Clients looking to wrap up a complete package of tax savings as the year draws to a close may be pleasantly surprised by a split-dollar lending strategy that takes advantage of both the tax preferences afforded to life insurance and today’s low interest rate environment. For high-net-worth clients, this strategy can provide an effective method for transferring wealth while taking advantage of these dual benefits.
The stakes can be high, however, and this often-overlooked strategy presents a minefield of potential pitfalls that must be carefully avoided in order to ensure that the client receives the full tax benefit of a split-dollar life insurance plan.
The Split-Dollar Strategy
The basic strategy first requires that the client establish an irrevocable life insurance trust (ILIT), which will then purchase a permanent life insurance policy insuring the life of the client (a joint life insurance policy insuring the lives of two spouses may also be used). The ILIT itself will own the life insurance policy, so that the policy death proceeds will not be included in the client’s taxable estate.
While the ILIT owns the rights to both the policy’s death benefit and cash value, the client is able to choose the trust beneficiaries, thus accomplishing the wealth transfer that this strategy is designed to facilitate.
Policy premiums are then funded by the client’s loans to the ILIT, which are secured through an approach known as collateral assignment. Though the ILIT itself owns the life insurance policy, the client will retain a security interest in the policy in order to protect his or her right to be repaid. Typically, this repayment will not occur until the death of the client—i.e., when the life insurance death proceeds become payable.
Like any other life insurance policy, the cash value in the policy will accumulate without the imposition of either income taxes or the new 3.8% tax on investment income, allowing the client to dodge a triple tax liability if the pitfalls (discussed below) are avoided.
While combining an ILIT with a split-dollar loan strategy can provide your clients with significant tax savings potential, it is important that several considerations be kept in mind in order to maximize the value of the life insurance proceeds and avoid potential tax pitfalls.
First, in order to avoid a potential gift tax issue, it is important that the loan be structured so as to charge an appropriate interest rate—namely, a rate that is no less than the current Applicable Federal Rate (AFR). This will prevent application of the below-market loan rules that generally apply to split-dollar arrangements under the Treasury regulations.
If a rate that is less than the currently applicable AFR is charged, the client runs the risk that the foregone interest will be treated as a taxable gift, eliminating part of the tax benefit of the strategy.
Further, in order to avoid estate tax inclusion, the collateral assignment agreement must ensure that the client has no other ownership interests in the life insurance policy—such as the right to revoke the trust or access the policy cash value during life.
A split-dollar lending strategy can allow your clients to maximize the tax value of their life insurance policies when combined with an ILIT—but the complexity of the rules involved require competent professional advice in structuring both the loan transaction and the ILIT itself.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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