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.
So which plan type works best in which situation? In general, because the economic benefit under a private financing approach is measured by the size of the loan (and hence the size of the premium), it will work best for clients when the premium is lower relative to their ages, when interest rates are low and when the client is already relatively old (age 75-plus).
Private financing is ideal when the client wants to make a lump-sum loan because the low loan interest rate can be locked in. Private financing also lets the ILIT own the potential policy cash value in excess of the premiums paid and use this cash value to help offset rollout costs. Finally, private financing is better than PSD when the client wishes to completely eliminate taxable gifts, as the loan interest can be deferred until death with no gift made. This approach may erode the death benefit left for the trust but can still be appealing to clients with serious gift tax concerns.
Private split-dollar fits into the opposite niche. On a single-life basis, PSD plans will work best for younger age clients and when the premium is high for the client’s age (e.g., rated cases, smokers). And PSD is almost always the best choice for survivorship cases, as the joint Table 2001-10 rates are significantly lower than even the single-life rates.
For example, assume a married couple, both spouses age 65 and preferred non-smokers, need to purchase $1 million of life insurance with an ROP rider. Assuming a premium of $14,467, which approach would work better for them?
As the chart demonstrates, PSD generates a much lower economic benefit rate until the clients reach 89 and would be a good choice for these early years. In the later years, the client can switch from PSD to private financing and thereby get the best of both worlds.
The client can also switch plan types when one of the insureds dies and the economic benefit rate reverts to the higher single-life rate. This is an advantage not offered by private financing, as once you elect a private financing arrangement, you cannot switch it to PSD.
Both private split-dollar and private financing are useful planning tools that can help clients fund an ILIT while minimizing gift tax costs. Knowing when to use each one can be the key to making the sale.