With the recent upheavals in the financial markets, the dramatic rise in long-term interest rates, and reduction in caps for Indexed Universal Life policies, we are seeing increased focus on the choice of recourse versus non-recourse debt in structuring Collateral Assignment Split Dollar Loan Agreements.
This memo summarizes key aspects of that choice. In general, use of full or limited recourse premium loans may not as a practical matter expose the employee to actual personal liability absent a severe economic downturn impairing the policy’s value, but use of non-recourse loans will increase the risk that the credit union or nonprofit will not be able to fully book the premium loan and accrued interest on its financial statements.
There are three labels associated with the promissory notes used in Split Dollar Agreements, although there are in fact only two basic structures.
- Non-Recourse Notes rely solely on the underlying life insurance policy for all repayment of principal and interest related to the funds borrowed to purchase the life insurance policy, including any related pre-funding account such as an annuity. The employee will never, in the normal course, be called upon to fund any shortfall, and the nonprofit will be solely at risk for policy underperformance with respect to repayment of its premium loans and
- Limited Recourse Notes provide that the life insurance policy is the primary security for repayment to the nonprofit, but in the case of a shortfall, the employee or his/her estate may be called upon to pay any However, these notes have specific language to ensure that debt repayment is sought first from the life insurance policy, and that the employee is only secondarily liable, after all recourse to the life insurance has been completed.
- Recourse Notes are a broader version of the Limited Recourse Notes in that the nonprofit may call on the employee directly for any shortfall, without first pursuing any recovery from the underlying life insurance policy. The employee will still have recourse to recover from the policy, and will thus have substantially the same net liability for any shortfall, but the employee will have the burden of satisfying the nonprofit and then pursuing recovery from the policy.
Risk Sharing Between Non-Profit and Employee
As illustrated by the definitions of the three note structures, there is a clear conflict of interest between the employee and the nonprofit when it comes to the choice of Recourse, Limited Recourse or Non-Recourse Note structures. The overview of that conflict can be summarized as follows:
- With Full or Limited Recourse Notes, the nonprofit is – at least in theory – substantially protected from shortfalls in policy performance, with attendant positive effects on the nonprofit’s financial statements and on its ability to meet the expectations of regulators such as the National Credit Union Administration that the premium loans will be repaid in all
- With a properly administered plan, if policy performance declines significantly, the first economic effect may be that the retired employee will be restricted in the amount he/she may borrow each year in retirement funds, based on an annual review of the ability of the policy to meet the ultimate goal of fully repaying the nonprofit out of death proceeds.
- The bottom line for the employee under a Recourse Note is that the retirement benefits may be reduced to match economic declines. While a demand for personal cash repayment of the nonprofit is a risk, as long as withdrawals from the policy are monitored annually and limited as necessary to protect the nonprofit’s collateral value, the risk should be manageable.
- With a Non-Recourse Note, there is not even a theoretical risk the employee or his/her estate will be called on to repay any part of the premium loan. Instead, the nonprofit is formally/legally exposed to the entire risk of insurer/reinsurer failure, or poor administrative oversight with attendant financial statement issues, in exchange for the employee’s formal insulation from economic declines.
With a Non-Recourse Note, the specific terms of the Split Dollar Agreement will be the primary determinant in defining the employee’s actual insulation from policy performance shortfalls. The Split Dollar Agreement often will include the requirement that annual retirement loans be limited to the extent there are available (cash value) funds in excess of those needed to secure repayment of a specified amount of the premiums paid, whether the notes are Non-Recourse or not. In those cases, the employee’s retirement income would follow the same track as if there were Recourse or Limited Recourse Notes since the nonprofit would have restricted lifetime borrowings in order to preserve policy collateral value.
- Adoption of less protective Split Dollar Agreement provisions (coupled with Non-Recourse Notes) does open the door to investment in a more highly volatile insurance product, such as an Indexed Universal Life (IUL) policy, where policy performance is based on an option strategy tied to a stock market index, since the employee is protected from the economic downside and directly benefits from the upside of a riskier type of policy. The credit union or nonprofit’s financial statements are, of course, exposed to that same increased volatility, and we understand that the NCUA views more exotic, higher risk types of policies as being of
- Use of Non-Recourse Notes, even coupled with prudent protective provisions in the Split Dollar Agreement preserving minimum cash value to cover the premium outlay (without interest), will, even with a less volatile investment, in many cases result in negative effects for the nonprofit (regardless of economic performance). The most frequent of these issues are a reduced ability to book the annual accrued interest on the premium loans, particularly in the early and late years of the program, and, a financial statement write-down of the carrying value of the actual premium loans
- The ability to book annual interest accruals on the premium investment, and the determination of the carrying value of the loans, is an accounting matter determined by the nonprofit’s accountants. In general terms, the financial statement value of the notes plus accrued interest must be viewed as fully recoverable from collateral at each year end. For this purpose, collateral includes the cash surrender value of the policy at that year end, and any personal recourse available. The absence of personal recourse automatically reduces the total potential carrying value. Interest accruals that will not be recoverable under this test are generally not recognized as income, and loan principal not recoverable would be written down.
- Note that the employee’s economic protections are not absolute with a Non-Recourse Note as there are some potential IRS income tax exposures for current and future personal income tax as a result of the forgiveness of the debt, whether that forgiveness is the result of voluntary termination, firing, death or other causes. Additional tax exposure may arise with the use of highly volatile
- Internal Revenue Code Sections 108 and 1017 provide the mechanics for determination of the actual tax effects of forgiveness of debt (both principal and interest) and are fact Barring bankruptcy situations, the general result is recognition of income either currently or deferred into the future.
- A less obvious risk arises with the confluence of Non-Recourse structures, highly volatile investments and minimal protection of the policy collateral value. The favorable IRS Regulations related to split dollar arrangements under Treas. Reg. 1.7872-15 will not be available unless the nonprofit and the executive can support the required tax statement that a reasonable person would expect that the loan will be repaid in full in all events. Failure of this test may expose the executive to a variety of negative income tax results under Treas. Reg. 61-22.
Summary
The choice of note type has significant implications for both the nonprofit and the executive, including financial statements, regulatory review, income taxation and economic risk sharing. Both parties should be fully informed on the details of each before choosing what is right for you.
Reprinted with permission of Cynthia A. Moore, Dickinson Wright PLLC. The views and opinions expressed are those of the Cynthia Moore. Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.
Cynthia A. Moore, Member and Division Director at Dickinson Wright PLLC
CRN202701-5647988
