Private split-dollar and private financing are 2 sophisticated planning approaches that can help fund a policy in an irrevocable life insurance trust while reducing gift tax costs. However, because they are sophisticated techniques, PSD and private financing are frequently confused with one another, and sometimes a good sale could be lost due to this confusion. Using the techniques effectively requires an understanding of the mechanics of each concept, the areas where they are similar and the areas where one concept works better than another.
Private split-dollar plans can take many forms. The most common approach is to use a non-equity collateral assignment agreement between a donor and an ILIT. The donor pays the policy premium and owns the policy’s cash value; the ILIT receives the remainder of the death benefit. In such an arrangement, the taxable gift from the donor to the trust is the economic benefit based on the insured’s age, the amount of death benefit the trust gets and either Table 2001-10 or (more usually) the insurance company’s alternative term costs. In general, the economic benefit costs will be substantially lower than the policy premium in the early years of the policy.
Private financing is a fair-market loan arrangement between a donor and an ILIT. In its simplest form, the ILIT and the donor enter into a loan agreement wherein the donor lends the ILIT enough money to pay for the policy premium. The ILIT then pays loan interest back to the donor based on the applicable federal rate, the term of the loan and the type of loan.
If the ILIT has no other assets (as is often the case) the donor would have to make a taxable gift to the ILIT of the loan interest, which in the early plan years will be less than the policy premium. The most common approach is for the donor to lend the ILIT the premiums on an annual basis, but another popular approach is for the donor to lend a large lump sum to the trust for a specified number of years.
Both PSD and private financing allow the funding of a life insurance policy in an ILIT at a reduced gift tax cost. In the case of PSD, the gift is generally limited to the economic benefit cost; with private financing, the gift would be the loan interest.
Another common feature they share is the need for an exit strategy. In PSD, the rate for measuring the economic benefit cost increases as the client(s) age, thereby reducing the leverage. Over time, the economic benefit can even grow to be greater than the annual premium. For private financing, as the loan increases or interest rates fluctuate, the loan interest due also grows and can eventually exceed the annual premium. So for both plans, considering an exit strategy is a must.
Still another feature shared by both plans is the return of premium rider. Since both plans require that the premiums or total loan amount be paid back to the donor at death, the death benefit available for heirs will be reduced by that amount. An ROP rider will increase the death benefit with each premium payment, ensuring that enough money is available to pay off the donor and secure the desired amount for heirs.