Financed life insurance has become one of the most popular estate planning tools for high-net-worth families. Recently it also has made significant inroads where it never went before: among ultra-high-net worth individuals — people with estates of $100 million or more.

Historically, the ultra rich have not used life insurance as often as people with more moderate estates. Senior members of the wealthiest families seldom were enthusiastic about the amount of cash flow they'd need to give up to pay the seven-figure yearly premiums required for the sizable amount of insurance their estates would require if the estate tax liability was to be paid in this way. Sometimes they wouldn't have the income stream necessary to fund such outsized premiums, which would mean that, in order to make payments, they might have to liquidate highly appreciated assets and suffer the capital gains tax consequences. Not an enticing prospect. Moreover, once a lawyer would explain that the yearly premium would need to be gifted to an Irrevocable Life Insurance Trust (ILIT) so that the life insurance proceeds could be outside the taxable estate, and that this would mean paying gift taxes (heresy!), the highest-net-worth clients tended to lose all interest. In contrast, moderate estates often are able to gift enough to cover yearly premiums to the ILIT using Crummy beneficiary provisions. There's also the problem of expectations. The rate of return on life insurance implemented in a traditional fashion might yield about 7 percent at life expectancy for the high-net-worth investor. That's a respectable return for some — but not for most ultra-wealthy clients, who tend to expect returns of more than 20 percent annually.

These hurdles still exist. Yet many owners of the world's mega-estates are considering life insurance these days. Why? They're being lured by the results that can be produced by financed life insurance enhanced by estate tax deductibility of the premium loan, and perhaps even income tax deductibility of interest paid. If the money borrowed to fund the premiums is turned into a liability of the taxable estate and a Form 706 estate tax deduction, the Internal Revenue Service will effectively subsidize the repayment of these loans by almost 50 percent.

How is it possible to achieve this result while still keeping the life insurance in an ILIT, outside the taxable estate? The insurance industry is suggesting a number of approaches — all complicated and risky. But the potential upside is so great, it's smart to consider the options.

Let's look at the standard approach to financed life insurance to understand the new deductible alternatives. Senior members of $10 million estates have easily understood the appeal of the basic approach and often invest in $5 million of life insurance as an estate-tax solution. Typically, an ILIT owns the life insurance, and yearly premiums are gifted to the ILIT using annual Crummy gifts.

Generally, a lender lends the premium directly to the ILIT with the taxable estate signing guarantees and pledging assets as collateral. If interest is paid annually, gifts are made each year to fund the ILIT's interest obligations. At the time of death, the death proceeds repay the outstanding loan, leaving the remaining proceeds for estate purposes.

As simple as this strategy may sound, there are important economic and tax issues. There is the problem of one party pledging assets and signing guarantees on behalf of another without any economic incentive to do so. One solution is to have the ILIT pay a yearly “guarantee fee” to the taxable estate through a gifting program and a grantor trust. The fee is recognition that the ILIT is receiving something that has economic value, and is therefore paying a fair market price for the value received.

Other key issues: Should the interest rate be variable or fixed? What is the term of the loan? Under what circumstances can the lender call in the loan? Also critical is the type of life insurance product. Are the numbers a projection based on a host of assumptions or on contractual guarantees? If a variable loan rate is used, it's important to consider the full range of possible interest rate increases. Similarly, an analysis should contemplate the impact of the carrier decreasing the credit rate or increasing the mortality charge on non-guaranteed products.

DEDUCTIBILITY

The easiest way to ensure estate tax deductibility of an outstanding loan created to fund premiums is for a client to borrow the yearly premium, gift it to an ILIT using Crummy beneficiaries, and have the loan reside in the estate while the ILIT owns the policy. Having an estate tax return Form 706 deduction effectively allows the taxable estate to be reduced by the amount of the loan. If the estate were $10 million and the outstanding loan $1 million, the estate tax deduction reduces the taxable estate to $9 million. The estate tax saving of almost $500,000 means the net cost of repayment of the loan is $500,000 — half of the $1 million borrowed to fund premiums. If the loan was made to the ILIT it would not be a liability of the estate and not an estate tax deduction.

Structuring the loan as a liability of the estate produces dramatic economic benefits. For example, a married couple, both 60, would have a projected yearly premium of $83,000 for $10 million of second-to-die life insurance. If death occurred at age 90, the yearly borrowing will have grown to $2.49 million. If the ILIT is the borrower and repays the lender $2.49 million out of the $10 million death benefit, this leaves a net benefit for the family of about $7.51 million (See “ILIT As the Borrower,” page 49.)

If the taxable estate borrows the yearly premium and gifts it to the ILIT, the loan at age 90 of $2.49 million is an estate tax deduction. The estate tax savings of $1.245 is added to the net benefit to the family, increasing it to about $8.755 million. A big increase compared to the first approach of about $7.51 milion.(See, “Estate as the Borrower,” page 49.)

The problem, of course, is that ultra-large estates could not possibly have enough Crummy beneficiaries to gift enough to fund annual premiums of seven figures. Mom and Dad, each gifting $11,000, would need 45 beneficiaries to reach the $1 million premium level. Unlikely.

Is there a way to borrow significant funds and then move this money into an ILIT without incurring onerous gift taxes? Perhaps. But be sure to understand the associated risks.

GRATS

A transfer technique sanctioned by the Internal Revenue Code provides clients a great deal of comfort, security, and no tax risk. The challenge is the length of time the grantor retained annuity trust (GRAT) may need to work properly as well as the potential non-performance of assets gifted to the GRAT. Non-performance of the gifted assets often results in no wealth being successfully transferred. These negatives can be overcome with the use of a 24-month zeroed-out Walton-type GRAT, funded with financial instruments that can deliver the explosive return needed to make this short-term GRAT effective.

For example, say a client borrows $40 million. He could invest $20 million in an option contract that matures in 60 days with a provision that, if the S&P 500 rises above a certain level, the contract would be valued at $41.2 million. The remaining $20 million could be invested in an option contract triggered by the S&P index falling below a certain amount, in which case the contract would be valued at $39.3 million. This enables the client to create a situation with one of two possible outcomes, either a profit of $1.2 million or a loss of $700,000.

If after buying the two contracts the client gifts the second option contract to a two-year Walton-type GRAT and retains the first, what are the possible outcomes? If it turns out that the option contract now owned by the GRAT is the successful contract, the GRAT will have $39.3 million after 60 days. There'll be an obligation to meet the annuity payments to the grantor over 24 months of $20 million, plus the applicable federal rate. That leaves about $19.3 million plus investment earnings to be distributed after 24 months to the beneficiary (possibly an ILIT), presumably gift tax-free. These monies could fund substantial amounts of life insurance that would turn the borrowing into a liability of the estate and a 706 deduction, while the life insurance would be owned in an ILIT.

There are numerous economic and tax issues that would need to be analyzed, depending on a client's fact pattern. It would seem, however, that this resembles the outcome achieved by the billions of dollars of pre-IPO stock gifted to GRATs during the tech boom, which often would explode in value after the IPO, and allow for large transfers of wealth after meeting the annuity payment to the grantor.

What if the option contract retained by the client was profitable? After 60 days, the client would receive $41.2 million, a tidy profit for a 60-day investment of $40 million. Which would mean the option in the GRAT would be worthless and the GRAT would be simply a failed GRAT. Something most of us have experienced thanks to the high tech crash.

Again, implementing this kind of plan would require careful examination and analysis. There are economic differences between an ILIT-as-borrower and an estate-as-borrower with the loan as an estate tax deduction. If the $19.3 million transferred to the ILIT gift tax-free is used to purchase a policy on two 80-year-olds with a death benefit of $100 million, the family would net $90.35 million. Here's how: The $100 million would be received tax free, less the cost to repay the $19.3 million plus the state tax saving of $9. 65 million, for a net to the family of $90.35 million. Not being able to treat the borrowed $19. 3 million as an estate tax deduction reduces the net to $80.7 million. The estate tax savings of $9.65 million is lost. (See “IRR If ILIT Is the Borrower,” and “Form 706 Deduction,” this page.)

Would interest paid by the client on the loan be deductible against investment income? Most tax preparers seem to think so. IRC Sections 163 and 264 preclude the deduction of interest on money borrowed and invested in tax-exempt instruments, such as life insurance. But what if a client invests the borrowed money in a taxable investment, decides to gift the investment, and the recipient elects to transfer the proceeds of the gift into life insurance? Is the interest paid by the donor a deduction against investment income? A tax preparer is best suited to decide. If the answer is “yes,” the cost of the loan interest is effectively reduced by the client's income tax rate. The yearly interest cost on the borrowed $19.3 million of $675,500 at a 3.5 percent interest rate drops to $440,040, a net effective interest cost of 2.28 percent, after the income tax deduction at the 35 percent tax rate. (See “Cost of the Loan,” this page.)

PARTNERSHIPS

Despite the difficulties presented by recent unfavorable Tax Court cases on partnerships, the partnership rules still can be used to achieve a financed life insurance homerun. Say Mom and Dad contribute $3 million in existing assets and another $5 million of borrowed cash to a partnership in exchange for partnership units; a generation skipping trust makes an additional contribution of $2 million. Typically the GST trust would own 20 percent of the partnership, while Mom and Dad owned the remaining 80 percent. There are many courses of action and directions for managing the partnership. Say that in year one the general partner elects to invest 10 percent of the assets in a life insurance program on Mom and Dad with a face value amount of $30 million. Based on a current assumption/standard universal life policy projection, four additional premiums of $1 million will be needed to keep the policy in full force and effect. At the end of five years, the partnership will have $5 million invested in the life insurance policy and $5 million invested in high-potential assets. If a death takes place in this period, the proceeds become an asset of the partnership, which at first blush seems undesirable, because it would be included in the estate. Still, it's a good deal for the family to have invested $5 million and receive $30 million income tax-free.

The holding period rules for partnerships allow for the distribution of property after seven years without an income tax event. Life insurance qualifies as property. Assuming the partnership decides after seven years to distribute the life insurance under IRC Section 731 to the GST trust (a partner) as a non-taxable, non pro rata distribution, the distribution will exceed the capital account of the GST trust, resulting in a negative capital account. Section 704 provides interpretive guidance. Section 7872 interest will not be an issue, provided the negative capital account is restored before the partnership is dissolved.

For easy math, pretend that the negative capital account is equal to the cash value, which we will say at the time is equal to premiums advanced, in this instance, $5 million. Fast forward to Mom and Dad's deaths. The GST trust owns the life insurance of $30 million, therefore receives the proceeds free of income, estate and (presumably) GST tax. Proceeds of $5 million are used to restore the negative capital account, leaving $25 million tax-free in the trust. This is a desirable result if it can be achieved, especially if the $5 million was borrowed before being contributed to the partnership. If interest were paid yearly at a 3.5 percent interest rate, reduced to a cost of 2.8 percent, because of the income tax deduction at the 35 percent tax rate, the cost would be $114,000 each year. Measuring an internal rate of return on an equivalent investment of the $114,000 in the taxable estate reveals an IRR of 34 percent in year 20 (See “Interest Is Paid,” this page). Accruing the interest instead of paying it means no deduction against investment income, because no interest was actually paid. The loan will grow each year, and principal plus accrued interest should be an estate tax deduction at death. Table 7 illustrates the loan growing to $9,948,994 in year 20, with a net cost after the estate tax deduction saving of $4,974,472. The life insurance proceeds of $30 million will be reduced by this net cost of borrowing of $4,974,472 as well as the estate tax cost on the $5 million negative capital account that is restored — $2.5 million. In other words, $30 million less $4,974,472, less $2.5 million is $22,525,528 to the ILIT. Not a bad result considering zero money was invested. (See “Interest Is Paid” and “Windfall for the ILIT,” this page.)

What are the risks? It may be difficult to assert a step transaction later, depending on what happens, including the death of the insured while the insurance is held by the partnership. Other dangers: The non pro rata distribution may be viewed as a disguised gift. How to avoid? The GST trust and other partners could agree to forego a large part of the future distributions in recognition of the non pro rata distribution. But there're also the economic risks of a variable interest rate and/or a non-guaranteed life insurance product.

Baseball fans know that only the bravest players dare swing for a homerun. Bold steps often are best rewarded, but they also create the greatest risk. Whole games can be lost going for the gusto. Financed life insurance and the various ways it can be structured will be in large estate practitioners' playbooks for years to come. But care is needed to ensure outstanding projected results do not cloud judgment in identifying potential tax and economic risks.

ESTATE AS THE BORROWER

When the estate borrows yearly from a third-party lender, then gifts to the ILIT, it can take a Form 706 deduction and leave more to the estate*

End Year Ages Premium (YEARLY GIFT) Total Loan Total Loan After Estate Tax Death Benefit Net Death Benefit
5 65/65 ($83,000) ($415,000) ($207,500) $10,000,000 $9,792,500
10 70/70 (83,000) (830,000) (415,000) 10,000,000 9,585,000
15 75/75 (83,000) (1,245,000) (622,500) 10,000,000 9,377,500
20 80/80 (83,000) (1,660,000) (830,000) 10,000,000 9,170,000
25 85/85 (83,000) (2,075,000) (1,037,500) 10,000,000 8,962,500
30 90/90 (83,000) (2,490,000) (1,245,000) 10,000,000 8,755,000
35 95/95 (83,000) (2,905,000) (1,452,500) 10,000,000 8,547,500
40 100/100 (83,000) (3,320,000) (1,660,000) 10,000,000 8,340,000

* Assumes a 50 percent estate tax rate.

Note: Policy values are based on non-guaranteed assumptions.

ILIT AS THE BORROWER

If the ILIT is the borrower, there's no Form 706 deduction and less for the estate

End Year Ages Premium Total Loan Total Loan After Estate Tax Death Benefit Net Death Benefit
5 65/65 ($83,000) ($415,000) ($415,000) $10,000,000 $9,585,000
10 70/70 (83,000) (830,000) (830,000) 10,000,000 9,170,000
15 75/75 (83,000) (1,245,000) (1,245,000) 10,000,000 8,755,000
20 80/80 (83,000) (1,660,000) (1,660,000) 10,000,000 8,340,000
25 85/85 (83,000) (2,075,000) (2,075,000) 10,000,000 7,925,000
30 90/90 (83,000) (2,490,000) (2,490,000) 10,000,000 7,510,000
35 95/95 (83,000) (2,905,000) (2,905,000) 10,000,000 7,095,000
40 100/100 (83,000) (3,320,000) (3,320,000) 10,000,000 6,680,000

Note: Policy values are based on non-guaranteed assumptions.

FORM 706 DEDUCTION

When the estate borrows then gifts to the ILIT, it can take a Form 706 deduction, resulting in more for the estate*

End Year Ages Interest at 3.5% Investment Pre Estate tax Net Benefit IRR**
5 80/80 ($675,500) $180,700,000 $90,350,000 240%
10 85/85 (675,500) 180,700,000 90,350,000 78
15 90/90 (675,500) 180,700,000 90,350,000 43
20 95/95 (675,500) 180,700,000 90,350,000 28
25 100/100 (675,500) 180,700,000 90,350,000 21

* Assumes a 50 percent tax rate.

** Assumes a 25 percent tax rate on investment annually.

Policy values are based on non-guaranteed assumptions.

IRR IF ILIT IS THE BORROWER

The rates of return experienced would satisfy the most demanding investor*

End Year Ages Interest at 3.5% Investment Pre Estate tax Net Benefit IRR**
5 80/80 ($675,500) $161,400,000 $80,700,000 231%
10 85/85 (675,500) 161,400,000 80,700,000 75
15 90/90 (675,500) 161,400,000 80,700,000 41
20 95/95 (675,500) 161,400,000 80,700,000 27
25 100/100 (675,500) 161,400,000 80,700,000 20

* Assumes 50 percent estate tax rate.

** Assumes a 25 percent tax rate on investment annually.

Policy values are based on non-guaranteed assumptions.

REDUCING THE COST OF THE LOAN

The interest rate cost is reduced by the income tax deduction, which increases the yearly rate of return*

End Year Ages Interest at 2.28% Investment Pre Estate tax Net Benefit IRR**
5 80/80 (440,040) 180,700,000 90,350,000 240%
10 85/85 (440,040) 180,700,000 90,350,000 89
15 90/90 (440,040) 180,700,000 90,350,000 49
20 95/95 (440,040) 180,700,000 90,350,000 33
25 100/100 (440,040) 180,700,000 90,350,000 24

* Assumes a 35 percent income tax rate and a 50 percent estate tax rate.

** Assumes a 25% tax rate on investment annually.

Policy values are based on non-guaranteed assumptions.

INTEREST IS PAID

Being able to deduct the interest reduces the yearly cost to $114,000*

End Year Interest at 2.28% Investment Pre Estate tax Net Benefit IRR**
5 ($114,000) 33,000,000 16,500,000 247%
10 (114,000 50,000,000 25,000,000 91
15 (114,000) 50,000,000 25,000,000 50
20 (114,000) 50,000,000 25,000,000 34
25 (114,000) 50,000,000 25,000,000 25

* Assumes a 35 percent income tax rate and a 50 percent estate tax rate.

** Assumes a 25 tax rate on investment annually.

Policy values are based on non-guaranteed assumptions.

WINDFALL FOR THE ILIT

The Form 706 estate tax deduction subsidizes the repayment of the laon plus accrued interest*

End Year Interest at 3.5% Total Loan Total Loan After Estate Tax Death Benefit Estate Tax on Policy Net Benefit
5 ($175,000) ($5,938,432) ($2,969,216) $30,000,000 $(15,000,000) $12,030,784
10 (175,000) (7,052,994) (3,526,497) 30,000,000 (2,500,000) 23,973,503
15 (175,000) (8,376,744) (4,188,372) 30,000,000 (2,500,000) 23,311,628
20 (175,000) (9,948,944) (4,974,472) 30,000,000 (2,500,000) 22,525,528
25 (175,000) (11,816,225) (5,908,113) 30,000,000 (2,500,000) 21,591,888

* Assumes a 35 percent income tax rate and a 50 percent estate tax rate.

Note: Policy values are based on non-guaranteed assumptions.