consequence of the regulations is that all new arrangements will fall under one of two regimes of split-dollar taxation – the economic benefit regime or the loan regime.

Split-dollar under the Economic Benefit Regime

Under the economic benefit regime, the employee or taxpayer is taxed on the “economic benefit” of coverage paid by the employer. The tax cost is not the premium but rather the term insurance cost of the death benefit payable to the taxpayer. The economic benefit regime usually uses the endorsement method but may also use the collateral assignment method.

Utilizing the endorsement method within a corporate setting, the corporation is the applicant, owner and beneficiary of the life insurance policy insuring a corporate executive. The company is the applicant, owner, and beneficiary of the life insurance policy. The company pays all or most of the policy premium. The company has an interest in the policy cash value and death benefit equal to the greater of the policy’s cumulative premiums paid or cash value. The company contractually endorses the excess death benefit (the amount of death benefit in excess of the cash value) to the employee who is authorized to select a beneficiary for this portion of the death benefit.

Under the collateral assignment method, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employee collaterally assigns an interest in the policy cash value and death benefit equal to the greater of the cash value or cumulative premiums paid.

The economic benefit is measured using the lower of the Table 2001 term costs set by the IRS or the annual renewable term insurance cost set by the insurance company. This measure is utilized for both income and gift tax purposes. Depending upon the age of the taxpayer, the economic benefit tax cost is a very small percentage of the actual premium paid into the policy, usually anywhere from1-3 percent.

Split-dollar under the Loan Regime

The loan regime follows the rules specified in IRC Sec 7872. Under IRC Sec 7872 for split-dollar arrangements, the employer’s premium payments are treated as loans to the employee. If the interest payable by the employee is less than the applicable federal rate, the forgone interest payments are taxable to the employee annually.  In the event the policy is owned by an irrevocable trust, any forgone interest (less than the AFR) would be treated as gift imputed by the employee to the trust. The loan is non-recourse. The lender and borrower (employer and employee respectively) are required to file a Non-Recourse Notice with their tax returns each year (Treas. Reg. 1. 7872-15(d) stating that representing that a reasonable person would conclude under all the relevant facts that the loan will be paid in full.

Split-dollar under the loan regime generally uses the collateral assignment method of split-dollar. In a corporate split-dollar arrangement under the loan regime, the employee or a family trust is the applicant, owner, and beneficiary of the policy. The employer loans the premiums in exchange for a promissory note in the policy cash value and death benefit equal to its premiums plus any interest that accrues on the loan. The promissory note can provide for repayment of the cumulative premiums and accrued interest at the death of the employee.

Strategy Example

  1. The Facts

Joe Smith, age 45, is the managing member of Acme Funds, a hedge fund.  Acme is a $1 billion fund with assets equally split between the onshore and offshore funds. The fee structure for fund provides for a two percent management fee and 20 percent carried interest. The fund earns 10 percent in 2012.  The expected carried interest for the offshore fund is $10 million. Joe typically splits half the carried interest with his managing directors and key traders.

Joe would like to forego $10 million of carried interest in the next ten years and allocate $1 million per year into a split-dollar arrangement. The projected death benefit in the

policy is $25 million. The policy will be owned by an irrevocable trust that will allow Joe to allocate two generation skipping transfer tax exemptions for he and his wife. His wife is the settlor of the Trust and Joe is a discretionary beneficiary of the Trust. The policy will be exempt from the claims of Joe’s creditors and the policy proceeds will be outside of his taxable estate.

  1. Solution

Acme’s offshore fund, a BVI corporation, enters into a split-dollar arrangement with Acme Investment Management, and the Smith Family Trust. Under the arrangement, Acme agrees to pay premiums equal to one-quarter of the carried interest calculation or $1.0 million as a premium in the split-dollar arrangement. Under the arrangement, Acme will have a collateral assignment interest in the policy equal to the greater of the policy cash value or policy’s cumulative premiums. Acme’s access to the cash value is restricted under the arrangement until the earlier of the termination of the split-dollar agreement, surrender of the policy or death of the insured (Joe Smith).

The Smith Family Trust is an irrevocable trust designed to provide multi-generational benefits to Joe’s wife, children and grandchildren. The trustee of the family trust is the applicant, owner, and beneficiary of a private placement life insurance policy insuring Joe’s life.

During the first ten years of the arrangement, the split agreement will use the economic benefit regime and then switch to the loan regime beginning in Year 11.

Year Income Tax Gift Tax Cum. Premiums
1    $14,250 $14,250 $1,000,000
5    $20,750 $20,750 $5,000,000
10    $28,750 $28,750 $10,000,000

The trustee terminates the collateral assignment agreement in exchange for a promissory note equal to the cumulative premiums paid to date, $10 million. The interest rate on the loan is the long-term AFR which is currently 2.65 percent per year.

The interest is capitalized and added to the promissory note.  The annual interest charge added to the policy is $1 million in Year 11. Ultimately, a portion of the death benefit equal to the accumulate principal and interest will be repaid to the Offshore Corporation. These repayments will be paid to Joe’s wife and family in a lump sum or on installments as part of a Death Benefit Only arrangement.

The trustee of the Smith Family Trust may take a tax-free policy loans and distribute the proceeds to Mrs. Smith who is a discretionary beneficiary of the Trust. The trust distribution is also tax-free.

In the event of Joe’s death, a portion of the policy death benefit would be paid to the offshore corporation as repayment for the loan plus any accrued interest. These funds never belonged to the offshore corporation and are paid to the Family Trust as a Death Benefit Only (DBO) arrangement.  The lump sum payment is subject to income taxation but not estate taxation. The excess death benefit, $25 million or more, would be payable to the Family Trust on an income and estate tax free basis.


The split-dollar strategy for hedge funds is extremely powerful beginning with the non-taxable treatment of the offshore fund (corporation) combined with the tax leverage of dollar split-dollar arrangement and life insurance. The replacement of the traditional deferred compensation arrangement for hedge funds with split-dollar provides an efficient mechanism to transfer the carried interest associated with a hedge fund’s offshore fund to the hedge fund manager.

The split-dollar program that uses a combination of the economic benefit and loan methods, aka Switch Dollar, provides the hedge fund manager with the ability to access the cash value of the life insurance policy on a tax-free basis during the hedge fund manager’s lifetime along with estate-tax free treatment upon death.  In many respects, the tax treatment of the split-dollar program is better and more tax efficient than the previous deferred compensation arrangement.

I don’t understand derivatives for investment purposes but I do understand life insurance and split-dollar arrangements. It seems to me that the combination of the tax advantages of life insurance combined with the tax leverage of split-dollar provides a tax-leveraged derivative that is more powerful than anything else in the hedge fund manager’s personal planning arsenal.