Tax Reform Gives Premium Financing The “Pilates” Treatment
April 11, 2011 by Chris Layeux & Peter L. McCarthy
Chris Layeux & Peter L. McCarthy
April 2011 Issue
Pilates sessions are famous for increasing physical strength and flexibility. The gift tax provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010) have this effect on life insurance premium financing. As a result, premium financing cases have the potential to be easier than ever in 2011 and 2012. This article discusses how the act adds new temporary flexibility to premium financing arrangements.
What Is Premium Financing?
Premium financing is a wealth transfer/estate liquidity strategy that has the potential to help wealthy people meet their estate liquidity needs and transfer more wealth to their children and grandchildren. This strategy is best suited to people who are quite wealthy and who do not wish to use their own funds to pay policy premiums. (See the Profile of a Suitable Premium Financing Prospect)
Profile of a Suitable Premium Financing Prospect
Premium financing is not for everyone; it is a complex transaction which carries a variety of risks.
A suitable premium financing prospect should meet these criteria:
• Has a need for life insurance death protection
• Has a net worth in excess of $5 million
• Has liquid assets to pledge as security for the premium loans
• Meets company underwriting guidelines
• Satisfies the lender’s minimum requirements
• Has access to knowledgeable tax and legal advisors
In a premium financing arrangement, a wealthy person creates an irrevocable life insurance trust (ILIT) which purchases a large life insurance policy insuring his life. The ILIT trustee borrows money to pay the policy premiums from a bank or other commercial lender. The policy is collaterally assigned to the lender as security for repayment of the loan. As part of the lending arrangement, the insured may be required to pledge additional collateral that is acceptable to the lender to fully secure the loan. If the loan is still outstanding at the insured’s death, the death benefit proceeds repay the outstanding loan balance and the remaining death benefits are paid to the ILIT so they can be distributed as directed by the trust agreement.
Why Do Wealthy People
Use Premium Financing?
Most suitable premium financing prospects have enough assets to pay their own premiums. Why do they choose to borrow the premium dollars from a commercial entity if they can afford to pay them themselves? There are a number of good reasons why some wealthy people decide to use outside funds to pay their life insurance premiums, including:
1. They may be asset-rich but cash poor. That is, their assets may be tied up in a variety of fixed or illiquid investments and cannot be easily converted into cash.
2. Converting assets into cash may trigger a variety of taxes, costs and fees such as: capital gains taxes, management fees and sales commissions. The extra costs, taxes and complexity of selling assets to create cash for premium dollars can make premium financing easier and more efficient than personally paying the premiums.
3. They may wish to save their cash and liquid assets for other purposes or to keep them available to deal with possible future crises and financial emergencies.
4. They may like the idea of using money other than their own to pay life insurance premiums because they can maintain control of their assets rather than spending them and losing any growth or earnings potential.
5. Borrowing premium dollars may be inexpensive relative to other available options in today’s low interest rate environment.
6. Until TRA 2010, gifting limits may not have been high enough to allow direct gifting to be an effective alternative option for paying policy premiums.
7. Commercial loans generally do not create a gift by the client to his trust; consequently, considerable gift tax savings may potentially be realized.
Favorable New Gift Tax
Rules for 2011 and 2012
TRA 2010 significantly expands the tax free gifting limits in 2011 and 2012. Effective January 1, 2011, the act increased the lifetime gift tax exemption from $1 million to $5 million per donor for two calendar years. The generation skipping transfer (GST) tax exemption limit also increased from $1 million to $5 million. Gifts and GST transfers exceeding these limits are potentially subject to gift and GST taxes at a maximum rate of only 35 percent. The increases in these limits have the potential to make premium financing arrangements much more flexible through 2012.
The expansion of the gift and GST limits offers wealthy individuals and married couples a wonderful opportunity to efficiently transfer more of their wealth to their children and grandchildren by making lifetime gifts before January 1, 2013. Individuals have an increase of $4 million in gifting capacity over what they could give in previous years. Married couples have an increased gifting capacity of $8 million. Individuals who haven’t yet used any of their lifetime gift tax exemption could give up to $5 million, while married couples could give away up to $10 million if neither spouse has previously used any lifetime gifting exemption.
Life Insurance Sales Opportunities
for Wealthy Clients
Parents and grandparents who are in good health and who can afford to make lifetime gifts have been given what may be a once-in-a-lifetime opportunity over the next two years. The increase in both the gift tax and GST exemptions to $5 million creates unique potential to pass on large amounts of wealth to younger generations. Gifts to GST trusts have the potential to accumulate and distribute family wealth outside the federal transfer tax system for several generations (the exact length of time depends on a variety of factors, including state law). When life insurance is used as a trust asset, it may be possible to leverage those gifts into additional wealth for the trust beneficiaries.
New Premium Financing Arrangements
New premium financing arrangements could be quite attractive to wealthy individuals and families. The ability to combine their expanded gifting and GST exemptions with funds their ILIT trustees may borrow from commercial lenders could significantly increase the amount of wealth they could potentially transfer outside the transfer tax system. At the same time, their premium financing arrangements could possibly be more flexible and efficient.
A hypothetical case may help make this clear. Let’s assume James Smith (age 65) needs $15 million of life insurance coverage to meet his estate liquidity needs. He has never used any of his gift tax lifetime exemptions, and he wants to establish a premium financing arrangement to cover the $900,000 annual premium cost. He creates an ILIT to own the life insurance policy. These are some of the flexible design alternatives potentially available to him:
1. Gift $1 million in cash to the trust in 2011 so the trustee has funds to pay the annual interest due on the outstanding loan balance.
2. Gift $3 million in additional cash to the trust in 2011 to reduce the total amount of premiums that need to be borrowed and the amount of required outside collateral he will have to put up to finalize the loan.
3. Gift an additional $2 million to the trust in 2012 which the trustee may use to pay down the outstanding loan balance; this may also reduce or eliminate the need for outside collateral.
4. Gift $1 million in income-producing property to the trust in 2011; the trustee may use the income to pay interest and/or possibly pay off part of the outstanding loan balance.
5. In either 2011 or 2012 create a 10-year grantor retained annuity trust (GRAT) funded with $10 million in assets. The ILIT would be the remainder beneficiary of the GRAT and, after 10 years, the GRAT would end and the ILIT would receive the GRAT’s remaining assets, which the trustee could use to pay down or pay off the outstanding loan balance. If the Section 7520 rate is 3 percent, the gift tax value of a 10 year, $10 million GRAT paying out 6 percent annually to the grantor is $4,881,800.
Existing Premium
Financing Arrangements
TRA 2010’s increased gifting limits give new flexibility to premium financing arrangements already in place. Wealthy clients have new potential opportunities to change or enhance premium financing arrangements they implemented years ago. To envision some of the possibilities, let’s assume that James Smith’s financing arrangement for his $15 million policy was put in place five years ago and that the current loan balance is $4.5 million. These are some of the new options he has for managing the arrangement:
1. Gift $4.5 million in cash to the trust in 2011 so the trustee can retire the outstanding loan balance.
2. Gift $1 million in cash to the trust in 2011 so the trustee has funds to pay the annual loan interest.
3. Gift $2 million in cash to the trust in either 2011 or 2012 so the trustee can pay back part of the loan balance (with a possible reduction in the amount of required outside collateral). The trustee may also retain part of the gift to pay annual interest costs on the reduced loan balance.
4. Gift up to $5 million in income-producing property to the trust before the end of 2012; the trustee may use the income to pay interest on the outstanding loan balance.
Premium financing arrangements can be complex and involve a number of risks. The act’s expanded gifting limits also create life insurance funding alternatives outside of premium financing. Because gifts in 2011 and 2012 have a much higher exemption limit, some clients may decide to bypass the complexity and risks of premium financing altogether.
Three available premium financing alternatives include:
1. Make Large Cash Gifts Directly to the ILIT. In Smith’s case, he could give up to $5 million directly to his ILIT over the next two years (assuming no prior use of his lifetime gifting exemption). The trustee could use these funds to pay policy premiums. If Smith is married, his spouse could agree to “split gift” with him and allow the use of part or all of her $5 million lifetime exemption to be applied to the gift. Thus, together they have the ability to supply the ILIT with up to $10 million gift tax free to pay premiums.
2. Create a Private Loan Arrangement. Instead of making large gifts to the ILIT, Smith could decide to lend the trustee the premium dollars himself. These transactions are known as private loan arrangements. The trustee and grantor enter into an arms-length loan agreement, using reasonable terms and setting a fair market interest rate. Smith would lend the trustee the premiums under the loan arrangement’s terms. In addition to lending the trust the premium dollars, Smith could make a lump sum cash gift to the trust so the trustee has funds to pay him interest on the outstanding loan.
3. Use a Gift/Private Loan Combination. Mr. Smith could also decide to use both gifting and private loans together in an integrated strategy. This combination approach could be useful if Smith’s remaining gifting exemption is not large enough to cover the needed premium dollars or if he wants to have the option of getting back some of his premium dollars if his financial circumstances change, the tax law changes, or be becomes dissatisfied with the life insurance policy. An example of this combination strategy would be for Smith to gift the trust $5 million in 2011 and lend it $1 million annually for each of the next five years.
Conclusion
The two year expanded gifting window created by TRA 2010 continues the long term uncertainty around wealth transfer planning. TRA 2010 provisions are temporary and expire at the end of 2012. Clients who can benefit from life insurance policies with large death benefits often borrow the dollars needed to pay premiums from commercial lenders in premium financing arrangements. The act’s expanded lifetime gifting limits appear to create temporary opportunities for premium financing clients to make their arrangements more flexible and potentially more efficient. The expanded gifting limits may allow them to reduce how much their trusts have to borrow to pay premiums and give them cash to pay interest on outstanding loans. The expanded gifting limits may also give them the opportunity to avoid premium financing arrangements altogether.
Now is a great time to show suitable clients and their tax and legal advisors how the new “pilates-like” flexibility in premium financing arrangements can enhance their wealth transfer planning.
These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor.
Author’s Bio
Chris Layeux
is the director of premium financing and advanced case design for the ING life insurance companies. He began his career in the financial services industry in 1983 and has worked with several companies in a variety of positions including advanced case consultant, agent and brokerage manager. He has extensive knowledge of non-qualified deferred compensation and estate planning. Layeux joined ING in 2003 as a member of its advanced case design team and, in 2005, was promoted to the advanced sales team to maximize ING’s premium financing sales. He is a published author and a popular speaker at local and national industry events. He is a past director of the Minneapolis/St. Paul Chapter of the Society of Financial Service Professionals. Layeux can be reached at ING, 20 Washington Avenue South 5750, Minneapolis, MN 55401. Telephone: 612-342-7699. Email: chris.layeux@us.ing.com.
Peter L. McCarthy, JD, MBA, CLU, ChFC
JD, MBA, CLU, ChFC, is a senior advanced sales consultant for ING’s life sales support. He has more than 20 years of experience in advanced marketing and has previously worked as advanced sales counsel for Minnesota Life, Prudential Insurance Company, and American Express Financial Advisors. McCarthy practiced law as an estate planning attorney with a large Minneapolis law firm. He earned his JD degree from the University of Miami (FL) School of Law and an MBA from Rollins College. McCarthy can be reached at ING, 20 Washington Avenue South #5750, Minneapolis, MN 55401. Telephone: 612-342-7699. Email: peter.mccarthy @us.ing.com.
