As Business Owners build PERSONAL wealth, they typically want to ensure that, in the event of their death, the value of their business equity will pass to a surviving spouse and heirs.
A variety of premium financing techniques-involving permanent life insurance comparable in value to the owner's business equity and borrowed premiums-offer a potentially attractive solution to this challenge.
Take, for example, a successful 40-year-old business owner who has built personal equity estimated to be worth $12 million in his business and now wishes to fund a buy-sell agreement with $15 million of individually owned permanent insurance. The premium for this coverage could easily be $200,000 per year in after-tax dollars.
Borrowing the premiums could be a beneficial option for the following reasons:
Permanent life insurance policies have a cash surrender value that,
under current laws and regulations, can provide collateral for a
secured loan.
New types of permanent life insurance offer
attractive options for the policy cash value that can diversify the
business owner's portfolio and outperform the cost of financing
premiums.
Borrowing has federal estate/gift tax advantages when used with an Irrevocable Life Insurance Trust (ILIT).
A thriving industry of specialty lending, called "premium financing,"
has evolved to facilitate this type of transaction by arranging
personalized secured loans.
Fine-Tuned Leverage
Most
business owners are familiar with the use of leverage to achieve
financial objectives and they understand the benefits of borrowing vary
with the type of asset financed. In a premium financing transaction,
leverage can work on three levels:
The contract provides the
immediate benefit of leveraging a first-year premium payment into a far
larger death benefit. In the example cited earlier, this leverage is 75
to 1-a $15 million death benefit acquired for a $200,000 first-year
premium.
The contract creates the potential over time for the
cash value to compound on a tax-deferred basis and eventually exceed
the cumulative cost of premiums.
The contract can have "tax
leverage" because the death benefit is normally free of federal income
tax. It also can be free of estate tax when properly structured and
owned by an irrevocable trust.
The advantages of borrowing life insurance premiums are tangible and valuable. The strategy can potentially increase personal net worth modestly during the business owner's lifetime and increase the after-tax estate substantially after death. Premium financing also creates the flexibility to adjust the amount of leverage built into the life insurance contract at the time of purchase and periodically over time.
For example, a business owner could "dial up" the premium financing leverage at age 40, reduce it in increments starting at age 50 by repaying some loan principal and eliminate it by retiring the loan as retirement approaches. For younger owners who are just starting to build serious net worth, premium financing can be a bridge until personal assets grow or a sufficient income stream becomes available to fund life insurance.
The Structure Of A Typical Transaction
Although each premium financing transaction is customized, the basic terms and techniques are somewhat standard, as follows:
The loan typically is non-recourse-secured by the policy's cash value
and a letter of credit (LOC) equal to any shortfall between loan
principal and cash value.
The policy is permanent life insurance
in which coverage is guaranteed for life or to a very high age (e.g.,
110). In form, it may be whole life, fixed universal life or indexed
universal life with a "secondary guarantee" of coverage. Variable life
insurance is typically not used in premium financing because of
regulatory restrictions on borrowing against securities.
The loan
interest is a floating rate typically tied to the 12-month LIBOR plus a
spread. Spreads have recently ranged from LIBOR + 2.25% for loan
commitments up to $2.5 million to LIBOR + 1.75% for commitments above
$20 million. The loan interest is not tax deductible for an individual,
trust or business entity.
A loan arrangement fee of 1.0% to 1.25%, depending on loan size, is charged and can be capitalized into loan principal.
The policy must be owned by a "bankruptcy-remote" entity so that the
premium finance lender has clear priority claim against cash value
collateral. An LLC or ILIT can qualify as bankruptcy-remote.
A
common arrangement is to fund the policy at the maximum level for the
first seven to 10 years, which can guarantee the death benefit. This
creates rapid cash value build-up and leverages policy benefits.
Funding should avoid Modified Endowment Contract (MEC) status. In a
"non-MEC" policy, loans and partial withdrawals of cash value may be
made on a tax-favored basis.
The policy is typically purchased by
an ILIT so that the death benefit can be paid free of federal estate
tax (a three-year look-back period applies on policies transferred to
an ILIT). The business owner normally is the insured person. Some
"survivorship" or "second-to-die" policies allow two lives to be
insured-a business owner and spouse-with the death benefit payable on
the second death. The trust's beneficiaries may be a surviving spouse,
children or, in the case of a business buyout arrangement, the LLC or
other partners of the firm.
Estate And Gift Tax Advantages
The
ILIT can help to avoid inclusion of the life insurance proceeds in the
grantor's taxable estate. With a competent institutional trustee, it
also can provide continuing management of assets and planned
distributions to beneficiaries according to the grantor's wishes.
There is, however, complexity involved in setting up ILITs funded with large amounts of life insurance. The trust normally owns the insurance and pays premiums, and the grantor can gift to the trust an amount needed to pay premiums annually. Such gifts can qualify for the annual gift tax exclusion-currently $12,000 per beneficiary-if they are of a "present interest." Then, any premiums gifted to the trust in excess of the annual gift tax exclusion can be sheltered under the grantor's lifetime gift tax exemption, which is currently $1 million. At the grantor's death, lifetime gift tax exemptions previously used will reduce the "applicable credit" for federal estate tax purposes, dollar-for-dollar.