Marrying income and gift tax efficiency.
When individuals are engaged in extensive wealth transfer planning, issues related to gifting and efficient funding of life insurance policies are often key topics in minimizing the impact on an estate. Within the context of that planning, individuals secure traditional life insurance products owned by irrevocable trusts while at the same time seek options to effectively manage their investments for optimal performance from a tax perspective. The product and funding alternatives merge and create opportunities to incorporate split-dollar financing for private placement life insurance (PPLI).
To minimize or eliminate estate taxes, PPLI is generally owned or placed in an irrevocable life insurance trust (ILIT), usually designed as a grantor trust. Like other forms of life insurance, PPLI owned by an ILIT provides a means to manage investments in an income and estate tax efficient manner. However, PPLI generally offers more extensive investment options, including alternative asset classes.
Purchasers of PPLI are generally estate owners with significant personal assets that they hope to conserve for their children and grandchildren. But of course, the premiums for large PPLI policies are often substantial, and planning concerns remain regarding the federal and state gift taxes associated with the transfer of assets or cash to heirs or ILITs to fund PPLI premiums. Frequently, the estate owners have used up their federal lifetime exemption1 and find their federal annual gift exclusion2 to be of modest effect.
PPLI Products
PPLI is similar to a traditional retail variable universal life insurance contract supported by a segregated asset account (separate account). The PPLI contract makes available various investment fund options (referred to as “insurance dedicated funds” in the case of private investment funds or “variable insurance trusts” in the case of registered funds). Alternatively, assets can be managed through a “separately managed account” (SMA). An investment manager may manage assets for an investment subaccount of a separate account of the insurance company. The asset manager has full discretion over the investment management of the SMA featured in the PPLI policy. The SMA may invest in a broad range of investments, including equities, fixed income, hedge funds, registered mutual funds and commodities. The contract owner’s separate account value varies over time with the investment performance of the investments to which contract premium is allocated.
The principal benefit of properly designed and administered life insurance is tax deferral. Returns on investments held for the benefit of these products aren’t subject to income taxation until the products are surrendered or withdrawals taken. Additionally, in the case of a properly designed and administered life insurance contract, death benefit proceeds pass to beneficiaries free of income tax. A secondary benefit of such products is administrative, in that product owners are generally relieved of tax reporting obligations (for example, K-1s) for the distinct investments held for the benefit of such products.
Benefits of PPLI?
PPLI differs from traditional life insurance in several beneficial ways. As noted above, investment options within PPLI products are generally broader than those available in traditional retail products. Further, PPLI products can provide greater flexibility in allocating contract values among new investment options as events and circumstances change.
Fees and expenses for PPLI products tend to be lower than in traditional life insurance products, and PPLI products thus tend to impose less expense pressure on policy investment account value (cash value). Subject to statutory limits, PPLI policy death benefit can be minimized, further reducing expense pressure on cash value.
The Role of Split Dollar
Split-dollar life plans offer an effective means to limit or eliminate gift tax issues associated with funding a life insurance policy owned by an ILIT, by reducing the amount deemed to be gifted from the full premium funded. A split-dollar plan may be implemented under two regimes. One is the economic benefit regime,3 which uses the economic benefit on the death benefit, and the other is the loan regime, which involves a loan whose proceeds are used to acquire a life insurance policy.4 Although both approaches are available, it’s more common to see the loan regime used in a private split-dollar arrangement than the economic benefit regime. A major advantage with a properly structured loan regime plan is that the policy is owned by the ILIT, and cash values and growth remain available to the ILIT and its beneficiaries. The estate of the insured/trust grantor retains a right to the repayment of its loan and accrued interest, either at termination of the agreement or at death of the insured.
In a typical loan regime arrangement, the estate owner will be the grantor of a grantor ILIT and will loan the premium amount to the ILIT. The ILIT can either pay or accrue the interest on the loan. As an alternative, the amount of unpaid interest can be imputed as a current gift by the grantor/donor to the beneficiaries of the ILIT.5 Properly designed, when the loan interest is deemed to be at an applicable federal rate (AFR) or higher, no additional gift will be imputed.6
The term of the loan dictates the AFR that applies.7 As an example, in October 2017, the mid-term AFR (loans for more than three, but less than nine years) was 1.85 percent, and long-term loan rates (longer than nine years) were 2.5 percent.8 An optional approach to consider is a demand loan, which allows the use of a blended rate.9 Blended rates are published solely in July of each year and used for transactions for the given calendar year. That published rate in July of 2017 was 1.09 percent.10
Risk Management Factors
Certain risks arise in a private split-dollar transaction involving a PPLI policy. Those risks are generally related to either the structure of the split-dollar note or to the insurance carrier and its product performance and features. As with any purchase of PPLI, it’s important to review the financial strength of the carrier and its commitment to the market. Flexibility in product design as well as the variety of available investment options are also important factors.
A fundamental risk of PPLI worth noting is the possibility of loss of some or all of the premium paid. Often, PPLI products provide no guarantees of investment returns and therefore there’s a risk that the ultimate cash surrender value (CSV) of a PPLI product will be lower than originally illustrated.
When private split-dollar is used to fund the PPLI premium and the policy significantly underperforms, there may be a plan to fund additional premium and reallocate to other investments in an effort to boost the potential for future performance. In that scenario, additional funding provided by a new or increased loan may take place in an environment in which the AFR is higher than the original split-dollar AFR, resulting in less benefit from a gift tax perspective.
Another risk factor associated with a PPLI policy is the potential for a mismatch between the liquidity provided by the policy and the grantor/lender’s future liquidity needs. Because the underlying investments of a PPLI policy often aren’t publicly traded, those investments may impose lock-ups or other liquidity restrictions that prevent an immediate liquidation of separate account investments in connection with a policy surrender or withdrawal request.
Independent of these product-related risks, the structuring of the private split-dollar transaction also may introduce variables that must be managed. For example, because the monthly published AFRs are used for term loans, if a split-dollar funding plan contemplates a series of term loans to fund each premium payment, the AFRs of those loans will likely be different. That potential variability in AFRs may, depending on the movement in interest rates, make the funding plan more or less efficient from a gift tax perspective. This risk can be managed with a single lump sum, long-term loan, but that may not be feasible for all clients. In a low interest rate environment, the risk of rising AFRs increases and should be actively monitored to maximize the economic efficiency of an ILIT funding plan.
Case Considerations and Steps
Identifying the profile for private split-dollar funding is important so the advisor can assess when to introduce it as an option. When a client is interested in purchasing a PPLI policy and having it removed from the taxable estate, that would generally involve planning with an ILIT. The question becomes whether the client has sufficient gift tax exemption to fund the ILIT and is willing to use it for that purpose. More often, PPLI policies are funded with total premiums in excess of $10 million, so flexibility with gifting is limited. Recall that private split dollar also arises when clients wish to maintain a degree of control and the ability to have their premium dollars returned to them plus interest in the form of full or partial repayment of the existing note.
Once a client has decided to proceed, implementation of a private split-dollar plan is carried out through a series of steps when using the loan regime to fund PPLI. The client often selects the split-dollar loan regime as the method of implementing the plan, because access to CSV is wholly controlled by the policy owner—namely the ILIT. The client must have significant liquidity available as a preliminary requirement to engage in the private split-dollar arrangement.
Step 1: Create and structure an ILIT so that assets owned by such ILIT are outside of the client’s taxable estate.
Step 2: The ILIT trustee applies for a PPLI policy on the life of the client or another individual in which the trust has an insurable interest.
Step 3: Prior to policy issue, the client loans the amount of premium desired to fund the PPLI. Depending on the length of the loan term, the rate of interest will be the short-, mid- or long-term AFR, as previously noted. The benefit of structuring the note as a lump sum loan is the ability to lock in the lower long-term AFR for added leverage.
Step 4: The client receives the split-dollar note from the ILIT (the note is included in the client’s taxable estate).
Step 5: The client and the ILIT enter into a split-dollar agreement. Generally, no interest or principal payments are due until the death of the insured, but there’s flexibility in structuring the term depending on the client’s circumstances.
Step 6: The split-dollar note may be repaid from the PPLI policy cash values during the client’s life. In the event the client doesn’t wish to reduce the CSV of the policy, the note can be repaid on the death of the insured.
Opportunities for Tax Efficiency
Consider James, 50 years old, married with two teenage children. As a successful investment banker, he’s accumulated significant wealth. His current net worth is $60 million, and he continues to earn in excess of $1 million annually. James is well aware of his annual tax bill and is regularly seeking ways to mitigate his tax liability. He invests regularly and is interested in incorporating alternative investments in his portfolio. James has a gross annualized return of 7 percent on his investments, but understands that the tax drag is significant because much of his gain annually is a blend of ordinary income and short-term capital gain.
James meets with his advisory team and is introduced to PPLI as an option for tax-efficient portfolio management and long-term accumulation. His advisors obtain a PPLI illustration and prepare a comparison for discussion with James. (See “PPLI Illustration,” p. 40.)
The analysis showed that in Year 20, when James is age 70, a PPLI policy will produce a 6 percent internal rate of return (IRR) on the cash value versus net 4.2 percent on the taxable investment portfolio. After review of the projected growth under his current versus proposed PPLI, as well as full review of available products and investment options in the market, he decides that PPLI is appropriate for his planning and investment needs.
With the assistance of his advisor team, James evaluates structuring options for the PPLI policy and decides to form an ILIT that’s a grantor trust for income tax purposes. The ILIT, as owner and beneficiary of the policy, is structured so that the PPLI policy isn’t included in James’ taxable estate.
The funding options being evaluated include funding the ILIT via a taxable gift, use of a lifetime exemption or entering a split-dollar agreement with the ILIT. Neither he nor his wife had their lifetime gift exemption available so that left them with the choice to pay a gift tax today or avoid it entirely while maintaining the ability to later collect the premium he funds the PPLI with via a split-dollar agreement.
James and his advisor team reviewed the short-term and long-term economics of a funding comparison for the PPLI premium with: (1) outright gifts, and (2) a split-dollar arrangement.11 (See “Funding Comparison,” p. 41.)
If James were to fund the premium with gifts of $2 million for five years, he would have a cumulative gift tax of $4 million paid by Year 5. Ultimately, the cost of funding the PPLI increased by 40 percent and if factored in to the net impact of James’ estate, it would have significant drag on the growth.
A split-dollar arrangement using loan regime would produce a significantly different result. Assuming the note was structured so that a lump sum loan of $10 million is made to the ILIT in Year 1 at the long-term AFR of 2.5 percent (as of October 2017), the growth removed from the taxable estate of James is equal to the difference between the long-term AFR and the annual growth of the PPLI. As long as the PPLI policy returns in excess of 2.5 percent, the split-dollar plan has been effective in shifting growth from being subject to estate tax.
The cumulative gift tax on split-dollar loan regime interest is the interest on the split-dollar loan that would be due to the lender, James in this case. James may allow that interest to accrue on the loan balance for the term of the loan. Assuming in Year 40, James elects to waive collection of the loan interest, it would be deemed a gift to the ILIT, and gift taxes would need to be paid. Not until Year 40 does the amount of gift tax that would need to be paid under the split-dollar plan equal the $4 million that would have been paid by Year 5 if gifted outright.
To illustrate the impact on James’ estate, we see in “Funding Comparison” that if the $4 million that would be paid in gift taxes under the outright gift plan were retained by James and had a net investment return of 3 percent on the savings of cumulative gift tax, then by Year 20, he would have retained $6,815,684, and by year 40, or age 90, the savings would have accumulated to $12,309,883. This reinforces the financial impact that saving gift taxes today and allowing those savings to accumulate over 20 years and 40 years has on James’ estate. While that growth creates an estate tax issue, there may be other assets that he would opt to shift out through alternative planning techniques and then elect to spend down some of this accumulated growth.
Ultimately, a split-dollar arrangement allows James to eliminate current gift tax to the ILIT, maintain flexibility in his future gifting options and have the ability to secure cash payments via interest payment from the ILIT to himself.
Key Solutions
When you align family assets with higher net investment returns, you can unlock significant value, especially for families focusing on future generations. PPLI products are key solutions to tax-efficient investing. PPLI products can be used along with, or in addition to, many other structures to enhance family wealth planning.
PPLI products offer the qualified purchaser access to both investment alternatives and product designs that may not exist with traditional tax-inefficient investment products. These products can be used to defer or potentially eliminate income tax or any tax reporting associated with investment activities. They provide a low cost, transparent, efficient and flexible approach to address a number of financial, estate and income tax planning objectives. Simply put, structured expense (that is, the cost of implementing the PPLI structure) may be substantially less than the taxes the family would otherwise incur. It’s just math.
Endnotes
1. Internal Revenue Code Section 2010.
2. IRC Section 2503.
3. Treasury Regulations Section 1.7872-15.
4. Treas. Regs. Section 1.61-22
5. To qualify for the annual federal gift tax exclusion, Crummey provisions will be included in the irrevocable life insurance trust.
6. IRC Section 7872 and Treas. Regs. Section 1.7872-15(e).
7. Treas. Regs. Section 1.1288-1.
8. Revenue Ruling 2017-20.
9. IRC Section 7872(e)(2)
10. Rev. Rul. 2017–14, Section 7872(e)(2) blended annual rate for 2017 is 1.09 percent.
11. Follows guidelines of split-dollar regulations; long-term applicable federal rate for a note over nine years (annual compounding) is 2.5 percent as of October 2017. The term of the note is structured to be for the lifetime of the insured.
—This material is designed to provide accurate and authoritative information with regard to the subject matter covered. This informational material isn’t intended as a solicitation to the general public and is designed for use with qualified financial professionals.