Working on sales of survivorship life insurance involves many client variables. Often, helping clients select an attractive financing strategy for survivorship life insurance policies owned by an irrevocable life insurance trust is the key to closing the sale. If you target this type of sale, it’s important to familiarize yourself with these commonly-used financing strategies.
Annual exclusion gifts are generally the favorite financing strategy. This approach works best when the policy premium is less than the dollar amount of annual exclusion gifts available. Relative simplicity, ease of communication, certainty, and ease of termination (if necessary) are the primary benefits of this strategy.
Clients who hold income producing, highly-appreciable assets, and who have a substantial net worth, may consider gifts of such property to an ILIT. Gifts up to $2 million may be made to an ILIT ($1 million from each spouse) without paying any out-of-pocket gift tax. Earnings from these assets, generally reported as income by the grantors, are used to pay policy premiums.
Future appreciation of these gifted assets is excluded from the clients’ taxable estate at death. Additional gift tax leverage may be available through discounting of minority interests in privately-held companies. Many planners consider it advisable to pay premiums on a limited-pay basis to minimize future self-completion risks, such as a decrease in the assets’ earnings. It is also important to remember that once property is gifted to an ILIT, it can not be returned to the trust’s grantors.
Regrettably, some planners no longer include private split-dollar arrangements among the options for financing large survivorship policies owned by ILITs. This view overlooks the significant gift tax leverage in arrangements involving survivorship policies.
Instead of annual exclusion gifts being linked to policy premiums, annual exclusion gifts in a private split-dollar arrangement are based on the amount of economic benefit provided by the arrangement sponsors. Typically, cash gifts to the ILIT are used by the trustee to reimburse the sponsors for economic benefit costs provided by the split-dollar arrangement.
While both spouses are alive, the economic benefit is generally measured using cost of insurance rates derived from Table 2001. The calculation of this amount assumes that both spouses die in the same year. The amount of this economic benefit is often exceptionally low when compared with the full policy premium.
Many planners and advisors recommend using a limited-pay design with survivorship policy in split-dollar arrangements. This approach minimizes the risk that the economic benefit amount will sharply increase after one of the spouses dies. If the economic benefit increases, then annual exclusion gifts will also need to increase.
When private split-dollar arrangements are used, clients are underserved if a well-defined rollout strategy is not part of the plan design. One popular rollout strategy is for the sponsors to terminate the split-dollar arrangement and not require the ILIT to repay premium advances.
This results in a taxable gift to the ILIT. If the sponsors both have their $1 million lifetime gift tax personal exemptions available at termination, and if the value of the gift is less than $2 million, then no out-of-pocket gift tax will be due. The actual amount of the gift will vary according to the plan design finalized by the clients’ tax counsel. Generally, the gift will be either premiums paid or the policy’s cash surrender value, disregarding surrender charges.
Another rollout strategy, most popular with very large estates, is to use a zeroed-out, grantor retained annuity trust (GRAT) to fund the ILIT’s repayment of premiums to the sponsors. Termination of the GRAT coincides with the limited-pay period of the survivorship life insurance policy. Once the GRAT terminates, any remaining trust property is distributed to the ILIT. The trustee then uses this property to repay the sponsors for premiums advanced.
This rollout strategy is attractive because, if done correctly, the value of the remainder interest legitimately passes to the ILIT without a taxable gift being generated. This creates a tremendous amount of gift tax leverage for the clients.
An interest-only installment sale of a business interest to an ILIT is often used to finance large purchases of life insurance. Typically, highly-appreciable stock in a closely-held family business is sold to an ILIT in return for an interest-only installment note. Principal is payable in full at the death of the second spouse to die, funded by survivorship life insurance inside the ILIT.
Usually, a 10% down payment is part of the arrangement. The ILIT acquires funds for this down payment from a gift by the ILIT grantors. This relatively large gift, which may be eligible for discounting for valuation purposes, is generally less than the grantors’ combined $2 million lifetime gift tax personal exemptions.
Earnings generated by the ILIT-owned asset are used to pay interest and insurance premiums. In these arrangements, ILITs are typically designed so that earnings are included in the grantors’ taxable income, much the same as if the grantors’ still owned the asset.
This strategy works best for very large purchases of survivorship insurance. It is used most often when lifetime personal exemption gifts of income producing assets to the ILIT will not provide enough earnings to pay premiums. This strategy eliminates gift tax annual exclusion concerns when policy annual premiums are larger than available exclusions. Also under this approach, annual exclusions are freed up for other gifting purposes.
Clients considering this strategy must be comfortable with loss of direct control over the assets gifted and sold to the ILIT. A limited-pay design generally makes the most sense as a way to limit the risk that earnings from trust assets may be insufficient at some future point. Another important point clients should consider is that assets sold to the ILIT generally will not be eligible for a stepped-up basis at death. In addition, the sale value of the asset is still included in the grantor’s estate for estate tax purposes.
In summary, clients considering these financing strategies, or others beyond the scope of this article such as premium financing or split-dollar loan arrangements, need to be comfortable with all aspects of the arrangement. Important factors to evaluate any arrangement include: (1) income, estate, and gift tax consequences; (2) duration of the arrangement and any self-completion risks; (3) ability to conclude the arrangement; (4) impact on the grantors’ other estate and business transfer planning; (5) the clients’ overall personal financial position; and, (6) the clients’ age, health, and family dynamics.