From the June 2003 issue of Investment Advisor • Subscribe!

Borrow and Invest the Difference

As financial planners know, an important part of any high-net-worth client's financial picture is the effective use of life insurance. And while these affluent clients can certainly afford their life insurance premiums, there's a growing trend in the industry to use financing to pay those premiums.

Whether used to offset estate taxes or to allow for a tax-free exchange, premium financing of life insurance offers a range of advantages. The attraction for clients is the ability to borrow at today's short-term rates while keeping their money working in their investment portfolio. Of course, for you, premium financing also provides a benefit--rather than liquidating assets to pay premiums, advisors can keep more of clients' assets under management.

Premium Financing Basics

First, let's look at the basics of a life insurance premium financing strategy. We'll use Ima Blueblood as an example. Ima is in her 70s, has three children, five grandchildren, and an estate worth approximately $10 million. The assets are split equally between real estate and her stock portfolio. Like most high-net-worth clients, Ima wants to pass as much wealth as possible to her family at her death.

As part of her estate planning strategy, Ima needs $5 million in trust-owned life insurance. But she doesn't want to liquidate her investments to pay the annual $150,000 life insurance premium (plus any applicable capital gains taxes). Instead, Ima's irrevocable trust borrows the money from a third-party lender unrelated to the life insurance carrier issuing the trust-owned policy.

Ima only pays annual interest on the loan, allowing her other assets to remain invested. As a trust grantor, Ima personally guarantees the loan. As with most loan arrangements, collateral is required to the extent the loan exceeds the policy cash values. As the cash values build in Ima's life insurance policy, they can ultimately be used as the sole source of the loan collateral. Even though some of Ima's investment portfolio is used as collateral, in most financing arrangements, trades can continue to be made and investment allocation changes made as needed.

It's important to note, however, that not all third-party lenders are alike. While most lenders are not interested in managing a client's assets, others may want to manage your client's investment portfolio if the client pledges it as collateral. This, of course, negates the benefits to you of keeping the client's investment portfolio intact and under your management.

With an appropriate financing arrangement, Ima's loan can be repaid at any time without penalty, or it could be repaid at her death.

As our example illustrates, the premium financing strategy can be a valuable tool for financial planners. Instead of the old insurance adage, "buy term and invest the difference," planners and clients can now consider "borrow for life insurance and invest the difference." This approach offers clients the key life insurance protection for their estate and business planning needs while ensuring assets are kept under your management.

Some Caveats

Naturally, financing insurance policy premiums makes the most sense when the loan's interest rate is lower than the rate the client would expect to earn on the assets that he or she did not need to liquidate to pay the premiums. Programs will differ in the interest arrangement but most have a variable rate using a spread on top of some short-term rate, such as the London Interbank Offered Rate (LIBOR).

Also, since the interest paid on the amounts borrowed to pay life insurance premiums is considered personal interest, clients generally cannot deduct this interest on their individual tax returns.

Figure 1 (on following page) lays out some of the factors that need to be taken into account when considering a premium financing program.

Like all financial strategies, there are specific issues to consider with premium financing. In most of these cases, the policy is owned by an irrevocable trust to avoid having the insurance proceeds included in the insured's gross estate. But if the grantor has made a personal guarantee of the loan, does this create an incident of ownership? To date, under Internal Revenue Code Sections 2033-2045, the IRS has not considered the personal guarantee a retained right, power or interest in the policy to cause the policy to be includable in the estate.

Additionally, in Private Letter Ruling (PLR) 9809032, the IRS ruled that even though an irrevocable trust had borrowed funds from the insured to pay life insurance premiums and the loan remained outstanding at death, the life insurance proceeds payable to the trust as beneficiary were not eligible for inclusion in the insured/grantor's estate.

Of course, private letter rulings are only applicable to the taxpayer that requested the ruling and the specific facts presented in the taxpayer's request. It does indicate, however, how the IRS might rule in a similar situation. This is why it is strongly recommended that your client's tax and legal counsel review the issue of the personal guarantee creating an incident of ownership for the insured.

Gift Tax Considerations

Another question to ask with premium financing is: Does the grantor's personal guarantee constitute a gift from the grantor to the trust? If a payment is made under the guarantee, it is likely that the IRS will consider the grantor to have made a gift for gift tax purposes. At the outset of the life insurance loan, however, there is only the provision of the guarantee, not an actual payment. So, it is still uncertain whether a personal guarantee constitutes a completed gift. Bradford vs. Commissioner, 34 T.C. 1059 (1960), PLR 9113009 and PLR 9409018, illustrate how conflicted the IRS is on this issue. Since the IRS is considering its position, it bears repeating that your client's tax counsel should review the gift tax consequences of a personal guarantee.

When Is It Appropriate?

There are a couple of areas where premium financing of life insurance can be particularly beneficial to clients, including the following:

IRC Section 1035 Exchange If an existing life insurance policy has a sizable outstanding loan, an IRC Section 1035 exchange might extinguish the existing loan, resulting in the owner having to realize the lesser of the gain or loan "boot" as income. Premium financing may offer a solution to this taxing problem.

Assuming the lender's financial criteria can be met, the irrevocable trust (as policy-owner) borrows the amount of the outstanding loan on the existing policy before executing the IRC Section 1035 exchange. The lender pays off the policy loan and the trust is able to execute the IRC Section 1035 exchange without any income recognition in the transaction. Further premiums on the new policy might also be borrowed from the lender.

Of course, the trustee would have to weigh the cost of paying interest on the new loan against the tax liability if the existing loan was extinguished during the exchange. But by using the premium financing strategy with an IRC Section 1035 exchange, clients may be able to pay off their old loans, increase their policy cash value, and lower out-of-pocket premiums.

Business-owned Life Insurance Another opportunity for premium financing is with business-owned life insurance. Just as individual clients might wish to retain their personal portfolios rather than liquidate for life insurance, a successful business can likely earn more on its capital than it might pay in interest with financed, business-owned life insurance. Financing is particularly attractive should the corporation need to fund permanent life insurance for a stock redemption plan, key person protection, or deferred compensation.

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