Would you like to buy $1,000,000 of life insurance for $1?" "Would you like to buy $1,000,000 of life insurance for $10,000?"
Assuming you said, "Where do I sign?" to the first and "No" or "Hold on!" to the second, your objection isn't about having life insurance. It's about paying for it. Well, the same is true for your affluent clients. When there is a need for life insurance, if you can find the money to pay premiums your wealthy clients are much more likely to go ahead than if you ask them to open up their pockets and write the check. And there also may be an opportunity to get substantial amounts of money under management as well.
There are more than a dozen ways for your clients to pay premiums other than asking your client to personally write the check. Many of them tie into and enhance other estate planning strategies. Other strategies stand alone. The list includes:
Gift of income-producing asset
Outside premium financing
Section 1035 exchange (tax-free) from existing coverage Annuity arbitrage
Life settlement arbitrage
Charitable Remainder Annuity Trust (CRAT)
Charitable Remainder Unitrust (CRUT)
Charitable Lead Annuity Trust (CLAT)
Existing special-purpose business entity such as Family Limited Partnerships (FLP)
Distribution from retirement plans
Purchase within a retirement plan
Grantor-Retained Annuity Trust (GRAT)
Self-Canceling Installment Note (SCIN)
While the list may be daunting, especially for someone who is not regularly involved in estate planning, here we are only deal with three: outside premium financing and two versions of private financing, loan split-dollar and economic benefit split-dollar. All three methods involve some sort of loan and typically are used for large amounts of premium and life insurance for very wealthy clients. I'm going to go into each one, tell about where each one fits best, and then compare their strengths and weaknesses. And we're going to talk about them in estate planning and not for other purposes. First, the vehicle:
The Irrevocable Life Insurance Trust (ILIT)
An ILIT is a trust set up so that the insured individuals are not considered the owners and the trust is the owner and beneficiary. That way the insured has no "incident of ownership" and the proceeds of the policy are not subject to estate taxes under Internal Revenue Code Sections 2033 and 2042. In setting up the trust, the originator (called the Grantor) sets up the terms of the trust-who are the beneficiaries, what they get and when they get it. Buying life insurance is desirable because of the leverage life insurance affords. The annual premium paid is a small percentage of the ultimate death benefit. And apart from not being included in the estate by virtue of the ILIT, life insurance in most cases is not subject to income tax. Most people who buy life insurance as part of their estate planning do so in ILITs.
ILITs are funded in almost all case by gifts. An individual has an annual exclusion amount of $12,000 per beneficiary. A husband and wife each have an annual exclusion, which is an amount not subject to gift tax. So if a husband and wife make a gift to the trust and the trust has three beneficiaries, they have an annual exclusion of $36,000 each for a total of $72,000. Additionally, an individual has a personal gifting lifetime exemption of $1 million. But using that exemption also counts against the estate tax exemption. Anything above those numbers is subject to gift tax, and the tax rate starts out at 41%!
If the gift is not accessible to the beneficiary, than it all goes against the lifetime exemption because it is not a Present Interest gift-a gift that is immediately enjoyable by the beneficiary. To make it a Present Interest gift, one has to give the beneficiaries a right to make withdrawals from the trust for a certain time period after the money is gifted to the trust (usually a month). This is another complication in gifting, the Crummey amount. That amount is the greater of 5% of the principal or $5,000, so until you have a value of $100,000 in the trust you are limited to $5,000 per beneficiary. The lawyers have drafting techniques when creating an ILIT that deals with the issue, but there are consequences too detailed to go into here.
Outside Premium Financing
This arrangement is for someone who doesn't initially have the cash to pay premiums, wants to minimize the out-of-pocket costs, thinks they can earn a higher rate of return than the loan interest and/or wants to minimize the gifts. In this situation an individual makes an arrangement with an outside lender, a special company or a bank that makes loans to finance life insurance premiums. The loan is made to the ILIT, with the grantor personally putting up collateral to assure repayment of the loan. In most cases the ILIT pays interest to the lender. In some cases the interest is accrued for some period of time. The interest rate is reset annually and is usually based on the London Inter-Bank Offered Rate (LIBOR) plus some additional percent of the loan (anywhere from 1% to 3%; on February 1, the rate was 5.44%, so the rate the ILIT would pay would be in the range of 6.44% to 8.44%). The interest payment is not deductible.
In the case of annual
interest payments, unless other assets are in the ILIT, the grantor
makes a gift to the trust equal to the amount of the interest. In the
early years that interest is going to be substantially less than the
premiums due. However, later on the interest is greater than the
premium. When the interest is accrued, it and the loan come due,
usually within ten years.
The most important thing in using this technique (as with the others) is that you have an exit strategy in place at the out- set. This is a strategy that provides the trust with enough money to pay off the loan and accrued interest, if any, and a mechanism is in place to pay future premiums if any are due. There are several such strategies.
For older insured (generally age 75 and above), the interest accrues for life and the policy has a death benefit that increases to offset the rising interest accrual. When the insured dies, the loan plus accrued interest are paid off and whatever is left goes to the beneficiaries. If someone lives too long, this can be a negative number, meaning the estate will have to pay off the balance of the loan.
A second is to make annual gifts in excess of the interest that has to be paid. With enough of these gifts and enough appreciation there eventually will be enough money to pay off the loan and continue paying the premiums, if any. This strategy is good for someone who thinks they can substantially outperform the loan interest rate.
A third is to have a lump sum go into the ILIT
at a later date. Because of their potential gift-tax advantages,
Grantor Retained Annuity Trusts (GRATs) are particularly suitable for
this as long as there is no generation skipping in the trust. An
individual takes property and converts it into an annuity that will pay
her specified payments for a certain period of time. The interest rate
used by the government is known as the 7520 rate, which is 5.6% as of
this writing. If someone can earn more than that for a long enough
period of time, after making the annuity payments there will be money
left over to go to the remainderman. As long as there is no generation
skipping, the value of the gift is measured when the GRAT is set up.
The value of the remainder interest is calculated by looking at the
aforementioned annuity payments and the 7520 rate in a present-value
calculation. It is possible to set up the GRAT so the value of that
interest is zero-hence no gift.
A fourth method is to gift some money to the trust and then sell an interest in an asset to the trust in return for a note. The asset should be one that has a discounted value relative to the value of the whole, and have appreciation and or cash flow greater than the interest rate of the loan. The interest rate used is the Applicable Federal Rate (AFR), which varies with the length of the note; if we assume the note is a balloon note to be paid off after more than nine years, the AFR as of this writing is 4.86%. While this results in servicing two loans, if the growth and cash flow of the asset are sufficient, there will be enough to pay off both debts plus any accrued interest. In order for this to work, the trust has to be an Intentionally Defective Grantor Trust (IDGT). The Grantor is the person who creates the trust. For our purposes all we need to know is that the trust is treated for income tax purposes as though all the property belonged to the grantor, but for estate tax purposes it is not included. A competent attorney (particularly one who specialized in trusts and estates) will be able to draft the ILIT.
Private Premium Financing
These methods all involve a private party (usually the insured) paying premiums for the ILIT. This is done either by direct or indirect loans. The IRS issued regulations in 2003 for these of arrangements, which are known as split-dollar. There are numerous technical requirements under the regulations-as with dynamite, work with an expert. But it's worth the effort. See below.
The indirect loan is when the individual pays the premiums and owns the policy, but assigns the death benefit to the ILIT. The death benefit typically is the face amount of the insurance less the greater of the premiums advanced or the cash surrender value of the policy. There is an economic benefit for the death benefit assigned to the ILIT. The IRS has published Table 2001, a value for one-year term that is multiplied times the amount of insurance. As the insured gets older, the rate used is the one for the insured's age that year. It can quickly grow to more than the actual premiums paid. However, if two lives are insured with the death benefit being paid, when the second one dies those rates are much lower because they are based on the likelihood of both dying in the same year. When one does die, the rate reverts to Table 2001. Regardless of the table, the amount of the economic benefit is considered a gift to the ILIT.
The direct loan situation is as it sounds. The individual makes loans to the ILIT. The loan(s) are collateralized by the life insurance (it can be just the death benefit).
The interest on the loan is determined by the time period of the loan. In order for the interest not to be considered a gift, to the loan must be for at least a minimum rate of interest at the AFR. The rates change monthly. Loans of three years or less are at the short-term rate, three to nine years at the mid-term rate and longer than nine years at the long-term rate. As of this writing, they are 4.93%, 4.69% and 4.86%, respectively. (Yes, the short-term rate is the highest-an inverted yield curve.) The interest on the loan can either be paid by the ILIT or accrued. If it is paid, it should not come from gifts by the lender to the trust. The IRS disregards the interest paid and deems the interest a gift. If it is accrued and it is not an Intentionally Defective Grantor Trust (see above), the grantor is taxed on the interest payable even though it hasn't been paid. If it is an IDGT, the grantor does not pay taxes on the accrued interest. However, if there are investments in the trust that create taxable income, that income is taxable to the grantor. That usually is a good thing. As described above, any money the grantor puts into the trust is a gift. However, as the IRS has ruled, if the grantor pays taxes for the trust it is not a gift.
If an individual makes a loan each year to cover the pre- mium, unless the loans are for one year, each loan will have a different rate. If the life insurance policy doesn't have an increasing death benefit to offset the amount of the loans, the death benefit to the ILIT will decrease. As in any premium finance arrangement, there needs to be an exit strategy. It can be the death of the insured, but generally there should be some way of paying off the loan plus interest. Some were already described above regarding outside financing. But there is a special arrangement for very wealthy people (generally a net worth of $25 million and up) that includes its own exit strategy. It offers a real discount to the client-and requires money under management.
Instead of making annual loans, a large one-time loan is made. The loan is enough to pay the premiums and have most of the cash left over for investment purposes. Based on current rates, the loan should be long-term, such as life expectancy. We use a special policy in which the insurance company guarantees that the policy will not lapse as long as the required premiums are paid on time (sometimes referred to as Guaranteed Universal Life-GUL). It is set up so that the premiums are only paid for a limited period of time and then no more premiums are required. What the investment needs to do is make enough money, before taxes, to pay the premiums and eventually the loan plus accrued interest. (That's because the grantor is paying the income taxes.)
Including a use of money factor, the above method will cost the client 40% to 70% less than if the client had paid the premiums outright. It includes all money lent to the trust or spent on taxes. It has the additional benefit of the client not making any gifts-no annual exclusion, no lifetime and no generation-skipping gifts. It's perfect for people who want to leave money to grandchildren (and beyond), because upon death there is no Generation-Skipping Transfer Tax.
To compare the three methods in summary, here are the highlights.
Outside Premium Financing
Best uses are:
?Cases where the client won't have liquidity for two or three years.
?Cases where the client wants to minimize gifts until some other funding mechanism can be put into place.
?Clients who can substantially outperform the loan interest.
Loan from a commercial lender specializing in making loans to pay for premiums.
Annual premiums must be at least $100,000 to qualify.
Interest rate is LIBOR plus 100 to 300 basis points (currently 6.44% to 8.44%).
Usually more than a wealthy individual would have to
pay for a personal loan.
Interest eventually will be more than the premium.
Not tax deductible.
Interest normally is paid annually but may be accrued
for a period of time.
If interest is paid by the Grantor, interest is a gift.
?Requires life insurance trust with "Crummey" powers
and annual administration.
If interest is accrued until the insured dies there is no gift.
?However, loan may be more than insurance proceeds, so the balance will have to be paid from outside collateral.
Loan collateral in addition to the life insurance is required.
Need an exit strategy in addition to pay off loan.
Economic Benefit Split-Dollar
Best uses to minimize gifts are:
?For second-to-die life insurance until the first death.
?Where the economic benefit is less than the premium.
Not a loan per se.
The premium payer owns the policy and endorses death benefit over to ILIT.
?The premium payer is entitled to get back greater of premiums paid or cash surrender value.
Is considered a gift.
?Requires life insurance trust with "Crummey" powers and annual administration.
The value of the gift is based on government one-year term tables.
?Risk that one person dies in any year.
?For second-to-die, risk that both people die in same year-but reverts to single life rate when first person dies.
Needs an exit strategy before economic benefit becomes more than premiums.
Best uses are:
?Reduce gifts when interest to be paid is less than economic benefit rates above.
?In special trust, has its own exit strategy.
?For the very wealthy, it can provide a substantial discount on life insurance versus paying premiums directly.
Loan interest is at AFR-rates depending on term of loan are 4.93%, 4.69% or 4.86%.
Interest can be paid or accrued.
?If paid, trust has to do so from funds other than provided by lender.
Except for special trust arrangement, it requires an exit strategy before loan interest becomes greater than premium or death benefit to trust reduces to zero.
Special trust involves money under management as well.
No "Crummey" or other annual administration issues if there are no gifts.
In conclusion, the individual is better off personally paying for the premium, either through the economic benefit or loan split-dollar arrangement-even if the individual has to borrow money from an outside source to fund the premiums. The interest rate payable by the trust is substantially lower if there is a loan. The net result is that the gifts to the trust are less. And if someone can utilize the special arrangement of loan split-dollar they can avoid the gift tax and generation tax issues entirely, and get a bargain as well.