2. What is Premium Financing?
What About Collateral?
How is Premium Financing Used in Estate Planning?
What Are the Exit Strategies?
Obtaining Additional Gifting Leverage During the Exit
How Does it Work?
Advantages
Considerations
3. What is Premium Financing?
Typically, premium financing is a fair market loan arrangement
between a commercial lender and an irrevocable life insurance trust
(ILIT) where the lender loans the premiums for a life insurance policy
on your life to the ILIT*.
The gift to the ILIT is equal to the amount of loan interest charged -
not the entire policy premiums. As a result, you are able to acquire
the death benefit needed with little or no gift tax impact. In addition,
there is minimal or no impact on your current investment portfolio:
You maintain control and use over assets that otherwise would have
been liquidated to pay life premiums.
•Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including generation-skipping
tax). Failure to do so could result in adverse tax treatment of trust proceeds.
For federal income tax purposes, life insurance death benefits generally pay income tax free to beneficiaries pursuant to IRC Sec. 101(a)(1). In certain
situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance
policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e. the “transfer-for-value rule”); arrangements that
lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(j). Guarantees
are subject to the claims paying ability of the issuing insurance company. Discussion covers fixed insurance only.
4. What About Collateral?
The policy usually serves as the primary collateral for the loan. During
the early years of a policy, cash surrender values are generally less
than premiums paid. As a result, you are typically required to provide
additional collateral.
Loan interest can be paid annually or deferred for a period of time.
Loan principal, including any accrued interest, may be
repaid from the life insurance proceeds or from other sources during
your lifetime. Potentially, a return of premium rider can be used to
repay the premium loan without diminishing the death benefit needed.
Premium financing makes great economic sense when there is a
positive arbitrage between the policy’s internal rate of return or the
trust’s investment return and the loan interest rate.
5. How is Premium Financing Used
in Estate Planning?
Premium financing can be used in tandem with estate planning if you
wish to obtain a large amount of life insurance for purposes of estate
tax liquidity.
If the policy is held outside of the estate, typically in a trust,
premium financing can provide gift tax leveraging because you will
not have to gift the premiums. If the loan interest is paid annually, you
have the option to use your gift tax exclusions and lifetime gift tax
exemption to reduce the taxes due
on the annual loan interest gifts.
Alternatively, you may be able to avoid making any gifts by having the
loan interest accrued.
6. What Are the Exit Strategies?
Certain risks are inherent in premium leveraging arrangements, such as interest rate
uncertainty (loan arrangements), increasing economic benefit costs (split-dollar
arrangements) and decreasing net death benefits due to the collateral assignee’s
increasing interest in the policy.
A well planned exit strategy provides you an effective way to terminate a premium
leveraging arrangement by providing the funds necessary to repay the debt and
maintain your desired level of insurance protection.
Popular exit strategies to consider are grantor retained annuity trusts (GRATs),
installment sales to an intentionally
defective irrevocable trust (IDIT) and charitable lead trusts (CLTs).
Generally, these techniques all provide for a future transfer of wealth at a reduced gift
tax cost in an effort to provide the necessary funds to retire the debt associated with
the premium leveraging arrangement at the appropriate time.
7. Obtaining Additional Gifting
Leverage During the Exit
Combining any of the popular exit strategies with other estate
planning techniques, such as a family limited partnership (FLP), can
significantly increase the leverage and reduce the value of the
taxable gift.
By incorporating assets that are subject to valuation discounts due to
lack of marketability and/or lack of control (e.g., FLP interests, limited
liability company interests, or non-voting stock) into the exit strategy,
you can effectively increase the value of the remainder interest by 40-
100 percent when compared to exit strategies utilizing transfers of
assets not subject to valuation adjustments.
8. How Does It Work? Collateral
Assignment
Client
Client ILIT Lender
Gifts
Loan
Death
Benefit
Premium
Death
Life Insurance Benefit
Company
1. You create an ILIT, the beneficiaries of which are typically your family members.
2. ILIT borrows funds to pay the premiums due and collaterally assigns the policy to the lender. Loan interest
may paid annually or deferred for a period of time, depending on the terms of the loan.
3. You pledge additional assets as collateral. (Not on the chart)
4. ILIT uses the loan proceeds to purchase a life insurance policy on your life, retains ownership rights and
designates the ILIT as the beneficiary of the policy.
5. At your death, the loan is repaid from the death proceeds. Alternatively, the loan may be repaid during
your lifetime in a lump sum or installments from sources outside of your estate. Funds to repay the loan
may include an ILIT side fund to which you have contributed annual gifts that have been invested, or an
existing trust or partnership that may have significant assets available.
6. Death proceeds in excess of the amount required to repay the loan are distributed to the ILIT beneficiaries,
estate and income tax-free.
9. Advantages
Death benefit payable to the ILIT should pass to the trust
beneficiaries, estate and income tax-free
Substantially reduce or eliminate gift tax cost associated with
your desired level of life insurance protection
Reduced net out-of-pocket cost for the life insurance
Minimal or no impact on the current investment portfolio: You
maintain control and use over assets that otherwise would
have been liquidated to pay life premiums
Potential to leverage your investment portfolio when the
portfolio returns are higher than the cost of the loan
10. Considerations
Premium Financing is complex and involves many risks, such as the
possibility of policy lapse, loss of collateral, interest rate and market
uncertainty, and failure to re-qualify with the lender to keep the
financing in place and maintain the desired level of insurance protection
Subject to the lender’s collateral and financial underwriting requirements
Loan interest paid by the ILIT is not deductible
ILIT assets may be insufficient to pay the premiums and loan interest
and/or repay the lender
Pledged collateral and, in certain situations, additional out-of-pocket
contributions to the ILIT, may be required to retire the debt and/or
maintain your desired level of insurance protection
A well-planned exit strategy should be in place from the beginning
11. Questions?
Jay C. Lewis, CLU®
IPS Advisors, Inc.
8080 N. Central Expwy., Suite 1500
Dallas, TX 75206
Office: 214-292-4117
Email: jlewis@ipsadvisors.com
Twitter: @Ins_Counselor
Blog: www.jayclewis.wordpress.com
12. Disclosures
National Financial Partners (NFP)
1250 Capital of Texas Hwy. S., Building 2, Suite 125 | Austin, TX 78746 | 512-697-6000 | www.nfp.com
This material was created by NFP (National Financial Partners Corp.), its subsidiaries or affiliates for distribution by their
registered representatives, investment advisor representatives and/or agents. This material was created to provide accurate
and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not
intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be
sought regarding your individual situation. Neither NFP nor its subsidiaries or affiliates offer tax or legal advice.
Securities and Investment Advisory Services may be offered through NFP Securities, Inc., member FINRA/SIPC. NFP
Securities, Inc. is a subsidiary of NFP (National Financial Partners Corp.).
Not all persons using this material are registered to offer securities products or investment advisory services.
Split dollar arrangements are subject to IRS Notice 2002-8 and Proposed Regulations that apply for purposes of federal
income, employment and gift taxes.
The Sarbanes-Oxley Act of 2002 makes it unlawful for a company regulated by the Securities Exchange Act of 1934 (“34 Act”)
to directly or indirectly make loans to its directors or executive officers. This includes not only companies required to register
their securities under the 34 Act, but also companies required to file reports (i.e. 10k and 10Qs) under the 34 Act.
Please consult with your attorney before purchasing a life insurance policy that will be corporate/business owned or used in a
split dollar arrangement to determine what restrictions may apply. This information is not intended to be tax advice. Please
consult your tax advisor for more information regarding the tax implications of this policy. .Distributions (withdrawals or policy
loans) from life insurance policies treated as Modified Endowment Contracts (“MECs”) under Section 7702A of the Internal
Revenue Code are subject to less favorable tax treatment than distributions from policies that are not MECs. If the policy is a
MEC, distributions will be taxable to the extent there is any gain in the policy. In addition, if the policy owner is under age 59 ½
or is a corporation at the time of the distribution, there is a penalty tax of 10% on the taxable amount. Without regard to
whether a policy is a MEC, a gain in the policy is taxable on full surrender of the policy.
