How do advisors plan with life insurance in this supposedly post-split dollar world? The answer lies of course in a client's particular goals. But the options are relatively clear: Clients can use a combination of outright and deferred gifts of the premiums; employ private split dollar; turn to third-party premium financing; or buy life insurance in qualified plans.

If we had to handicap these horses in the race for the payment mechanism of choice, premium financing seems to be fast replacing traditional split dollar as the most widely illustrated payment mechanism for big policies. That's largely because the client doesn't have to pony up a lot of his own money… or so he thinks.

Private split dollar is taking an inside position in the race, and may deserve a fresh look. Although it's a version of premium financing, private split dollar leaves the client with more control over the destiny of the arrangement than does third-party premium financing.

Qualified plans have the advantage out of the gate for using before-tax dollars. But the success of the approach may rely on a few tricks that the officials are about to prohibit.

The outright and deferred gifts, however, may well cross the finish line first — because the discerning client will see that they involve the least expensive policy and the least reliance on its parts having to work just right.

HYPOTHETICAL

Consider one typical situation. Suppose a client wishes to buy a significant amount of life insurance through an irrevocable life insurance trust (ILIT) to keep the proceeds of the policy out of his estate. He wants to hear about some options that will enable him to buy an efficient policy at low gift-tax cost.

Assume that the ILIT will be designed as a defective grantor trust because the client knows that by paying the trust's taxes, he will correspondingly increase the trust's cash flow, which will save him gift taxes in the long run. Payment of the trust's income taxes also will be an efficient way to reduce his taxable estate. He wants to buy an insurance product that gives him the flexibility to change the premium and adapt to changes in circumstances as well as any parental mood swings about leaving money to the kids. The client is comfortable with a well-constructed, well-monitored current-assumption product. He would buy a survivorship policy for himself and his spouse — if such a policy, and the strategy for its purchase, were appropriate.

Let's also set the stage with some guidelines that would be relayed to the client at the outset. He'd see fairly quickly that there is a straightforward relationship between plan design and product. The simpler the plan design, the cheaper and more efficient the product; therefore the less he has to depend on product performance and the less number of things have to go right. The more complicated the plan design, the more expensive the policy, the more dependent on policy performance — and the greater number of things have to go right.

BASIC APPROACH

The client can make outright gifts of the premium to the ILIT. The gifts may be covered by his annual exclusions. If not, he will have to use an exemption. The client might balk at this simple approach, because he won't see any tax leverage. But, once he understands the whole game plan, he'd realize a lot of tax leverage, without much tax or product risk.

We'd start with a relatively low premium to minimize his gifts. But we'd suggest that he follow quickly with substantial, but tax-free, gifts of discountable, income-producing property. We'd also suggest that he put more income-producing property in a grantor retained annuity trust (GRAT) that will pour over to the ILIT. The objective of these large transfers would be to fund the ILIT with as much income-producing property as possible on the gift-tax cheap, so that the ILIT could pay an increasing share of the premium with its own cash, the income tax on which is paid by the client. We'd explain to him that every dollar of premium the ILIT can pay with its own cash is a dollar of gift that he doesn't have to make. Of course, the client should eventually be able to redirect those annual exclusion gifts as he sees fit.

There are several variations on this approach. For example, once the GRAT distributed its assets to the ILIT, the total trust assets should be sufficient to serve as seed money for an installment sale of even more income-producing property to this defective grantor trust. The enhanced funding of the ILIT should enable it to accelerate the funding of the policy, thereby potentially reducing the long-term premium outlay.

This technique allows a client to purchase a cheaper, more efficient policy than many other approaches. The policy will not require an increasing death benefit as other plans do, nor the robust cash value often necessary to make those plans work. Success of the plan will not depend on the policy performance so critical to other strategies' success. The client retains his flexibility, particularly the freedom to unwind the arrangement without a lot of expense or hassle.

PRIVATE SPLIT DOLLAR

Another strategy is for the client to implement a split dollar arrangement with the ILIT. The client will want to explore split dollar for the same reason clients have always been interested in split dollar — to help minimize gifts to the ILIT. To comply with the final regulations for split dollar issued by the Treasury Department on Sept. 11, 2003, effective for plans implemented after Sept. 17, 2003, the arrangement would have to be structured as a loan from the client to the ILIT. The premium loans would not necessarily be secured by the policy. In fact, many commentators suggest that the loan not be secured, even through a limited collateral assignment, because this security might result in the client having an incident of ownership under Internal Revenue Code Section 2042, which would make the proceeds of the policy includable in the client's estate. For the same reason, he probably shouldn't have the right to terminate the arrangement either.

It's fair to say that the client's utmost concern, after estate-tax exclusion of the proceeds, would be gift-tax efficiency. In other words, he'd want to minimize the gift-tax cost over the lifetime of the arrangement and, if possible, maximize the predictability of the arrangement's economics.

In our scenario, the ILIT would pay or accrue interest based on the applicable federal rate; otherwise, we'd have to rely on the dense and far too constricting Reg. Section 7872.15, which contains rules for below-market split dollar loans. Once in open water, the client would have more latitude to design the loan as he wished.

The final regulations on split dollar did nothing to alleviate the following familiar, but often unheeded, planning challenges:

  • Does the client want the ILIT to receive the full initial face amount of the policy or just the amount of death benefit net of the loan? If the former, then the policy would need a return of premium option or some other device to keep the ILIT whole, which would increase the cost of the policy.

  • Will the loan be repaid during the client's lifetime or upon his death? If the former, then the client either will have to overfund the policy (meaning lend more money than would be otherwise necessary), make substantial gifts to the ILIT, or both, to enable the ILIT to use policy values and trust assets to repay the loan sooner rather than later. If the latter, he'll need an economist and a soothsayer on staff to predict the long-term cost of the arrangement.

  • Will the ILIT pay interest or let it accrue for eventual repayment with loan principal? This question also deals with a matter of cash flow and policy economics…and will require showing the client plenty of illustrations. As far as policy selection is concerned, the client's preference for the flexible premium product funded on current assumptions will likely prove wise. Such a policy will enable him to minimize loans in the early years and, after he has funded the ILIT on the gift-tax cheap, he can direct the ILIT to increase the premiums with its own money. The flexibility will also help him manage the plan over time, reshaping the policy to adapt to changing circumstances and economic conditions.

Once you depart from making outright and deferred gifts to the ILIT, plans get pretty complicated, not to mention expensive — and a whole bunch of things have to fall into place for the arrangement to work.

PREMIUM FINANCING

Though popular for several years now, premium financing is enjoying renewed interest after split dollar was forced to be considered a loan. The marketing appeal of premium financing can be quite simple. It essentially promises: “Buy your insurance with no out-of-pocket outlay.” But, as with any leveraged technique that offers a significant upside, it can also be a significant downside, depending upon the interplay between the loan, the performance of the policy and the ability of the insured to exit gracefully.

The most typical approach is for the ILIT to borrow the premiums directly from a third-party lender. The client gifts to the ILIT the annual amount necessary to cover the interest. In turn, the ILIT collaterally assigns the policy to the lender, but the client also might have to personally guarantee the loan. The loan may call for interest only until it is repaid on or before the grantor's death.

In certain transactions, the ILIT borrows a lump sum to purchase a single premium immediate annuity based on the life of the client or insured. The ILIT uses the payments from the annuity to pay the premiums on the life insurance policy. Because the ILIT is a grantor trust, it will have the benefit of the whole annuity payment. And, until basis in the annuity is exhausted, most of the annuity payments are nontaxable to the client. This strategy uses one carrier for the annuity and another carrier for the life policy. The hope is that the life carrier will underwrite the insured favorably — thereby requiring a lower premium — but the annuity carrier will underwrite the insured less favorably, thereby generating a greater payout on the annuity. The plan works best if the insured does not live too long, because once the ILIT's basis in the annuity is exhausted, all of the payments will be taxable to him and he still will be making gifts of the interest on the loan. Clearly, this approach is only appropriate for older clients.

Like most proposals of packaged life insurance sales strategies, recommendations for financed life insurance transactions tend to make them look like no-brainers to clients seeking to pay substantial premiums with minimal capital outlay or current gift tax consequences. But the full details of the transaction and the entire constellation of risks may not be fully known by the client or the advisor. Most significantly, the specific loan terms and the selection and design of the policy may not be readily apparent. The risks of the strategy include: fluctuating loan interest rates; reluctance of the lender to make subsequent loans; problems associated with the selection and performance of the policy; and reinsurance limitations. This means the client had better look into the lender's identity, strength and commitment to the premium-financing program. The client should understand: all the terms of the loan; how the interest rate is determined; how the transaction could be structured for a lower rate; how and when the rate will be reset; when interest must be paid; and what collateral will be required and for how long. Other considerations include the lender's conditions for continuing to lend, conditions for accelerating the repayment of the note and, of course, how much financial underwriting is required, both initially and subsequently.

The life insurance policy itself too often takes a backseat. It shouldn't. The client will want to be assured that the policy is competitive within its peer group and efficiently designed for high, early cash values relative to the premium paid so as to mitigate the client's risk if he changes his mind. Will there be limitations on the growth of the death benefit vis-a-vis increases in the loan and accrued interest? Is the policy flexible enough to accommodate change in the underlying strategy?

Most of all, the client should see detailed exhibits depicting how the strategy will unfold under various assumptions about loan interest rates, premium outlay, life expectancy and policy performance. For example, what happens if the lender increases the interest rate substantially or refuses to lend subsequent premiums, the policy underperforms, the death benefit maxes-out relative to the size of the loan, or the client lives too long (thereby requiring him to make taxable gifts of the interest forever)? The client should understand what mid-course corrections or exit strategies would be available if the financing strategy begins to unfold unfavorably. In short, is there an exit strategy that does not involve death?

QUALIFIED PLANS

A popular approach for buying life insurance in qualified plans uses a client's profit-sharing plan to purchase a survivorship policy.

The plan trustee purchases a survivorship life policy on the client and his spouse. The trustee pays the annual premium on the policy. The client is taxed each year on the economic benefit of the life insurance. The client designates his ILIT to receive the insurance proceeds and to be the beneficiary of that portion of the account that comprises the policy. The client's spouse is likely to be the beneficiary of the remainder of the account. The beneficiary designation directs the trustee of the plan to distribute the policy to the ILIT if the client dies first. Because this beneficiary designation is revocable, there are not yet gift tax implications to the arrangement.

The strategy calls for rather complicated provisions and contingency planning, depending upon who dies first (the client or his spouse). If the client dies first, the policy is distributed to the ILIT, pursuant to the beneficiary designation. The ILIT owes income tax on the cash value. The balance of the account is distributed to the surviving spouse. Where will the trustee get the funds to pay the tax? A gift or loan from the spouse? Insurance on the client? A policy loan? The cash value is includable in the client's estate and does not qualify for the marital deduction, because the policy does not pass to the client's spouse. Thus, estate taxes and additional premiums may be due under some circumstances. How will they be paid?

If the spouse dies first, the client has to move the policy out of the plan and into the ILIT. The plan can distribute the policy to the client. The cash value is included in the client's income, though it would be offset by the economic benefit recognized in income up to the time of distribution. Alternatively, the client can purchase the policy from the plan for its cash value, but then he has to transfer the policy to the ILIT. Still another option is for the ILIT to purchase the insurance policy from the plan. Private Letter Ruling 200120007 provides practitioners with some comfort that if the ILIT is a grantor trust for income tax purposes, then sale of the policy to the ILIT will be tantamount to a sale to the insured. Of course, the ILIT will need the funds to buy the policy…but for how much?

At the end of the day, if the dominos fall in the right order and contingency plans are in place, the client will have purchased a policy with before-tax dollars and succeeded in getting the policy out of his estate. He just couldn't achieve this feat with split dollar, premium financing or outright gifts. But many planners try to squeeze even more tax economics out of the deal. And, predictably, the IRS is now moving to shut them down.

How are better tax economics achieved? One way is to use a flexible premium policy with an initial death benefit that is several times greater than the amount of insurance the client actually needs or wants. Illustrations for this maneuver project that the policy is to be heavily funded for three to five years, whereupon the plan distributes the policy to the insured or sells the policy to the ILIT. As soon as possible after the policy is distributed, the client reduces the death benefit to an amount that the cash value supports forever, with no further cash premiums. The purpose of the ultra-high but temporary death benefit is to create a substantial surrender charge against the cash value so that, when the policy is distributed or sold, it has a very low cash-surrender value relative to the premiums paid by the plan, thereby minimizing the amount of taxable income to the insured or purchase price from the ILIT. Indeed, the insurance company selling such policies may even have been designed them to maintain a low cash-surrender value for years just for this purpose. The term for these policies out in the marketplace is “sponge policies.” They soak up all the value — then let it out when the holder squeezes.

The value of the policy at the point of distribution or sale has been a matter of concern for years. Proponents of this approach cite Prohibited Transaction Exemption 92-6 as authority for the ability of the plan trustee to sell the policy for its cash surrender value. But PTE 92-6 is merely an exemption from the excise taxes that will otherwise apply under IRC Section 4975 if those guidelines are not followed. PTE 92-6 does not relieve a trustee as plan fiduciary of customary fiduciary responsibility, nor does PTE 92-6 govern the income or gift tax consequences of this transaction. The IRS has expressed views on this topic, starting with Notice 89-25 and springing cash value policies. What's more, many practitioners have been warning clients that there was more than a little element of the too-good-to-be-true in these techniques. They have been concerned about issues related to income tax, ERISA and, where applicable, gift tax.

We now expect the IRS to announce its position on the valuation of policies coming out of retirement plans. The pendency of proposed regulations or other pronouncements on the subject suggests that clients should hesitate before adopting an approach that incorporates rapid funding of a policy followed by its distribution or sale at a surrender value sharply less than the premiums paid.

DOT ALL THE “I”S

Obviously, these are only a few of the methods for paying premiums on a big policy. And even these approaches can be crafted in many ways. But planners who are as careful as they are creative should be sure to address the economics, the flow of funds, the tax implications, the design implications and, most of all, what has to go right for the technique to work, what can go wrong and how the client can mitigate the downside.

With so many “design ideas” floating around, here is some sage advice for separating the wheat from the chaff: First, ask to see all of the current literature on the strategy… pro and con. If you see that the only articles in favor of the technique are written by the people who are, in one form or another, selling the technique, while articles opposing it are written by those who are not selling that or any other technique, then it's an indication something is too good to be true. Second, ask the agent if any well-known carriers active in the large case market are prohibiting their agents from selling products in this particular strategy. If the answer is yes, be wary.