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Premium Financing
- 1. Premium Financing Jay C. Lewis, CLU
- 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 PremiumFinancing? 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? Thepolicy 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 PremiumFinancing 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 theExit 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 LeverageDuring 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 ItWork? 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.