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Private Financing Arrangements Can Provide Flexibility For Clients

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Life insurance has long been a tool used to increase one’s ability to transfer wealth from one generation to the next. One strategy used often is to purchase a policy inside of an irrevocable life insurance trust (ILIT). As long as the insured doesn’t retain incidents of ownership, then the death proceeds will not be considered part of the decedent’s taxable estate.

As is common practice, the insured makes regular, ongoing gifts to the trust so the trustee may make the required premium payments. But what if clients want the flexibility to take back the dollars they’ve provided to pay premiums? With the uncertainty surrounding the fate of federal estate tax laws, having more versus less flexibility in this type of strategy might be of interest to some clients.

Or perhaps the client has already used up, or doesn’t want to use, the $1 million lifetime gift tax exemption and/or gift tax annual exclusion (currently $12,000 per year per person). Is there another option to consider?

Private financing

Private financing is an agreement between two parties in which one party (the lender) lends the other party (the borrower) the funds needed to pay the premiums on a life insurance policy. Private financing arrangements are usually between a family member and a trust he/she created for the benefit of his/her children and/or grandchildren. The borrower is responsible for paying the annual interest on the loan balance and eventually must repay the loans.

There are a number of advantages of this type of an arrangement to the parent, including the ability to:

o Leverage loans into income tax-free death benefits.

o Effectively control the policy without actually owning it.

o Change your mind and get your money back.

o Secure part of the death benefit estate tax-free.

o Avoid limits on the gift tax lifetime exemption or annual exclusion, since loans are not considered gifts.

Here’s a visualization of how premium financing works.

As many as 3 documents will be needed to put the arrangement in place. An attorney should be used to draft them. The documents include:

(1) A note. This is the loan agreement between both parties. A new note is needed each time there is a new premium loan.

(2) A collateral assignment. This document should be filed with the insurer if the life insurance policy will serve as security for repayment of the loan.

(3) An irrevocable life insurance trust or ILIT. If estate taxes are a concern, then this trust can own the life insurance policy and keep the policy death benefits outside the lender’s estate.

Interest payments can be handled in a number of ways. The borrower can pay the interest from other assets. If the borrower is an ILIT, there must be other assets in the trust to make the interest payments. If there are no other assets in the trust, then the parent can make a gift to the ILIT so it has the ability to pay the interest. The borrower can withdraw or borrow policy cash values to pay the interest. Also, the interest can be accrued by adding it to the loan principal.

There are also options for paying off the loan balance. Among them are using part of the death benefit; tapping other assets in the ILIT, and, if the policy cash values exceed the loan balance, authorizing the ILIT to withdraw and/or borrow against the cash values. This last approach, however, can threaten the policy’s long-term ability to remain in force.

Of course there may come a time when the parent decides that he or she will be financially secure without the assets represented by the loan balance. If so, he/she may forgive all or part of the ILIT’s repayment obligation. This is a taxable gift that may reduce the parent’s lifetime gift tax exemption. Lastly, the ILIT and the parent can agree to combine any of these methods into a plan customized to meet their needs.

There are several tax issues to consider when structuring a private financing arrangement. A CPA and/or attorney should be consulted. Generally, there is no income tax consequences to the ILIT (borrower); however, there can be both income and gift tax consequences to the parent as the lender.

Tax consequences may be triggered if the loan interest rate used is lower than the market interest rate for loans of similar length (as published by the IRS’s “applicable federal interest rate”). Additionally, if the ILIT pays less than the required interest payment, as defined under the terms of the note, then the parent is deemed to make a taxable gift of the difference. This gift may not be a present interest that qualifies for the gift tax annual exclusion.

Interest payments to the parent are generally treated as taxable income. However, it may be possible to avoid this if the parent creates a grantor trust and makes the loan(s) to it rather than to the child. A properly drafted ILIT can qualify as a grantor trust.

There are also estate tax consequences. Any notes outstanding on the date of the parent’s death are included in the parent’s gross estate. In addition, any interest that was due but unpaid on these notes is also part of the gross estate.

Summing up

In conclusion, private financing arrangements can be very effective in meeting a family’s retirement and estate planning goals. Parents may use them to create additional inheritances for their children and grandchildren while retaining the ability to get their money back if their objectives or finances change. But like most complex strategies, one must take the time and care to understand all the pros and cons to determine if it is right for a family’s particular situation.

Matthew Stewart, CFP, is a partner with Columbus Financial Partners in Dublin, Ohio. You can e-mail him at .


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