The ability to leverage one’s assets through the use of life insurance makes it an extremely compelling and almost universal part of most high-net worth individuals’ estate plans. One popular strategy, especially among clients with insufficient or no annual gift exclusions or lifetime gift exemptions, is called self-financing (also referred to as private financing).
Self-financing works extremely well when established with a grantor-retained annuity trust as an exit strategy. Moreover, today’s low-interest rate environment works to maximize the advantages of both strategies.
In a self-financed arrangement, the insured/grantor lends funds to a second party, either to an ILIT (irrevocable life insurance trust) or directly to the insured’s heirs. The funds enable the trustee of the ILIT to own and pay premiums due on a policy on the life of the grantor.
The grantor can:
o Make loans annually to pay the premiums.
o Make a larger single loan the trustee can use to purchase either a single- or short-pay policy.
o Invest the funds and use the appreciation and any principal to lend the premiums to the trust over time.
Usually, the transaction is structured with the intent that the grantor be repaid the outstanding principal from the death benefit of the policy. Some policies are thus purchased with a return of premium rider to facilitate the loan payoff without losing the death benefit needed for the heirs.
In order for the loan to be considered an arms-length transaction, the trustee must pay the grantor annual interest on the loan at least equal to the applicable federal rate (AFR). If the trust does not have enough additional funds to pay the loan interest, the grantor can make annual gifts to the trust to cover the interest, or the interest can be rolled into the principal of the loan.
If the interest is rolled into the principal of the loan, the trust runs the risk of the loan becoming so large as to dwarf any amounts retained from the death benefit. The ability to use the AFR to set the interest rate is extremely advantageous, especially in today’s low interest rate environment. With the recent drastic cuts in lending rates by the federal bank, the AFR is currently at some of its lowest levels. Lower interest rates mean the trust needs to have less additional funds to pay the interest.
Avoid gift taxes