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.

Self-financing

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

Self-financed premiums allow the grantor to avoid gift taxes, since the funds given to the trust are a loan, not a gift. Only for those grantors who make additional payments to the trust to provide enough liquidity to pay annual loan interest, would annual gift taxes be due.

In most circumstances, the gifts could be structured so as to take advantage of the annual gift exclusion amount. The loan interest due would likely be considerably less than the premiums due, making it more possible to shelter the loan interest gift with the annual exclusion than a gift of the entire premium.

If the strategy is set up so the grantor makes a single lump-sum loan to use for the premiums and possibly the loan interest payments, then a low AFR amount can be locked in at the beginning of the transaction. However, for grantors who will make annual loans for premiums and/or annual gifts to pay loan interest, then the interest rates will fluctuate.

In addition to the possibility of rising interest rates, future changes in tax laws may warrant an early exit from a self-financed transaction. As a result, for most self-financing arrangements, prudent planning would warrant the consideration and establishment of an exit strategy at the beginning of the plan.

Using a GRAT as an exit strategy

Using a grantor retained annuity trust (GRAT) as an exit strategy offers two benefits. First, the grantor can gift assets to a trust at a substantially reduced gift tax cost. In addition, the use of a GRAT freezes the value of the asset for transfer tax purposes, thus removing all future appreciation from the grantor’s estate.

A GRAT is an irrevocable trust set up by a grantor and funded with an asset. The grantor retains a right to receive an annual annuity for a period of years from the trust, usually a percentage of the fair market value of the trust. Because the grantor retains the annuity, the value of the gift is only the remainder interest in the gifted asset, and thus gift tax is due only on that value.

The remainder interest is valued at the time of the GRAT’s creation using valuation tables and the Section 7520 rate (a monthly rate issued by the IRS equal to 120% of the applicable midterm federal rate). Typically, the lower the Section 7520 rate, the more the value of the gift to the GRAT is discounted, resulting in less gift tax due. This is because the Section 7520 rate is the IRS’s estimation of the rate at which the asset will grow.

If the IRS estimates a lower growth of the asset, then the remainder interest would be low, resulting in a lower amount of gift tax assessed. However, if the asset appreciates at a higher rate, that added value passing to the remainder beneficiary goes untaxed. At the end of the GRAT’s term, the appreciated asset passes to the remainder beneficiary, in this case the ILIT.

Once the gifted asset held in the GRAT passes to the ILIT, the trustee can decide what to do with it. The asset can be liquidated and used by the trust to satisfy the outstanding debt to the grantor for the self-financed premium loan(s). Alternatively, the asset can be left in the trust and invested so that the income can be used to pay the self-financing loan interest.

By coupling the self-financing transaction with a GRAT, the client can anticipate an exit strategy, which will either conclude or manage the transaction to prevent the loan from exceeding the death benefit passing to heirs, depleting the cash value or putting the policy in jeopardy of lapse, as happens with other attempts to roll out of the self-financing arrangement. GRATs are a long-established technique to pass assets in a gift-tax- efficient manner while also providing estate freeze benefits and allowing all future appreciation to build up in the life insurance trust, outside of the client’s taxable estate.

Nerre Shuriah, JD, LL.M, is an advanced marketing consultant for Transamerica Insurance & Investment Group, Los Angeles, Calif. She can be reached at