For example, take a business owner who gifts premiums of $100,000 in one year to an ILIT established for four beneficiaries. Four annual gift tax exclusions, each worth $12,000, are used, covering $48,000 of premium. The remaining $52,000 will go against the business owner's lifetime gift tax exemption and offset the applicable estate tax credit by the same amount.  If the client used up their lifetime gift tax exemption they would be liable for gift taxes of up to 45% on future gifts. Many advisors, it should be noted, believe this is not the best use of the lifetime gift tax exemption.

By reducing the out-of-pocket premium payment obligations, premium financing can soften the impact of gifted premiums on the grantor's estate planning. The annual gift to the trust could be limited to the amount necessary for the trust to pay financing charges, which normally is far less than premium cost. In the example above, it is possible that none of the lifetime gift tax exemption would be used.

Exiting The Loan
In evaluating a proposed transaction, business owners should understand the common strategies for exiting a premium financing arrangement. In addition to paying off the loan with liquid cash as it becomes available, the options include:
Having the trust or estate pay off the loan after death, using insurance proceeds.
Surrendering the contract and using its cash value to pay off the loan.
Restructuring the loan.
Using a combination of personal assets and policy withdrawals or policy loans to pay off the premium finance loan. This is not usually recommended because large withdrawals or loans may jeopardize the guaranteed coverage feature of the policy.

Premium financing arrangements normally do not include loan prepayment fees. Therefore the business owner can "dial down" leverage by paying off loan principal whenever liquid cash becomes available, such as during years when profits are strong and incentive allocations are high.

Policy Performance
Premium financing works best when the policy has the potential to grow cash value at higher rates than the cost of financing. An analysis of prevailing interest rates over the past 20 years by the British Bankers Association shows that one-year LIBOR rates have averaged 5.19%. A premium financing arrangement at LIBOR + 1.75% would have averaged 6.94% interest annually over this period.

Most whole life policies' cash value growth, including any dividends paid by mutual companies, is less than 7% annually. Also, regulations preclude premium financing arrangements from including variable life insurance. Fortunately, a type of permanent policy called Indexed Universal Life (IUL) has emerged to fill the gap. IUL credits to cash values an interest rate that is the higher of a percentage of returns produced by a market index such as the S&P 500 or a guaranteed minimum annual rate, such as 2.0%.  Policy values are not subject to market fluctuations. Any cash value gains from year to year are locked into the contract.

We are seeing even more attractive "next generation" IUL products emerge. They credit cash value with interest based on an averaged "basket" of leading investment indexes, including those that invest in U.S. and international stocks. Other advantages of leading-edge IUL products include:
Lowest return dropped-The index that produces the lowest performance for the basket over a given period of time is dropped from the average.
Variable basket weightings-The highest performing index in the basket is given a greater weighting in the averaging process, on a look-back basis, than lower performers.
Five-year point-to-point measurement-Index returns are measured on a five-year rolling point-to-point measurement, which helps to smooth out temporary dips and produce the most favorable cash value crediting rates for policyholders.
One death benefit option available in most IUL policies allows insurance protection to increase dollar-for-dollar with cash value. Choosing this option can help to protect estates that keep growing with company success and an owners' increasing equity values.

When Does Premium Financing Work Best?
Premium financing strategies can work best for business owners when the benefits align with owners' personal needs, in the following ways:
The owner has a need for permanent guaranteed life insurance coverage and has limited liquidity or cash flow to pay premiums.
The owner expects liquidity or cash flow will improve at some point in the future and would like the flexibility to "dial down" life insurance leverage.
The owner has significant personal net worth tied up in the company and is confident it will keep performing well.
The owner believes the IUL basket of indexes has the potential to outperform the cost of financing premiums.
The need for life insurance coverage is large enough to create gift/estate tax issues because gifted premiums would exceed the annual gift tax exclusion.

Because IUL cash value crediting rates can fall below financing cost over intervals, it is essential to implement premium financing programs with the help of professionals who can monitor results and maintain program advantages. If the program begins to deliver less benefit than planned, it is best to know this fact and take remedial action sooner rather than later.

In the right circumstances, and with experienced professional support, premium financing can be a valuable technique for helping business owners pursue wealth accumulation and distribution goals, including protecting and ultimately cashing out the value of their business equity.