Voluntary Participant-Funded Split-Dollar: What to Test Before You Adopt It

Participant-funded split dollar starts with compensation the executive chooses to forgo. Before that compensation is earned, the executive elects to have the organization advance that amount, sometimes more, into a life insurance policy the executive owns. The advance is a loan, with repayment generally due at death.

The organization replaces a compensation payment with a receivable. Whether the arrangement works for the executive depends on what they ultimately receive after accounting for repayment, taxes, and policy costs. That comparison should include both a policy purchased directly with after-tax money and taking the compensation and investing it.

This design goes by several names, including capital accumulation plan, voluntary salary reduction split dollar, alternative compensation arrangement, and leveraged deferred compensation. Some materials call the pay cut a compensation adjustment. Some plans simply call the whole thing loan-regime split dollar, which names the tax structure rather than the funding source. Several of these labels also cover employer-funded plans, so identify the design by how it works: who gives up pay, who advances the premium, and how the organization is repaid.

The problem it is meant to solve

Section 457(f) works well for employer-funded retention with a genuine forfeiture condition attached. It is a more difficult fit for an executive who voluntarily wants to give up future cash compensation in exchange for a long-term benefit.

Deferral under 457(f) generally lasts only while the benefit remains subject to a substantial risk of forfeiture. For an executive voluntarily giving up cash compensation, that means accepting the possibility of losing the benefit. Guidance proposed in 2016, still not final but available to rely on, would recognize certain elective deferrals subject to a forfeiture condition, but requires a materially greater benefit, a minimum period of future service or a qualifying noncompete, and advance election timing. The organization has to offer something for the executive to accept that risk.

There are other limitations. The benefit is taxed when the forfeiture condition lapses, whether or not the executive receives payment. It cannot be rolled into an IRA, it must fit within defensible total compensation, and an unfunded benefit remains exposed to the employer’s general creditors. Once an executive sits at the top of the reasonable-compensation range, there may be little room for an additional benefit.

Employer-funded split dollar has often been offered as an alternative. But it requires the organization to advance capital that may remain outstanding for decades, with repayment dependent on the policy and whatever additional recourse the agreement provides.

Participant-funded split dollar changes the funding arrangement. The executive elects to forgo future cash pay or eligible future SERP contributions, and the organization loans at least that amount into the policy. The organization recovers principal, plus interest where the note requires it, and the remaining death benefit generally passes to the executive’s beneficiaries.

The appeal to the organization is straightforward. Compensation paid out is an expense, while a properly structured loan creates a right to repayment. The organization still commits capital for decades, however, and someone has to administer, monitor, and report the arrangement each year. Successor boards inherit those responsibilities.

What the organization gets

Potential excise-tax savings. Principal advanced under a bona fide split-dollar loan is generally not remuneration under Section 4960. That can produce meaningful savings where cash compensation would otherwise exceed $1 million and attract the 21% excise tax. The exposure is now broader than it used to be. For taxable years beginning after December 31, 2025, the definition of covered employee reaches any current or former employee since 2016, not just the five highest paid, so a large organization may have more people over the threshold than it did under the prior rule.

Any imputed compensation from a below-market loan belongs back in the calculation. The excise tax also never applied to pay for performing medical services. For a physician executive, that means the savings only reach the administrative part of their compensation, and sometimes there is not much there. Quantify the actual savings before treating them as a reason to adopt the plan.

A repayment asset. The organization holds a receivable, with repayment generally coming from the death benefit. Tax characterization does not settle the accounting. Imputed compensation expense, interest recognition, administration costs, and payroll taxes may all apply. Confirm the treatment with the auditor before approving the design, including whether an allowance for expected credit losses is required and what supports the amount. Any amount the organization adds on top of the forgone pay is its own capital, recovered on the same terms and subject to the same risk.

Potential employment-tax savings. The design may reduce employment taxes where the forgone cash otherwise would have been wages and the principal is respected as a loan. For an executive already over the Social Security wage base, the recurring federal difference generally involves Medicare taxes. Include the employment taxes attributable to any imputed compensation when calculating the savings.

Different Form 990 reporting. Amounts move off Schedule J and the loan balance surfaces on Schedule L. That is a trade rather than an elimination, and it is only a clean trade where the loan bears adequate interest. If the arrangement runs below market, the forgone interest is compensation and reports as compensation every year, which puts back part of what the design was meant to move. Decide which reporting you would rather explain.

What the executive gets, and what it costs

In a properly structured non-MEC policy that remains in force, cash value grows tax-deferred and can generally be accessed without current income through withdrawals up to basis and policy loans. Any residual death benefit after repayment of the organization goes to the executive’s beneficiaries.

An added amount from the organization, where offered. Some designs advance more than the executive gives up, or pay a bonus toward loan interest or the tax on imputed compensation, discussed below. That addition is often what makes participation worthwhile, because without it the executive funds the entire arrangement and the organization recovers all of it. Ask how the addition was sized, how it is delivered, and how long it lasts. A cash bonus is taxable wages, while a larger advance stays within the loan.

Two other potential advantages come from comparing the arrangement with an elective 457(f) deferral.

Ownership of the policy. An executive with an unfunded deferred-compensation benefit holds an unsecured claim against the employer. A rabbi trust does not remove that exposure. It may protect against a change of heart by management, but its assets remain available to the employer’s general creditors.

Under an executive-owned split-dollar arrangement, the executive owns the policy, subject to the organization’s collateral assignment. That creates a different position from holding an unsecured promise to pay.

Ownership is only part of it. The agreement decides the rest. A successor may be able to stop future advances, leaving the executive to continue funding with after-tax money, which is precisely the alternative the whole design was measured against. Some agreements also permit termination and acceleration of the existing loan. For someone who has voluntarily given up compensation, those rights deserve close attention before signing.

Different tax timing. A 457(f) benefit is generally taxed at vesting. If a decade of contributions vests together, the accumulated benefit can land on a single return.

In Massachusetts, for example, income above roughly $1.1 million attracts an additional 4% surtax, and a joint return does not receive two thresholds.¹ A large vesting event therefore hits the executive at both the federal and state level. It lands on the employer at the same moment, since the amount enters Section 4960 remuneration when the forfeiture condition lapses rather than when it is paid.

If the advances are respected as loans, there is no equivalent 457(f) vesting inclusion event. In an interest-free, death-payable form, the executive instead recognizes annual imputed compensation. That amount may be much smaller than a concentrated vesting inclusion, although it can become substantial as advances accumulate.

On the cost side, three items belong in front of the executive before an election is signed.

Annual taxes. Each premium advance is a separate split-dollar loan for federal tax purposes. In the common death-payable form, each advance is tested using the applicable federal rate, or AFR, appropriate to its expected term when made. If the advance is below market, special rules provide for annual forgone-interest calculations using that advance’s original rate.

Annual funding therefore creates separate advances, often carrying different rates. The administrator must track each one. Any later refinancing or modification requires its own analysis and should not be assumed to provide an automatic reset to a lower AFR.

Policy performance. The policy may fall short of its illustration. Early termination can expose a gap between cash surrender value and the amount owed. A surrender or lapse can also produce taxable gain, and an outstanding policy loan can leave the executive with a tax bill even when no cash is received. MEC distributions and forgiveness of the employer loan raise separate tax issues.

Access to money. A design built around a particular withdrawal schedule needs to be tested against the executive’s actual needs. A large unplanned withdrawal can change the policy’s ability to support later income and repayment.

What recourse means for the executive

With a full-recourse note, the executive is personally liable for the repayment obligation even if the policy falls short. In a participant-funded design, the executive has already given up compensation to fund the arrangement.

If the loan becomes due in year six with cash value below the amount owed, the executive may have to write a check for the difference. That consequence should be explained alongside the projected income, rather than left in the loan agreement for the executive to discover later.

Nonrecourse repayment limits collection to the agreed collateral, but introduces a tax complication. Unless the parties timely make the required written representation about expected repayment, an otherwise noncontingent nonrecourse payment is treated as contingent under the split-dollar loan rules.² The representation needs support from the actual repayment assumptions.

The organization’s position deserves equal attention. Full recourse provides another source of recovery, but enforcing it may mean pursuing a former executive for a shortfall.

Forgiveness is not a painless exit. An amount waived, cancelled, or forgiven is generally treated as compensation, and a forgiveness feature intended or understood from the outset can create additional tax and loan-characterization problems. A board should not approve a personal repayment obligation on the assumption that a future board will decline to collect it.

The agreement may also provide something between full recourse and nonrecourse. I have laid out those distinctions in a separate framework for evaluating split-dollar risk. Whatever the label, show the executive what becomes due under early termination and underperformance.

The test that should decide it

Start with the plans the executive already has. Confirm the executive is using the room available in the organization’s 403(b) or 401(k), including any match, and in its 457(b). Those plans take pre-tax dollars with no loan to repay and no policy charges, so compensation that still fits there usually belongs there first. A 457(b) at a nongovernmental tax-exempt organization is unfunded and remains exposed to the organization’s creditors, and that belongs in the comparison, but it rarely reverses the order. Participant-funded split dollar is mainly a question about compensation above those limits.

A complete analysis runs two comparisons.

The first is a directly owned, max-funded, non-MEC policy purchased with the executive’s after-tax compensation. This helps isolate the effect of the split-dollar arrangement from the insurance product itself.

The second is taking the compensation, paying the tax, and investing the remainder in a diversified taxable portfolio. An executive who does not particularly want more life insurance needs to see that alternative.

Participant funding puts more money into the policy than would remain after a paycheck is taxed, and the executive never gets the forgone pay back. At a 35% tax rate, $100 of pay would leave $65 to put into the same policy, with nothing owed. Participating puts the full $100 in, but leaves $100 owed to the organization. The extra $35 has to outgrow that debt and its cost before the executive comes out ahead, measured on total value to the executive and the beneficiaries after the organization is repaid, not on cash value alone.

If the note requires accruing interest, the policy must support a repayment balance growing at that rate. If the note is interest-free, the AFR used to calculate imputed compensation does not automatically increase the contractual debt. The executive instead bears the annual tax cost. A below-market note with some stated interest may involve both costs. At current AFRs, the point where the executive comes out ahead can take decades to reach unless the organization adds something, so ask the presenting firm to show when it arrives for each advance.

Employer-funded split dollar depends on the policy out-earning the cost of the loan. When that spread narrows, the arrangement stops delivering what it promised, which is why higher AFRs have pushed designs toward interest-free notes and notes with a stated rate below the AFR, where the forgone interest is recognized annually as imputed compensation. Those choices do not remove the cost. They shift it from an accruing balance the policy has to carry into an annual tax bill. Who pays that bill is worth asking. Some arrangements include a bonus to cover it, sometimes grossed up for the tax on the bonus itself, and some of those bonuses stop when employment ends. Where no reimbursement is provided, the executive pays the tax out of pocket, and in a participant-funded design that cost comes on top of the compensation already given up.

The policy must generate enough value to support the planned income and the repayment obligation, with the executive’s tax costs included in the comparison. If it falls short, an executive who gave up compensation to fund the arrangement may receive less income than projected, need to contribute additional money, or face a repayment shortfall, depending on the agreement.

Ask to see:

• When cash surrender value exceeds cumulative premiums, and separately when it covers the employer’s loan balance.
• The executive’s annual taxes on imputed compensation and any actual interest payments.
• The employer’s loan balance over time.
• Planned policy withdrawals and loans, including carrier loan costs.
• The compensation the executive gives up and any additional employer incentive.
• The organization’s projected tax savings and administration costs.
• Results after early separation, interrupted funding, and prolonged underperformance.

Run the analysis beyond life expectancy. Age 105 is a useful longevity stress point, with attention to the policy’s actual maturity and continuation provisions.

Early cash value deserves particular attention. Ask whether a surrender-charge waiver is available, what it costs, and how it changes the results. A waiver can improve both the executive’s exit position and the organization’s collateral, but it does not necessarily eliminate a shortfall. Enhanced early-value features should also be priced against the same policy without them.

Watch how the taxable alternative is modeled. Applying ordinary income rates to every dollar of portfolio growth can distort a comparison with a portfolio receiving qualified dividends and realizing long-term capital gains. Use the taxes appropriate to the actual investments, turnover, withdrawals, and estate assumptions.

The presenting firm should be able to show both alternatives using consistent assumptions and explain what causes one to outperform the other.

Three things that can undermine the plan

Election timing. The executive must elect to forgo compensation before it is earned. An election involving compensation the executive already has a right to receive raises constructive-receipt, assignment-of-income, and deferred-compensation questions.

Get counsel’s written analysis of when elections must be made, whether they can change annually, and which compensation is eligible. Relinquishing an existing SERP contribution or accrued benefit requires particular attention. It should not be treated as interchangeable with an election over future salary.

A design that pays cash to executives who decline presents the election as a choice between cash now and a funded benefit later. Ask counsel whether that affects how the election is characterized.

Distribution timing and the design assumptions. Conservative designs generally allow the policy to build value before distributions begin. Early borrowing reduces that cushion and can increase lapse risk. An overloan protection rider may provide a safeguard, but its availability, conditions, costs, and tax treatment need to be understood.

Some designs let executives withdraw most of each year’s advance within weeks of funding. The executive is then spending loan proceeds in place of salary, which makes it easier to argue the salary was never really given up. If the face amount is also reduced to control costs, a reduction in the first 15 years can make related withdrawals taxable to the extent of gain in the policy under Section 7702(f)(7).

Start with the assumptions used to build the proposal. Reducing an aggressive illustrated rate slightly does not necessarily produce a conservative result.

Then test the policy appropriately. For whole life, review the guaranteed ledger and a reduced dividend scale. For IUL, examine lower crediting and early zero-credit years. For VUL invested in separate-account funds, test adverse return sequences. A VUL allocated to an indexed account needs stress testing appropriate to that allocation.

Across all policy types, test higher policy-loan rates, interrupted premium advances, early separation, and longevity beyond life expectancy. Also calculate the lowest sustained return that supports the planned withdrawals, while recognizing that the order of returns can matter as much as the average.

A year-by-year comparison of cash surrender value with the employer’s loan balance helps show when the arrangement is most exposed.

The employer’s promise. The plan document should identify whether the organization is committing to annual advances or promising a particular benefit. A projected income figure can easily become an expectation, especially if the distinction is never discussed.

For a contribution-based arrangement, the executive’s outcome depends on policy performance and the terms of the loan. Each advance funds a policy the executive owns, while future advances remain subject to the agreement and future elections. Make those limits clear before participation begins.

Check whether the amount the executive gives up is fixed in dollars or tied to current pay. A fixed amount based on a prior year takes a larger share of actual pay if compensation later falls, and the executive’s ability to leave the plan may be limited to set windows.

The design questions that decide the outcome

Whether the organization can make the loan

Start with the employing entity’s determination letter. If it is a §509(a)(3) supporting organization, loans to disqualified persons raise the automatic excess-benefit rules under §4958(c)(3). Reasonable total compensation does not by itself resolve that problem.

The split-dollar regulations expressly characterize qualifying premium advances as loans. A supporting organization should treat this as an approval blocker unless independent counsel supplies a defensible contrary analysis in writing.

State law is a separate question. Some states restrict loans by nonprofit corporations to officers or directors, while others provide exceptions for particular insurance arrangements. Check the law in the state of incorporation before proceeding with design work.

Joint ownership does not automatically solve either issue. Under the split-dollar ownership rules, the first-named owner generally is treated as owning the entire contract. A narrow rule recognizes genuine undivided interests where each owner holds a consistent fractional share of every right, benefit, and obligation. The usual arrangement in which the employer recovers its advances and the executive receives the residual does not match that model.

If joint ownership is proposed, ask counsel to explain what it accomplishes under both the tax rules and the applicable lending restrictions.

Which type of policy

Whole life, indexed universal life, and variable universal life behave differently as funding vehicles and collateral.

Whole life carries dividend-scale sensitivity. IUL carries crediting risk, including changes to caps and participation rates. VUL invested in separate-account funds adds direct market exposure. A fixed indexed account inside a VUL requires analysis of that account’s terms, rather than assumptions based solely on the VUL label.

Premium flexibility matters because the compensation an executive elects to forgo may change from year to year. An adjustable-premium policy can accommodate that need, within its funding requirements. A properly blended whole life design may also provide meaningful flexibility through paid-up additions, subject to carrier limits.

For a VUL, the collateral analysis can raise Regulation U questions. Both the purpose of the credit and whether it is directly or indirectly secured by margin stock must be considered. The policy’s allocations and contractual restrictions are relevant facts.³

A VUL may also be priced more efficiently than a comparable IUL in a particular case. Compare actual products and designs, with counsel addressing the regulatory position separately.

How the policy is built, and what it pays in commission

The executive gave up compensation to fund this policy. Acquisition costs and policy charges affect how much value is available in the early years, when a shortfall may matter most, and how the policy performs long-term.

An off-the-shelf, base-heavy policy sends a large share of early premium to commission, so cash value can sit below cumulative premium for years while the executive still owes the full loan back. A max-blend design puts far more of each dollar to work for the executive. On whole life that means the minimum base the carrier will write, a term rider carrying the death benefit, and maximum paid-up additions, all within MEC limits. Base premium carries most of the compensation, the rider and paid-up additions carry a small fraction, so blending down cuts the drag substantially. On IUL and VUL the levers are maximum term blending and the structure of the policy itself. An increasing death benefit at inception, for example, lowers the initial face amount and lets as much cash into the policy as possible.

Ask for the carrier’s compensation schedule and any associated overrides for the specific product, what share of the premium is commissionable, and what the same funding looks like at minimum base. Compare early cash surrender value, longer-term performance, guarantees, and funding flexibility.

The goal is to understand what the proposed design costs and whether another design would serve the executive and the organization better.

The governance cost nobody prices

This is a decades-long commitment. Boards turn over, CFOs turn over, and the plan may outlast everyone who approved it.

Successors need enough information to administer a structure they did not choose. Annual reporting, loan records, policy monitoring, and corrective action all need an assigned owner. The organization should also know how it would obtain its records and continue administration if the original provider were no longer involved.

Eligibility raises its own problems. Age or health may exclude some executives, and an employer incentive can create fairness questions among people who were not offered the plan or could not qualify.

Before adoption, decide which role will remain responsible for the arrangement and how that responsibility will transfer. A file containing the original illustration and signed agreement is not enough to manage it for the next thirty years.

Questions to put to the presenting firm

1. When must the executive elect, can the election change annually, and which compensation is eligible? Provide counsel’s analysis, particularly if an existing SERP benefit is being relinquished.
2. How does this compare with any unused room in the organization’s retirement and 457(b) plans, a directly owned policy, and an after-tax taxable portfolio, using consistent assumptions?
3. What assumptions support the planned income, and what happens under lower returns, early losses, higher loan costs, and interrupted funding?
4. What compensation does the proposed policy pay, and how does it compare with other designs using the same premium?
5. What does the executive owe if the loan becomes due in year six and the policy cannot repay it?
6. Can the employer stop future funding, terminate the agreement, or accelerate existing loans? What changes after an acquisition or bankruptcy?
7. Does the employing entity’s exempt status permit the arrangement, and does state law permit the loan?
8. If VUL is proposed, what are the allocations and counsel’s conclusions on Regulation U?
9. Is the organization promising annual funding or a particular benefit?
10. What has the auditor concluded about the accounting?
11. Who handles annual administration and policy monitoring, what does it cost, and how does that responsibility transfer to a successor?
12. Does the organization receive anything beyond principal and interest? If so, what supports treating the advances as loans?

What review is actually for

Participant-funded split dollar can fit some organizations and executives well. The decision depends on the economics, the executive’s needs, and the rights created by the documents.

The illustration, loan agreement, and collateral assignment need to be read together. Someone should be responsible for checking whether the projected withdrawals are permitted, whether the repayment assumptions match the note, and what happens if the arrangement ends earlier than expected.

An independent review before adoption gives the organization and the executive an opportunity to resolve those questions while the design can still be changed. Once the policy is in force and compensation has been forgone, an exit may be considerably more expensive.

There is a secondary market for these receivables, which softens that somewhat. Selling into it requires the executive’s authorization, and it typically repays the organization on a set horizon rather than just at death. The price comes out of the executive’s share, for example, giving up some of the excess death benefit.