The competition to attract business from the desirable high-net-worth niche is fierce, and wealth managers must continually find ways to differentiate themselves to capture their share. One opportunity that may allow wealth managers to stand out from the crowd lies in the premium financing of life insurance. Often misunderstood and improperly utilized, the concept of premium financing can be a very attractive strategy for both the client and the advisor.
But first, it’s important to understand for whom and when premium financing may be most appropriate.
Illiquidity issues in the estate
Think of some of your current clients. Do any of them have a considerable net worth consisting primarily of illiquid assets? If so, how do they envision the transfer of their assets via their estate plan?
Under current law, an estate worth more than $3.5 million ($7 million if the clients are married and have a properly structured plan) is subject to federal, and possibly state, estate and inheritance taxes. A client with an illiquid estate above this threshold risks the possibility that illiquid assets such as real estate and business interests will have to be sold by heirs in order to pay the estate tax liability associated with those same assets. And in a situation where the seller’s hand is forced, sales proceeds are often diminished–therefore exacerbating the issues surrounding the tax liability.
Is there a simple solution to such a situation? Yes: life insurance. This should come as no surprise, as life insurance has long been a staple of effective and efficient estate plans. The trouble, however, lies in the ability of a client with an illiquid estate to obtain the appropriate coverage while being able to support the premium payments.
Financing an irrevocable life insurance trust
Life insurance is useful in estate planning because it offers the ability to instantly create liquidity, enhance or create a legacy, and replace wealth that would otherwise be depleted by transfer taxes. For most clients, an estate plan that includes a marital and credit shelter trust, along with an irrevocable life insurance trust (ILIT), is more than adequate. But the high-net-worth client is not like most clients.
If you have experience in implementing an ILIT, you are most likely familiar with the practice of using a client’s annual gift tax exclusions (currently $13,000) to provide for gift tax-free transfers of cash to the ILIT trustee on behalf of the trust beneficiaries. The trustee then applies the gift toward the payment of life insurance premiums. This method of funding an ILIT is simple and tax-efficient. The gifts to the ILIT are gift tax-free, and the death benefit received by the ILIT is estate and income tax-free. It doesn’t get much easier.
So why wouldn’t every client establish an ILIT if it is so simple and effective? One reason could be that the client is uninsurable, in which case he or she must seek an alternative strategy that doesn’t include life insurance. Another reason–and the one I would like to focus on here–is the client’s inability to effectively fund the trust due to potential gift tax costs or cash flow constraints, rather than affordability of the insurance.
Take, for example, a client who is worth $16 million and whose wealth is primarily composed of investment real estate. Understanding that the gross estate will be subject to estate taxes upon death, the client has formed a family limited partnership funded with investment properties. Using his applicable credit for lifetime gifts (currently $1 million per individual), he has transferred $1 million of limited partnership interests to his children. When applying the discounts available to the partnership interests, the gift has reduced the gross estate to just under $15 million.
The client wants to do more to mitigate the damage of estate taxes upon his death, but he is concerned about paying out-of-pocket gift taxes for any additional lifetime transfers. The client’s advisor recommends an ILIT to provide a pool of liquidity to pay estate taxes and therefore avoid a fire sale of any of the investment properties.