Premium Financing As a Gift Tax Leveraging Technique


Premium financing can be a potential gift tax leveraging solution for large cases, assuming the client is an appropriate candidate for premium financing. If the loan interest is payable each year, then we have a potential gifting problem i.e., the gifts of funds to the third-party owner to enable it to pay the loan interest can pose adverse gift tax consequences. A possible solution would be to accrue the interest on the loan. This eliminates the need to annually gift the loan interest to the third-party owner.


Premium financing has some risks, especially if loan interest is being accrued. There is, of course, interest rate risk. The longer the arrangement is in place, the greater the risk that interest rates will average higher than illustrated. This is particularly true considering the current low interest rate environment. There is also the risk that the performance of the insurance product may not keep pace with the loan interest rate, meaning that the third-party owner could receive less net death benefit than anticipated. Also, the long-term interest rate risk could pose a collateral issue, assuming the policy performance isn't sufficient to keep pace with collateral requirements.

For these reasons, it may be a prudent idea to utilize a rollout strategy for the premium financing arrangement, particularly when interest is being accrued. However, getting the necessary funds to repay the loan principal and accrued interest into the hands of the third-party owner can be problematic from a gifting standpoint.

Walton GRAT Rollout Technique

A strategy that can be used with either non-equity split dollar or premium financing to rollout of the arrangement is a Walton GRAT. A Walton GRAT is simply a Grantor Retained Interest Trust in which the remainder interest is valued at approximately zero for gift tax purposes. Thus, a Walton GRAT can be an excellent technique for transferring funds into the hands of the third- party policy owner to be used for rollout purposes with a minimum of gift tax consequences.

Here's how it generally works. Let's assume your goal may be to terminate the premium financing arrangement after ten years in order to potentially limit the interest rate risk. The insured would set up a ten year GRAT and name the third-party policy owner as the remainder beneficiary of the GRAT. The GRAT would then pay the insured/grantor a steam of income for ten years. The income to be paid is calculated based on the percentage payout needed to zero out the remainder interest for gift tax purposes. At the end of ten years the remainder interest passes gift tax free to the third-party policy owner, who uses the assets to repay the premium financing loan.

Additional leverage can be obtained by transferring in assets that qualify for a discount, such as Family Limited Partnership (FLP) interests. In the case of discounted assets, the GRAT payout is based on the discounted value rather than the underlying value of the assets. This means that a lower amount needs to be paid out each year, resulting in a potentially greater remainder interest passing to the third-party policy owner

Let's take a look at a case study utilizing premium financing in conjunction with a Walton GRAT. For purposes of the case study, let's assume the following:

• The insured is a 70-year-old widow
• She has about a $30 million estate
• She has a need for $15 million of life insurance coverage to be owned by an irrevocable life insurance trust(ILIT)
• She has already used up her $1 million lifetime exemption
• She has 3 children and 5 grandchildren, and thus only has $88,000 of available annual exclusions
• The full-pay premium for this amount of universal life coverage would be in the range of about $400,000 per year for life, well in excess of her gifting ability.
• She has placed the majority of her assets into an FLP and has been gifting FLP interest to her children and grandchildren for the past few years
• She is an appropriate candidate and has the risk tolerance for premium financing

Case Study


STEP 1:


• The trustee of the ILIT enters into an arrangement with a third party lender to finance the premiums (and loan interest) for $15 million of life insurance coverage.
• The trustee then purchases a policy that is designed to have a face amount in the early years sufficient to repay the loan and still enable the ILIT to net $15 million of death benefit. Since it is anticipated the loan will be paid off after year 10, the policy is designed to have a level $15 million death benefit thereafter.
• The policy is designed as a five-pay, with a premium of approximately $1.7 million.
• Based on an illustrated premium financing loan interest rate of 5.5%, total principal and interest at the end of ten years is anticipated to be approximately $13 million. This is the amount the trustee of the ILIT will need to pay off the loan.

NOTE: Assuming the loan is paid off in ten years, the interest rate risk is limited to just ten years. However, assuming that the 5.5% interest rate used is sufficient to lock-in the rate for five years, the interest rate risk really only exists in years 6-10. In addition, using this higher five-year lock-in rate helps to more accurately calculate the amount needed to rollout of the arrangement at the end of year 10. This is important when determining how much to gift to the GRAT.


STEP 2:


At the same time the policy is purchased the client gifts $14.2 million of limited FLP interests to a GRAT, with the ILIT named as the remainder beneficiary.


• Assuming a 30% discount for lack of marketability and lack of control, the discounted value of the transfer is approximately $9.94 million.
• Based on a 10-year GRAT term, a 7520 rate of 3.80% (the March 2003 rate) and payout rate of 12.2% (approximately $1.2 million annually), the gift tax value of the remainder interest is zero.
• Based on a growth rate of 8%, the underlying value of the FLP interests in 10 years is expected to be approximately $13 million.
NOTE: If the limited partnership interests don't generate enough income to enable the GRAT to pay the $1.2 million annually to the grantor, then the FLP may need to liquidate assets within the FLP and make additional distributions to the GRAT to make up the difference.
NOTE: By the end of the ten-year term the client will have received GRAT payments totaling approximately $12 million. Thus, although the client originally gifted $14.2 of assets to the GRAT, the client's net outlay is considerably less than that amount.


STEP 3:


• At the end of ten years the GRAT terminates and the limited FLP interests pass to the ILIT. It is anticipated that the underlying value of the assets in the FLP will be approximately 13 million.
• Should the ILIT desire to pay off the premium financing loan and accrued interest of approximately $13 million,
a couple of options exist:
Option 1: The assets in the FLP could be sold and a pro rata share of the proceeds equal to the ILIT's percentage ownership in the FLP could be distributed to the ILIT.
Option 2: The FLP could be dissolved and a pro rata share of the assets could be distributed to the ILIT, who in turn liquidates the assets.


NOTE: It is assumed that the ILIT is a grantor trust for income tax purposes, and that any income taxes due upon the liquidation of the assets that were in the FLP will be paid by the client/grantor.


NOTE: If the client dies before the term of the GRAT expires, the value of the GRAT is includible in her estate. However, since she paid no gift tax at the time of the transfer, she is really no worse off than if she hadn't made the transfer. In this event, the death proceeds of the policy should be sufficient to pay off the loan and ensure that the ILIT nets $15 million.


Conclusion


Although large life insurance cases have become more difficult and complex to design since the demise of equity split dollar, there are other gift tax leveraging planning techniques, such as non-equity split dollar and premium financing, that can be used to overcome gifting issues. When combined with a rollout technique, such as a Walton GRAT, the potential risks of using these strategies can be greatly diminished. In next month's issue of Advanced Solutions, Part 2 of this sales idea will discuss using a non-equity split dollar arrangement in conjunction with a Walton GRAT.


Insurance products are issued by ReliaStar Life Insurance Company, Security-Connecticut Life Insurance Company, Security Life of Denver Insurance Company and Southland Life Insurance Company. All are members of ING.