PHOENIX — Advisers who take the time to understand and help implement a private loan regime/split dollar arrangement can net ultrahigh-net-worth clients big estate tax savings and flexibility, as well as efficient gift tax leverage.
A split dollar arrangement is an agreement between two parties to split a life insurance policy’s cash value, death benefits, and premiums, explains Steve Kroeger, a senior director of advanced sales with Crump Life Insurance Services. In private split dollar financing, the split is between the insured person (or a family member, another trust, or a business) and an irrevocable life insurance trust, or ILIT, according to Kroeger, who spoke at NAPFA's spring conference. That puts the life insurance policy outside the owner’s estate, but still gives the owner access to its equity, he says.
There are several versions of private loan regime/split dollar financing, with taxation depending on who owns the policy and/or its cash value. In a private loan regime/split dollar arrangement, the policy’s owner loans the trust a substantial sum. The trust invests that money and pays the life insurance policy premiums with the money the investment earns. The trust repays the loan at the IRS’s published intra-family interest rate — a rate almost certainly less than the rate the investment will earn. When the policy is entirely paid up, the trust returns the grantor’s money.
“Rather than making gifts, make a loan to a grantor trust on an interest-only basis,” Kroeger suggests. “The trustee uses the trust income to purchase a life insurance policy.” When the policy is paid up — which can occur on an accelerated schedule, he says — the trust returns the asset to the client.
Kroeger offered a hypothetical family as an example. In it, a couple loans the trust $4.5 million. The income from that invested asset purchases a life insurance policy with a $5.3 million death benefit. The trust makes nine tax-free interest payments of $90,000 each at 2% to the borrower, and repays the initial $4.5 million loan in year nine, when the policy is paid up. Any additional appreciation remains in the trust and passes tax-free to heirs.
The strategy is particularly useful in situations where clients have already used their exemptions, have a plan for that exemption, or own businesses and/or real estate, Kroeger says.
Clients who prefer that their children not receive a death benefit could use a 501(c)(3) charity instead of an ILIT. “Think broadly,” Kroeger urges. “You could use a church or other charity instead of a trust. The money comes back and the church gets the death benefit.”
This strategy works particularly well in an environment of low interest rates. “It might be worth doing this before intra-family loan rates go higher,” Kroeger says.