Certain techniques offer many benefits for
very wealthy clients.

    How would you like to be able to offer your most affluent clients a way to purchase life insurance that accomplishes the following: The insurance is purchased at a substantial discount (approximately 50%) after factoring in use of the money, is not subject to any taxes, provides a guaranteed rate of return and can go to as many generations as the individual desires.
This technique is most appropriate for very wealthy people, with a net worth $25 million and above. The right candidate will have assets that produce cash flow or can be converted to produce cash flow. Among those assets are cash, money under management, hedge funds, investment real estate assets, business interests and interests in family limited partnerships or limited liability companies. Another possibility is to borrow from outside sources to fund the program.

The Issues Of Confusion
    The ideal candidate may be one that has issues about gifting. There are limits on the amount that can be gifted. In 2006, each individual can use the annual gift exclusion of $12,000 per recipient. If there is a spouse, the spouse too can give $12,000 per recipient. If they exceed that amount, the gifts are applied against the gift tax unified credit of $1 million. And while the unified credit for estate taxes changes, the gift tax credit does not. Currently, the estate tax unified credit is $2 million. (Please note that any gifting that goes against that unified credit also goes against the estate tax unified credit.) Also, someone can make gifts to "skipped persons" (i.e. someone more than one generation below the individual, such as a grandchild) of $2 million. Confused? So are your clients. Let's look at a traditional life insurance example.
    Because the premiums on life insurance can be much smaller than the ultimate death benefit, life insurance can be an ideal gift if done properly. The idea is to have an owner who is not the insured, so that at the insured's death the proceeds are not subject to estate taxes. The favored method is to set up an Irrevocable Life Insurance Trust (ILIT). It is structured so that the insured is not considered the owner, while the trust names the beneficiaries and the terms under which they can access the funds. But a complication about gifting has to be addressed. If a beneficiary does not have access to the annual gift made to the trust, the annual gift exclusion cannot be used.
    In 1968, there was a court case, Crummey v. Comm., which created a way to have a gift to an ILIT qualify for the annual exclusion. It gave rise to Crummey gifts and Crummey powers. Basically, the decision says that if a beneficiary has access to the funds put into an ILIT for some period of time after the money has been gifted (30 days is most often used), then it qualifies as a present-interest gift and the annual exclusion can be used. However, the portion of the annual exclusion that can be applied in a particular year under Crummey is the greater of $5,000 or 5% of the assets in the trust, not the same amount as the annual exclusion. This leads to some language in the ILIT that postpones the use of part of the annual gift exclusion until a later time, such as after all premiums are paid or the cash surrender value of the life insurance policy exceeds $100,000. To further complicate matters, if the skipped person mentioned before under the generation-skipping tax rules is a beneficiary, the Crummey provisions generally do not qualify that gift for an annual exclusion, so that it goes against the lifetime GST exclusion amount.
    Let's look at a sample situation. A husband and wife want to set up an ILIT to buy $20 million of life insurance on their lives. They have three children and two grandchildren. By naming all of them as Crummey beneficiaries under the trust, each spouse has five annual exclusions or $60,000 ($12,000 times 5) to cover premiums, for a total of $120,000. But the premiums are more than $120,000, so part of their lifetime exclusions have to be used. And if one spouse dies while premiums are still being paid, that spouse's annual exclusion is gone and only $60,000 can be applied. If they want to make other gifts to the children and grandchildren and have used the annual exclusions in funding the ILIT, those gifts also go against the lifetime exclusion amount.
    The above very short course on gifting and life insurance is necessary for you to understand the issue facing these affluent clients and why the regularly roll their eyes when the topic is brought up. So, instead of going down the rabbit-hole that is the rules about gifting, estate taxes and generation-skipping transfers, how about a way, defined by regulations, that does not involve making any gifts at all?

"Split Dollar" To The Rescue
    There has been a technique to purchase life insurance that has been in constant use since 1955. It has the off-putting name "split dollar." In essence, instead of one party being the premium payer, owner and beneficiary of a life insurance policy, through a side agreement two parties have different rights and obligations regarding the contract. With the split-dollar technique, two parties share the premiums, ownership and benefits.
    Skipping past all the history of split dollar to the present, in 2003 the IRS came out with final regulations for split dollar plans giving a road map to be followed. In the regulations split dollar is defined by any arrangement in which life insurance cash value and/or death benefit is used as collateral in exchange for someone paying or loaning money to pay premiums.1 One of the two methods involves making a loan to another party that will be repaid, plus interest, and that is the one I'll focus on.
    The Applicable Federal Rate of interest must be charged for the length of the loan to avoid some serious traps. The three terms are three years or less (short term), over three years up to nine years (mid-term) and anything longer than nine years (long term).2 These rates are published, and changed, every month. And the interest can be paid or accrued. In effect, if you structure a transaction properly you always know what the interest charge is going to be. For example, if you make a one-time loan of $5,000,000 to an ILIT to be repaid plus interest in nine years, you have locked in the mid-term rate for that time period. By making a loan we are not making any kind of gift.
    The second piece is that the ILIT is considered a grantor trust. What that means is that for income tax purposes the grantor is considered to be the owner, but for estate, gift and generation-skipping tax purposes the trust is the owner. The grantor pays taxes for what takes place in the trust (a good thing) without that being considered a gift. This is important because of what happens in the trust.
    The ILIT takes that loan and pays premiums on a life insurance policy with a guaranteed death benefit. The insurance company guarantees that if those premiums are paid on time, the death benefit will be guaranteed no matter when someone dies. But we loaned a lot more than was needed. The balance of the money is invested by you-the investment advisor. The grantor pays any income taxes on the income in the ILIT, so we only have to worry about gross returns. Each year a premium is paid from the assets. At the end of a set period of years, if the investments have made the bogey (the premiums plus the accrued interest) the loan is repaid to the grantor. Again, because it is a grantor trust the interest the grantor receives upon repayment of the loan is not taxable.

A Happy Ending
    Voila! No gifts have been made. At the same time, because the life insurance policy death benefit is guaranteed and the interest rate is fixed at the outset, those costs are known.3 The rate of return is guaranteed and only dependent upon when the insured dies. And after looking at all the lost use of money and the loan to the ILIT and the income taxes paid, the use-of-money cost is about 50% of what it would have been if the person just paid premiums on the policy outright.4 Moreover, this doesn't take into account the gifting, Crummey and generation-skipping issues in paying directly for the policy.
    As stated at the outset, this technique is good with many different kinds of assets, including those that the individual does not want to sell to provide funds such as real estate and business interests. And even if the money is going to come from an outside lending source, it makes more sense to do the transaction this way then to have the loan go directly to the ILIT. There is more certainty, no gifts and the interest rate the ILIT will pay to the grantor is less than what a lender will accept. The grantor can pay the lender directly without having to make gifts to the ILIT to cover the interest.
So, do you have very wealthy clients who may want to create a family bank for future generations and/or are using their annual exclusions for other purposes, or for whom premiums on large amounts of life insurance themselves would create gift tax problems, or clients who have nonliquid assets that produce cash flow that they do not want to sell?
    At the very least, bringing this technique to your clients will show your creativity and open up a discussion that can only prove profitable.

Richard L. Harris, CLU AEP is managing member of BPN Montaigne LLC. He works in the very advanced areas of life insurance, developing tax- and cost-efficient plans, and is on the editorial advisory board of Trusts & Estates magazine.

1 Among the items are Treas. Regs. Secs. 1.61-22(j) and 1.7872-15(n).
2 For March 2006, the short-term rate is 4.58%, the mid-term rate is 4.51 % (a reverse of the yield curve and not normal) and the long-term rate is 4.68%.
3 Because this is guaranteed by the insurance company it is important that you deal with carriers that are among the top-rated by the various rating agencies-AM Best, Moody's, Fitch, and S&P. If an insurance company should become insolvent the guarantees will no longer be valid.
4 I use a ten-year AAA Municipal Bond rate.