InKnowVision July 2013 HNW Technical PPT - Split Dollar

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Split Dollar and Intra Family Loans
Powerful Wealth Shifting
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• Loan at the AFR
• From a wealthy family member
• To a grantor trust
• For an unsecured promissory note
What is it?

Why do it?
• Ability to shift opportunities to heirs
• Ability to effectively make income tax free gifts
• Possibility of discounting the value of the note at
death

Facts
• Father loans
 $10M to a defective trust
 Interest rate at current AFR of 1.22%.
 10 year term
• The family believes that they will be able to
achieve a total annual return on investment of 6%.

1. Ability to shift
wealth to heirs
• Under these facts, this strategy would allow the
father to effective transfer $5.9M in 10 years
without gift tax.

Investment Interest Rate
Paid
Growth Rate Change Growth
Rate in Year
New Growth Rate
10,000,000 1.22% 6% 11 8%
1. Ability to shift
wealth to heirs
BOY Balance Growth Interest
Payment
EOY Balance
1 10,000,000 600,000 (122,000) 10,478,000
2 10,478,000 628,680 (122,000) 10,984,680
3 10,984,680 659,081 (122,000) 11,521,761
4 11,521,761 691,306 (122,000) 12,091,066
5 12,091,066 725,464 (122,000) 12,694,530
6 12,694,530 761,672 (122,000) 13,334,202
7 13,334,202 800,052 (122,000) 14,012,254
8 14,012,254 840,735 (122,000) 14,730,990
9 14,730,990 883,859 (122,000) 15,492,849
10 15,492,849 929,571 (122,000) 16,300,420
Less Principal 6,300,420

2. Make income tax free gifts
• Assume same facts as above but add that all income is
annually taxable to the grantor.
• The after tax advantage to having the grantor pay the
tax at the end of 10 years is $2M.
• Combining the results achieved with loans in items 1
and 2 above, your client has the ability to shift $7.9M
to his kids without gift tax or to grandkids without GST
tax over a 10 year period.

3. Value Adjustments
for the Note
• Why do this?
 Gift tax savings
 Estate tax savings

Example
• Using the facts as described above, assume that
Dad makes a loan to a defective trust for $10M at
current AFR of 1.22% at a time when market
interest rates for a similar loan would be 6.00%.

Present Value
• The present value of a 25 year $10M loan at its stated
rate of interest is $10M. However, the present value of
a 25 year $10M loan with stated interest of 1.22% is
much less if the discount rate used to calculate present
value is a FMV rate of 6.00%.
• In fact, the PV of this loan would be $6.48M. A 35%
adjustment from face. The adjustment could also be
affected by other issues, such as the borrower’s ability
to repay the loan, whether or not the loan was secured,
the size of the loan, etc.

How to Get There
• Reg § 20.2031-4. Valuation of notes.
• The fair market value of notes, secured or
unsecured, is presumed to be the amount of
unpaid principal, plus interest accrued to the date
of death, unless the executor establishes that the
value is lower or that the notes are worthless.

How to Get There
• Evidence must be submitted that the note is worth
less than the unpaid amount because of:
 interest rate
 date of maturity, or
 other cause, or
 the note is uncollectible, either in whole or in part (by
reason of the insolvency of the party or parties liable,
or for other cause), and that any property pledged or
mortgaged as security is insufficient to satisfy the
obligation.

How to Get There
• The burden of proof is on the estate.

Key Elements
• Cases where the burden has been established fall
into 3 basic categories:
1. Market rate of interest for similar notes is
substantially higher than the stated rate of interest at
the time of decedent’s death.
2. Maturity date of note is far into the future making the
note more susceptible to potential long terms negative
impact of fluctuating interest rates and borrower
creditworthiness.
3. The borrower did not have a strong ability to repay the
note.

Estate of Hoffman
• 17 year note
• Interest rate of 7.61%
• Due at maturity
• Ultimate Discount Rate for note 12.5%
• Discount from face of approximately 50%

Estate of Meyer B. Berkman
• Interest rate at 6%
• Prime Rate of 9.75%
• Lack of security
• Considerable length of time to maturity
• Court finds approx 50% discount

Split Dollar Loans

The 3G Concept
• Assumed facts: Grandfather, age 70 (G1) looking to
pass wealth to child, age 45(G2) and grandkids (G3)
 Create a GDOT with G3 as beneficiaries.
 GDOT purchases insurance on life or lives of G2 (or G3)
 G1 (Lender) loans money to GDOT (Borrower) for premium
payments
 Loan calls for repayment of principal and accrued interest at
the then current AFR at the death of G2(of G3).
 G1 continues to make premium payments of 500k per year
for 5 years
 At the end of year 6, G1 dies
 What is the value of the loan in G1’s estate?

The 3G Concept
• There are five loans, totaling $2.5M.
• Each loan has a term equal to G2’s life expectancy-
approx. 28 years.
• Assume that all loans carry 3% interest rate
• Also assume that we can sustain the burden of
proving that the value of the loan is lower than
that determined under Reg § 20.2031-4.

Split Dollar
• Think old style collateral assignment
• Trust is policy owner
• G2 or G3 is insured
• G1 is premium payor
• The policy is collateral
• AFR rate for interest is charged on the loan

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Split Dollar
G1
Pays Premium
Trust
Owns Policy
• Payment of premium constitutes a loan
• Policy is assigned as collateral
What is the Value of the Loan Obligation at death or gift?

The 3G Concept
• Present value calculation, using a market interest
rate assumption of 6.0%, the present value of the
loan is $1.4M.
• A 60% valuation adjustment.
• Split dollar governed by Reg § 1.7872-15. Split-
dollar loans.

Key Advantages
• Transfer of wealth to G2 and G3 without gift or
GST tax
• Valuation discounts
• Tax free cash buildup in policy
• Life insurance death benefit

InKnowVision July 2013 HNW Technical PPT - Split Dollar

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