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Loan Regime Split Dollar: The Importance of a Plan Document

            You are the CEO of a thriving credit union.  Your leadership has put the credit union on solid financial footing.  Your regulators are happy with the way you’re running things, your membership is growing, and your board of directors wants to keep you around for a long time!  So they’ve decided to reward your efforts by offering you a loan regime split dollar plan (or “LRSD”), which is also known as collateral assignment split dollar (or “CASD”).  Under current tax law, this type of Executive Benefit Plan provides tax free income to you while you are employed and/or while you are retired. 

So how does this type of plan work? 

In a nutshell, the credit union loans you, the credit union executive, a large amount of money to buy a cash value life insurance policy, which you own outright.  You use this policy as collateral to secure the loan; thus, the reason these arrangements are often called “collateral assignment” split dollar plans.  There’s only one catch: the loan has to be repaid.  Fortunately for you, you don’t have to repay the loan until death, at which time the policy’s death benefits fully cover the loan balance.  If designed properly, the insurance policy provides enough death benefit to pay off the loan and to provide your beneficiaries with additional tax-free income. 

All this may seem confusing and complex, and it is!  Which is why you need to make sure your plan document is drafted carefully to protect both you, your beneficiaries, and the credit union.  You want to make sure the arrangement avoids unintended tax or other consequences.  After all, LRSD loans are typically in the millions of dollars.

The purpose of this article is to help you understand what goes into a well-drafted LRSD arrangement.  So here goes:

1.) It’s a Binding Legal Contract. The LRSD arrangement is a legally binding contract between you and the credit union and consists of four parts:

a. The Plan Document. The plan documents set forth all relevant terms and conditions regarding the loan, vesting, termination of the plan, repayment, claims, notice, and other provisions. More specific provisions of this document are addressed in item number 2 below.

b. Promissory Note. Accompanying the plan document is a promissory note, which sets forth the actual terms of the loan, including interest rate, amount of the loan, term of the loan, and other appropriate terms and conditions.

c. Collateral Assignment. The collateral assignment form will be provided by the insurance carrier and secures the loan. This document assigns the policy as collateral to the credit union and comes with certain restrictions. It generally prohibits you, the employee, from impairing the credit union’s right to be repaid. Thus, you can’t surrender the policy for its cash value without the credit union’s consent. You can’t sell the policy or change the face amount of the policy. And access to the cash surrender value is controlled through this and the other documents just mentioned.

d. The Insurance Policy. The insurance policy itself is the final piece of this puzzle. It builds cash value that, under current tax law, can later be withdrawn or borrowed on a tax-free basis. When sized properly, the insurance policy accumulates enough cash value to provide you with a stream of income for a specified period of time, and it pays back the loan upon your death. In some designs, there are two policies: one strictly for repayment of the loan and one that is used to provide the income stream.

2.) Plan document provisions.

a. Your plan document should contain policy, insurance carrier, and insured information.

b. The document should detail the legal basis for the arrangement, including relevant tax code provisions.

c. It should contain a description of how the arrangement is structured. For example, is this a demand loan or a term loan? Is the loan fully recourse or nonrecourse? What are the tax consequences?

d. Vesting. The document should describe in detail the vesting schedule. This schedule should show when the executive is entitled to begin borrowing or withdrawing cash from the policy. Included in this section is information on how vesting may be accelerated, such as on a disability, change in control, or involuntary termination of employment. Many plan documents also provide for vesting upon a termination for “good reason,” which is when the credit union demotes the executive or otherwise diminishes their responsibilities.

e. Rights and responsibilities of the parties. The plan document should contain a section detailing the rights and responsibilities of the parties. This section would include any information pertaining to the executive’s ability to borrow or withdraw cash value, the schedule of such borrowing, the limit on the amount of such borrowing, and any other pertinent information related to the borrowing. There should also be information relating to the credit union’s rights and responsibilities, such as the right not to interfere with executive’s rights.

f. Termination of the arrangement. This is a very important section, because it details what happens when the arrangement terminates. Typically, this section will set forth a process whereby the executive pays back the loan to the credit union. This repayment can occur through the death proceeds of the policy or through use of personal funds. A good arrangement will protect both the executive and the credit union in this process.

g. Death benefits. The plan document should clearly outline what happens with the death proceeds. The priority will go to repaying the credit union the amount it is owed. Any excess over and above that amount is typically paid to the beneficiaries.

h. Other important provisions. The plan document should contain other important provisions, such as the parties’ right to amend or terminate the plan, relevant definitions contained within the plan, required Department of Labor language regarding claims when benefits are not paid, and other boilerplate contractual provisions. One such provision is a provision stating that the executive has had a chance to consult with his/her own outside tax or legal advisors regarding the arrangement.

In summary, a well-written plan document will allow both parties to clearly understand the arrangement, the rights and responsibilities of both parties, and it will anticipate and set forth a process for dealing with future events, such as disability or termination of the plan.  The plan document is the heart of any LRSD arrangement. 

Make sure your plan document is written by someone with experience drafting LRSD plans.  Many legal elements and design characteristics of LRSD plans are not well understood by a credit union’s outside or in-house counsel.  Often a credit union will choose to use an attorney who drafts many of their standard contracts.  This approach often ends in disappointment and frustration for all parties involved, inaccurate plan documents, and higher expense and often re-drafting of the plan with different attorneys. 

You have worked hard to get to where you are.  Don’t let a bad plan document spoil your future.