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October 19, 2009 at 08:00 PM
This year has brought with it applicable federal rates that are lower than many of us thought possible. The AFRs, in addition to being used to calculate the value of remainder and annuity interests, are the safe harbor provided from the Internal Revenue Service to ensure that a debt transaction will not have below-market interest. But how do these historically low AFRs help us plan for clients who want guaranteed rates of return?
Leveraging the DIGT
A simple technique for achieving this objective is the intentionally defective irrevocable grantor trust. If a trust qualifies under the tax code as a DIGT, the grantor of that trust is treated, and taxed, as the owner of the trust’s assets for income tax purposes. This shifting of the income tax burden from the trust to the grantor opens many different wealth and appreciation shifting techniques.
The first technique involves the loan of funds to the DIGT. The grantor lends a sum of money to the DIGT in exchange for an interest-only promissory balloon note that charges interest at the applicable AFR. The DIGT pays interest on the loan and principal at the end of the note’s term. During the note’s term, the DIGT invests the loaned funds and the grantor pays the income tax due on the income generated by the DIGT’s investments. If the grantor is seeking a guaranteed rate of return, the trustee can invest the funds in a no-lapse guaranteed life insurance policy. 
Often when the grantor lends funds to the DIGT the loan is large enough that the income generated by the funds is enough to pay the interest due on the note and the premiums on the life insurance policy. By just using the income generated by the fund the bulk of the loaned funds is preserved and used to repay the note’s principal. When this loan technique is used, both the promissory note and the life insurance premiums are usually structured to be completed in 9 years to take advantage of the mid-term AFR. By year 10 the grantor has the funds back, plus interest; and the DIGT owns a paid-up guaranteed life insurance policy.
This large-loan technique, while very effective in some situations, will not work if the grantor does not have liquid assets or if the grantor/insured is of advanced age, making the 9-pay premium too large. An alternative is to have the grantor make a smaller loan that will function as a “sinking fund” designed to be consumed over the term of the promissory note. The sinking fund allows the trustee to structure a longer premium payment schedule for the life insurance policy. But the trust will also need another means of repaying the principal on the grantor’s note (an “exit strategy”).
There are many different options for putting an exit strategy in place so that the DIGT can repay the grantor’s loan. The simplest exit strategy is to use some of the death benefit from the life insurance policy to repay the loan. The drawback: Distributing a large portion of the death benefit to the grantor’s estate is likely to run contrary to the reason for purchasing life insurance inside a DIGT.
In addition, the longer the promissory note runs, the more death benefit is required to repay the loan; in some instances the loan balance can outstrip the death benefit, making the DIGT insolvent. Should this happen, the IRS might re-characterize the initial loan as a gift to the DIGT.
