How would you like to be able to fund life insurance policies in an irrevocable life insurance trust (ILIT) without making any taxable gifts? Doing so is helpful when the premiums are high. Furthermore, the trust can be generation-skipping, and the technique is specifically covered by Treasury regulations.
Funding the ILIT Before 2003
When funding life insurance policies in an ILIT, one issue that comes up every time is how to get the money into the trust. Up until 2003, there were three ways: (1) outright gifts, (2) economic benefit split-dollar arrangement, and (3) an existing funded trust. The first two require gifts. If your client is using the annual exclusion amount to cover the gifts, they’ll need to have enough beneficiaries to take in the premium without dealing with the lifetime exemption. Example: If the premium is $50,000 and the annual exclusion is $14,000 per recipient, four annual exclusion gifts must be available.
If the number is achieved by using both spouses’ annual exclusions, when one dies, half of the annual exclusions are lost. Both gifts for the premium and gifts for the split-dollar benefit amount require Crummey notices to qualify for the annual gifts exclusion. And if the amount of the annual gift is more than $5,000 or 5 percent of the value of the corpus, the ILIT must have hanging powers. Only using an existing funded trust won’t involve making a gift.
Split Dollar
A split-dollar arrangement is handy because it can reduce the amount of the gift relative to the amount of the premium. The economic benefit arrangement (covered by Treasury Regulations Section 1.61-22, effective Sept. 17, 2003) is similar to having a house but letting someone else live in it. There’s a value for the use of that house known as rent. In the split-dollar arrangement, the premium funder gets the greater of cash value or sum of premiums paid either at death or when the arrangement is terminated. (Please note: The moneys paid by the funder are called “advances.” They’re not loans, and there’s no interest factor.) The ILIT receives a net death benefit for one year—the face amount of the policy less what’s due the premium funder. That value (the rent) is also based on the age of the insured(s). The standard for value is Table 2001. As the insured gets older, the rate goes up. Because it goes up every year (regardless of whether a premium is actually paid), at some point the Table 2001 rate may be higher than the actual premium paid. Example: If the premium funder is entitled to receive $100,000 from a $1 million death benefit, the amount taxable is the Table 2001 rate for the $900,000 death benefit in the ILIT. If the insured is age 50, the rate per thousand is $2.30, and the total benefit is $2,070. However, if the insured is age 70, the rate is $20.62, and the total benefit is $18,558. Therefore there must be an exit strategy—another discussion.
No-Gift Strategy
A no-gift way to fund the ILIT emerged in on Sept. 17, 2003. At that time, Treas. Regs. Section 1.7872-15 came into existence. That regulation provides the key to a no-gift funding strategy. Internal Revenue Code Section 7872 covers loans between related parties.
If you make a loan to a trust, that loan isn’t a gift. If the note that you get in return for the loan allows interest to accrue, there’s still no gift. (If the trust is a grantor trust and the lender is the grantor there are no original issue discount problems.) The loan can be for the life of the insured. The interest rate to be used must be be no less than the applicable federal rate (AFR) for the term of the loan at the time the loan is made. If the loan is for life, use the table under Treas. Regs. Section 1.72-9 to determine life expectancy. If the expectancy is over nine years, use the long-term AFR. If a male insured is age 77 or older or a female insured is age 82 or older when the loan is made, the life expectancy according to the table at those ages is less than nine years, at which point the appropriate AFR will either be the short-term or mid-term rate. In April 2016, the short-term AFR is .70 percent, the mid-term AFR is 1.45 percent and the long-term AFR is 2.25 percent.
Example: The insured is age 51, and the annual premium is $150,000. If the lender (often both the grantor and the insured, but almost always the grantor) makes annual loans, each new annual loan bears the appropriate AFR interest at the time that loan is made. If that $150,000 loan for life was made today, the interest rate would be 2.25 percent.
If there’s another loan next year, the interest rate will be the appropriate AFR at the time that loan is made. Making annual loans to the ILIT has two negatives: (1) there’s bookkeeping involved for each loan; and (2) there’s uncertainty as to what the future AFR will be.
Your client can get around those negatives. Suppose instead of making annual loans, the lender makes a lump-sum loan made that’s large enough to fund all the future premiums. The only bookkeeping involved is for one loan, and the interest rate is locked in forever at the time the loan is made. Could your client live with a guaranteed 2.25 percent rate as long as the loan is outstanding? Better still, if the insured lives to the life expectancy of the table at the time the loan was made, the loan is reissued at the demand rate, and the loan isn’t tested for sufficient interest going forward.
Exit Strategy
What about having an exit strategy? If the loan is for the life of the insured, one strategy is to repay the loan at death. However, with the interest accruing, the size of the loan grows and the repayment will substantially reduce the death benefit. That can be dealt with by having the death benefit rise each year or by getting more insurance so that the net after repayment amount is what’s desired at the outset. But either of those options will probably raise the premium on the policy.
A second exit strategy is to invest the lump sum and use the growth of the investment to repay the loan. Because the ILIT is a grantor trust, as long as the grantor is willing to pay any income taxes, the return to the trust is the gross return. If the policy is arranged so that there are a limited number of premiums and assuming a 5 percent return on the investments, with the right amount of lump sum loan, the loan and accrued interest will ultimately be sufficient to repay the loan. Or, it may make sense to continue to arbitrage against the 2.25 percent interest rate by continuing the loan even though there will be sufficient assets to pay off the loan.
Treatment as Loan
How can you be sure the IRS will treat this as a loan? Treas. Regs. Section 1.7872-15 includes a provision that states that even if the loan is non-recourse, if the lender and the borrower make representations that it’s the intent that the loan be repaid, and the representation is filed properly with the income tax return for the year in which the loan is made, the IRS is bound to treat the transaction as a loan. Any future loans can be covered by filing a copy of the initial representations with the income tax returns for the years in which the loan is made.
If you would like indexed and annotated Treas. Regs. Section 1.61-22 and/or Treas. Regs. Section 1.7872-15, email me at the address below.
This is the first of what will be monthly blogs about life insurance and life insurance as it pertains to estate planning. If you have a topic you’d like covered please email me at [email protected].