Premium Leveraging Arrangements
Five key exit strategies revealed.
September 20, 2007
Sponsored by National Financial Partners Corp. (NFP)
Many clients use premium leveraging arrangements, such as Premium Financing, Private Financing and/or Private Split Dollar, to facilitate funding their life insurance premiums with little or no cash flow and/or gift tax impact.
However, there are certain risks that are inherent in premium leveraging arrangements, including interest rate uncertainty (loan arrangements), increasing economic benefit costs (split dollar arrangements) and/or decreasing net death benefits due to the collateral assignee’s increasing interest in the policy. In general, the longer the arrangement is intended to be in effect, the greater the risk to the client. Thus, especially in the case of a long-term premium leveraging arrangement, a well planned exit strategy should be in place from the beginning.
Two “so-called” exit strategies that have oftentimes been illustrated are rollout at death or rollout using policy values. Rolling out at death may result in a decreased net-death benefit for the client’s beneficiaries even if the policy is designed with an increasing death benefit or includes a return of premium rider. In the case of loan arrangements, especially if interest is accrued, it is possible that the death benefit may eventually be insufficient to repay the debt. Rolling out at death is generally only advisable for loan arrangements in situations where those who are insured are not expected to live for more than 10 years to 15 years (i.e., are generally older than age 80). With split-dollar arrangements, the cost of the arrangement may become prohibitive in later years, making a rollout at death highly impractical.
Reliance on policy cash values to retire the debt may also be misplaced as it assumes the existence of future policy cash values that will support a policy withdrawal sufficient to both repay the debt and sustain the policy after rollout. Hypothetically, it may be possible to illustrate a rollout using policy cash values (except in the case of non-equity split dollar, due to the fact that the greater of the premiums or cash value is owed). However, the policy is unlikely to perform exactly as illustrated and policy cash values will likely not reach the required level for decades — 20 years to 30 years — if at all. Moreover, capitalization of loan interest exacerbates the risk that policy cash values will not be sufficient to retire the debt and maintain the desired level of insurance protection thereafter. As a result, this approach is usually not a viable solution to mitigate long-term risk.
A well-planned exit strategy provides clients with an effective way to terminate a premium leveraging arrangement by providing the funds necessary to repay the debt and maintain the client’s desired level of insurance protection. However, in wealth transfer situations creating an efficient exit strategy can be difficult due to the potential gift tax consequences. The following is a discussion of some exit strategies for wealth transfer oriented premium leveraging arrangements.
Potential Exit Strategies
Popular exit strategies to consider are grantor retained annuity trusts (GRATs), installment sale 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. By doing so, the client is able to utilize the premium leveraging arrangement to acquire his or her desired level of insurance protection, while at the same time managing and/or mitigating the risks associated with the arrangement.
Grantor Retained Annuity Trust (GRAT)
A GRAT is an irrevocable trust to which the grantor transfers property and retains an income stream from the transferred property for a fixed term. At the end of the GRAT term, the remaining trust assets are distributed to the remainder beneficiary without the imposition of additional gift tax and are excluded from the grantor’s taxable estate. In the event the grantor dies during the GRAT term, a portion of the GRAT assets are included in the grantor’s taxable estate.
When the GRAT is created, the value of the gift to the remaindermen is determined by deducting the present value of the grantor’s retained interest (valued using the IRC Section 7520 rate in effect at the time of the transfer) from the fair market value of the property transferred to the trust. In general, a lower rate results in a smaller taxable gift. If the GRAT is structured as a Walton GRAT or “zeroed-out GRAT,” the gift to the GRAT may be valued at virtually zero for gift tax purposes.
Utilizing a GRAT as an exit strategy for a premium leveraging arrangement can minimize the potential gift tax impact of contributions to fund the anticipated termination of the premium leveraging arrangement. To effectively use a GRAT as an exit strategy, the owner of the policy subject to the premium leveraging arrangement (e.g., an ILIT) is simply designated as the remainder beneficiary of the GRAT. The GRAT remainder beneficiary receives the balance of the trust assets when the GRAT terminates and utilizes the assets to repay, in whole or in part, the premium leveraging arrangement debt. As a result, the client is able to exit the premium leveraging arrangement in a timely and efficient manner, thus avoiding any additional long-term risks associated with the arrangement.
It should be noted that using a GRAT as an exit strategy for an arrangement involving a generation skipping transfer (GST) is not prudent. This is because the GST exemption cannot be allocated to the GRAT upfront, but must instead be allocated to the value of the GRAT at the time that it terminates.
Installment Sale to an Intentionally Defective Irrevocable Trust (IDIT)
An IDIT is an irrevocable trust which is “defective” for income tax purposes. Like most transfers to an irrevocable trust, the transfer of assets to the IDIT is “complete” for transfer tax purposes. As a result, the IDIT assets remain outside the grantor’s taxable estate for estate tax purposes. However, when a trust is “defective” for income tax purposes, it is classified as a grantor trust and any income tax liability generated by trust assets flows to the grantor.
A number of unique advantages result from utilizing an IDIT, including:
An installment sale to an IDIT may facilitate the transfer of significant wealth to subsequent generations with minimal impact from estate, gift, and generation skipping transfer taxes. Moreover, an installment sale to an IDIT may be an effective exit strategy for a premium leveraging arrangement and tends to work well when the grantor owns highly appreciating and/or income producing assets.
To use an IDIT as an exit strategy, the grantor gifts cash and/or income producing assets (typically 10 percent to 15 percent of the anticipated installment loan) to the grantor trust which has entered into a premium leveraging arrangement for the purpose of “seeding” the trust. Thereafter, the grantor sells assets to the IDIT through an installment sale on an income tax neutral basis. Specifically, the grantor sells property to the IDIT in exchange for an installment note, bearing interest based upon the Applicable Federal Rate (AFR), payable over time. No income tax liability is incurred in the transaction because (1) no capital gains are recognized by the grantor in the sale of assets to the IDIT and (2) the installment note interest payments from the trust are not taxable to the grantor when received. The income generated by the IDIT assets is used to fund the installment note payments. Any IDIT assets remaining after repayment of the installment note are used to retire, in whole or in part, the debt associated with the premium leveraging arrangement. As a result, the client is able to exit the premium leveraging arrangement in a timely and efficient manner.
Using an installment sale to an IDIT as an exit strategy has several advantages over a GRAT. First, unlike a GRAT, the grantor’s GST exemption can be allocated up front to the grantor’s relatively small “seed” gift. By allocating the grantor’s GST exemption to the “seed” gift and because the subsequent installment sale is not a “gift” and, as such, does not require any allocation of GST exemption, the IDIT remainder interest is GST exempt. Second, unlike a GRAT, an IDIT has no survivorship requirement to ensure that post-transfer appreciation of the assets remains outside the grantor’s taxable estate. Third, the interest rate applicable to an installment note is based upon the AFR and not the potentially higher IRC Section 7520 rate which applies to a GRAT. Fourth, the terms of repayment of the installment note are more flexible (e.g., installment loan payment can be interest only with a balloon payment) than the rigid requirements of the GRAT.
Charitable Lead Trust (CLT)
A CLT is a split-interest irrevocable trust where the grantor transfers property to the CLT, creating an income interest in favor of a charitable organization for a period of time. At the end of the trust term, the CLT remainder interest passes to non-charitable beneficiaries, who are often the heirs of the grantor. The value of the grantor’s gift to the remainder beneficiaries is determined by deducting the present value of the charity’s interest (valued using the IRC Section 7520 rate in effect at the time of the transfer) from the fair market value of the property transferred to the CLT.
Similar to a GRAT, a CLT can be an effective rollout technique for premium leveraging arrangements by naming the owner of the life insurance policy (e.g., an ILIT) as the remainder beneficiary. The remainder beneficiary receives the balance of the CLT assets when the CLT terminates and utilizes the assets to repay, in whole or in part, the premium leveraging arrangement debt. One form of CLT, a Charitable Lead Unitrust (CLUT), which pays a fixed percentage of trust assets to the charity, can be effectively used with GST trusts, because the GST exemption can be allocated upfront to the value of the grantor’s gift. Thus, a CLUT (but not a Charitable Lead Annuity Trust, which pays a fixed dollar amount to the charity) should be considered as an exit strategy for premium leveraging arrangements involving multi-generational wealth transfers.
Obtaining Additional Gifting Leverage
Combining these 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. Specifically, the grantor can transfer assets to the GRAT, IDIT or CLT, which 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). In that case, payments from the trust are based on the discounted value of these transferred assets rather than their fair market value, resulting in a lower payout during the trust term. Using these valuation discounts can also increase the value of the assets which ultimately pass to the remainder beneficiary, without any additional gift tax. It is not uncommon for valuation discounts of 20 percent to 50 percent to be applied to such assets, which can effectively increase the value of the remainder interest by 40 percent to 100 percent when compared to exit strategies utilizing transfers of assets not subject to valuation adjustments.
As a result of the risks inherent in premium leveraging arrangements, it is crucial to include a well-planned exit strategy from the inception for arrangements that will last longer than 10 years to 15 years. The use of a GRAT, IDIT or CLT as an exit strategy provides clients an effective way to terminate premium leveraging arrangements with minimal gifting implications by providing the funds necessary to retire the debt in whole or in part, while at the same time maintaining the client’s desired level of insurance protection.
For more information, visit National Financial Partners Corp. (NFP).