Even in normal financial times, many clients balk when faced with estate planning that involves the transfer of their assets “now.” Control, finality and lack of access can dampen planning activity. The economy and tax uncertainty creates further challenges. The “two year patch” implemented by Congress to the gift and estate tax rules has only added to confusion and speculation. In contemplating estate distribution options, many clients are content to do nothing. Inaction is deemed a strategy.

An “orchard loan” is an estate planning option that doesn’t require the permanent transfer of assets or current taxation. It can entice clients into action, regardless of what happens with the federal estate tax. As a planning technique, it can help avoid the permanent transfer of assets and loss of control, protect the estate from gift taxes, and allow for the build-up of assets for the estate’s heirs outside the taxable estate

An orchard loan involves a single lump sum loan of assets to an irrevocable life insurance trust (ILIT) established as a “grantor trust.” The loan is created using a “loan regime” private split dollar approach to fund the purchase of life insurance.

It does not require the permanent transfer of assets or payment of gift taxes, but it does help get value out of the taxable estate now to benefit the heirs. It can work well with large estates and especially so with clients who possess income producing assets that are currently illiquid by circumstance or choice. In the current economy, many estate owners hold real estate or stock whose values are depressed but expected to rebound. It may also be an alternative for clients considering commercial premium financing to purchase life insurance for estate purposes.

Case Study

John Johnson and his wife Joan have been advised that they will need at least $5 million of additional life insurance for estate planning and tax purposes. John is 62 and Joan is 64. He is in excellent health but Joan has medical issues that make her uninsurable. Married 40 years, they have two children and two grandchildren. Their current estate is valued at $20 million. Heavily invested in real estate, they have liquid assets in excess of $5 million. They are currently deciding how to address the premium on the $5 million of life insurance needed. Although their attorney suggested that they take advantage of the increase in the equivalent exemption, they are not convinced. They are considering commercial premium financing to purchase the insurance. John’s is concerned about how to get out of commercial financing if he lives more than 10 years? Here is where an “orchard loan” offers an alternative option.

The Trust
Creating an ILIT for the benefit of their heirs, a trust is set up to qualify as a “grantor trust.” As a grantor trust, its earned trust income is taxed to the Johnson’s, as the trust grantors, not the trust. Any income tax they pay as grantors on behalf of the trust is an additional benefit to their children as beneficiaries of the trust.

Private Split Dollar Arrangement

The Johnsons enter into a “loan regime” split dollar agreement with the trust. They loan the trust a lump sum $3million for a stated term of years, in this case 10. The loan can be in cash or in income producing assets.

Both the loaned assets and the life insurance policy will be available to secure repayment of the loan amount.

The $3 million transferred to the trust as a loan will be invested or managed by the trustee to generate trust income. (The Johnsons suggest a 10% pre tax earnings rate be used for illustration purposes). The Johnsons are liable for the income tax on trust earnings.

Under the private split dollar arrangement interest payments are made by the trust to the Johnsons using the published federal rate. We assume a hypothetical 4.1175% rate so that the numbers in the example are easier to follow. If the actual rate is lower additional funds would be available in the trust for the beneficiaries. (In January 2011 the actual federal rate, however, was 3.88%). Because of the trust’s status as a grantor trust, the amounts received from the trust as interest payments are not subject to income tax when received by the Johnsons.

As the trust earns income, it is applied by the trustee to life insurance premium payments and interest due to the Johnsons under the loan regime split dollar agreement.

Excess earnings, if any, will be invested by the trustee for the future benefit of the trust and eventual repayment of the loan

Life Insurance

The Trust applies for a single life policy on John’s life. Survivorship life insurance is also an option if both spouses are healthy but, in this case, Joan is not insurable. The premium payments are structured on a ten pay (year) basis and are projected to be $176,000 per year. A portion of the trust’s earned income is applied by the trustee towards the premium payments. If the asset earnings remain at their projected level over the ten years, the trust earnings will be sufficient to cover both premiums and interest payments.

At the end of the 10-year loan term, the $3 million loan is repaid by the trust using the trust assets. The trust retains the $5,000,000 life insurance policy. Assuming they are still alive, the trust grantors have the option to take the loan principle back or to forgive part or all of the loan repayment and make it a permanent gift. Over ten years, they will use their money to place a $5 million life insurance policy in the ILIT and outside their taxable estate. They have avoided gift taxes, maintained control over their assets, retained maximum flexibility and do not have to worry about a separate exit plan.

Cash or “Asset in Kind”

The Johnson’s assets include income producing rental properties, such as a small hotel valued at $3 million that provides net yearly income of $300,000 and is projected to appreciate, at a rate of 4%, over the next 10 years.

Instead of a cash loan of $3,000,000, the Johnsons transfer, as a loan, their hotel valued at $3,000,000. The agreement is to pay back $3,000,000, at the end of the loan period. Not only does this asset produce income at a rate of 10%, it is projected to appreciate in value at a minimum of 4% per year.

At the end of the loan term, the asset has grown in value to $4,440,733.

The $3 million loan is repaid by the trust using the trust assets. If the grantors decide at the end of the term that they want the original asset back, they can purchase it from the trust at the appreciated value.

In addition to the life insurance policy, there is value available for the benefit of the trust for the children, here $1,440,733. This value may be used to purchase additional life insurance to enhance the estate tax protection provided by the trust, for current distributions or invested in other assets.

Benefits:

–Keeps a string on the assets

–Funding an ILIT with $5 million of life insurance

–Transfers value out of the estate

–Protects estate from gift taxes

–Leaves door open for future gift

Risks:

As with any planning option, assumptions must be realistic. The stated value of assets in kind loaned to the trust must represents “fair market value.” The evaluation should be well substantiated. If earnings on assets transferred to the trust are less than projected, the loan term may have to be extended or a portion of the loan be forgiven and deemed gifted to the trust at the end of the loan term. Likewise, if earnings are greater than projected, the loan term can be shortened or additional assets may be available in the trust for the beneficiaries.

With proper planning, an orchard loan can be an extremely flexible and powerful estate planning tool.

Richard L. Olewnik is assistant vice president- Advanced Markets, AXA Equitable.