There are numerous ways to fund premium payments on life insurance when the policy is held in trust. They include using an existing funded trust and making annual exclusion gifts. For larger premium payments, private finance, split dollar and borrowing from a commercial lender are options. They all have pros and cons. Here’s an analysis of the techniques.
Existing Trust
If there’s an existing funded trust with the right language and the right beneficiaries, review this option first for funding the premiums. The beneficiaries and the terms should be the same as if a new irrevocable life insurance trust (ILIT) was being done now. The grantor of the trust must be comfortable with using the trust funds for the premiums. Also, the trust must either have assets that produce cash flow or assets that can be sold to provide the funds to pay the premiums. (This isn’t meant to be a comprehensive piece regarding grantor and non-grantor trusts nor strategies to get a step-up in basis at death. Those issues should always be addressed regarding any technique using irrevocable trusts.)
Annual Exclusion Gifts
These annual gifts are the most common techniques for funding life insurance premiums if the amounts will cover the premiums. There are three cases that specifically address annual exclusion gifts: Crummey v. Commissioner,1 Estate of Cristofani2 and Estate of Clyde W. Turner, Sr.3 They tell an interesting story.
In Crummey, the court approved annual exclusion gifts made to a trust even though the beneficiaries didn’t know they had a right to demand funds from the trust. The court said:
As a practical matter, it is likely that some, if not all, of the beneficiaries did not even know that they had any right to demand funds from the trust. They probably did not know when contributions were made to the trust or in what amounts. Even had they known, the substantial contributions were made toward the end of the year so that the time to make a demand was severely limited. Nobody had made a demand under the provision, and no distributions had been made. We think it unlikely that any demand ever would have been made.4
The court concluded that the beneficiaries had a “right to enjoy” and therefore allowed the annual exclusions—$3,000 at the time.
In Cristofani, the deceased, Maria Cristofani, created a trust for the benefit of her two children with five grandchildren as contingent beneficiaries. Over the course of two years, she gifted two undivided 331/3 percent interests in real property. Each one-third interest was valued at $70,000. She claimed a $70,000 annual gift tax exclusion, $10,000 for each of the children and the grandchildren. The beneficiaries had 15 days from the time the gift was made to exercise their withdrawal powers. Citing Crummey, the court allowed all of the gifts as present gifts. Note that a so-called “5 by 5” (greater of 5 percent or $5,000) power wouldn’t cover the gifts. Instead, the provision in the trust allowed for a gift in an amount not to exceed the gift tax exclusion under Internal Revenue Code Section 2503(b).
In Estate of Clyde W. Turner, Sr., the decedent made indirect gifts via payment of premiums directly to the insurance companies for life insurance policies owned by a trust. The Internal Revenue Service took the position that because the gifts weren’t made to the trust, they didn’t qualify for annual exclusions. Under the terms of the trust, a beneficiary was required to give notice to exercise the withdrawal right within 30 days of the transfer to the trust. If such a demand was made, the trustees were authorized to distribute cash or any other trust property or borrow against the cash value of the life insurance policies. The gift tax annual exclusion was $10,000 per donee. In citing both Crummey and Cristofani, while saying that some or all of the beneficiaries may not have known they had the right to demand withdrawals, the court ruled they were in fact present interest gifts qualifying for the annual exclusion, even though they weren’t direct gifts to the trust.
These cases raise two questions: (1) Is a Crummey notice to the beneficiaries necessary for a completed gift, and (2) When paying premiums on a life insurance policy, is the annual exclusion amount limited by the 5 by 5 powers? While prudence is always good, if a client didn’t send Crummey notices, the three cases may counter any argument the IRS would make to disallow them as present interest gifts.
Private Finance
Private finance is a transaction in which one party loans money to another party to pay life insurance premiums. These arrangements fall under Treasury Regulations Section 1.7872-15 covering split-dollar loans. Falling under the regulations is a good thing. It allows the accrual of interest, loans for the life of the insured(s), using the cash value, the death benefit or both as collateral, and binding the IRS to treat the transaction as a loan. To avoid falling under IRC Section 7872, use the appropriate applicable federal rate (AFR). If a loan is for the life of the insured, refer to Table 1.79 for annuities to determine life expectancy. If the life expectancy is for more than nine years, it’s long term. Assuming a grantor is going to make loan(s) to an ILIT, the loans can be done either as a lump sum (under Treas. Regs. Section 1.61-22, which governs, you can pay all or any of the premiums) or annually. If your client makes a lump-sum loan, the actual payments to the insurance company can be done over any time period. Whatever isn’t needed to pay the initial premium can be invested to fund the future premiums. If your client makes an annual loan, each new loan is made at the AFR for the term in effect at that time. If interest is accrued and the ILIT is a grantor trust, there are no gift or income tax consequences.
To properly use this method, a notice (spelled out in Treas. Regs. Section 1.7872-15) needs to be filed with the income tax return of the first person to file, either the lender or the borrower. Because only one notice needs to be filed, it isn’t a problem if the ILIT is a non-filer. If subsequent loans are made, a copy of the original representation needs to be filed for each year a loan is made. Additionally, each loan needs to be documented, and the interest, whether paid or accrued, needs to be accounted for.
A record-keeping complexity occurs if multiple loans are made or the terms are shorter than the life of the insured. Each loan has to be accounted for separately. If the loans are for a period shorter then life expectancy, when a loan matures, either it must be repaid or a new loan for the amount due under the old loan has to be made. Right now, with the small difference between the short-term rate and the long-term rate (43 basis points in March), I would opt for the loan for life. If additional loans are made, the terms don’t have to be the same. Note the long-term AFR is lower than the Section 7520 rate.
Another issue is interest on the loan. If interest has accrued, the amount of the loan will eat into the face amount of the insurance policy. One way of dealing with that issue is to have the death benefit go up by the amount of the premiums paid. Some companies will even allow you to add in an interest factor. A clever disposition of the note can fix the problem. If interest will be paid, the lender can’t directly give the trust the money with which to pay it. The gifts are disregarded, and it’s treated as though the interest was forgiven. The transaction then falls under the provisions of IRC Section 7872. If a lump-sum loan is made and interest is paid annually from the money in the trust, interest shouldn’t be a problem. Otherwise, the lender should gift amounts unrelated to the amount of the interest at times other than when the interest is due. If interest will be forgiven apart from having to account for it as a gift, use the original issue discount method for accounting for the gifts. If your client is going to make gifts, compare this method with the split-dollar method under Treas. Regs. Section 1.61-22 to see which makes more sense. An exit strategy other than death of the insured(s) may be a good idea.
Split-Dollar Arrangements
Under a split-dollar arrangement,5 one party “rents” term insurance annually while the other party pays the premium on a (more) permanent policy. The premium payor is entitled to get back the greater of cash surrender value or premiums paid either at termination of the agreement or the death of the insured(s). The IRS issued Table 2001 (subject to change) to determine the value of the rent. The amount for an individual changes every year as he gets older. The amount of insurance used in the calculation is the face amount less whatever is due back to the premium funder. (This is considered an advance, not a loan.) The table is based on the age of the insured(s) without taking health into account. If two lives are insured, there’s a method for determining that value. It’s much less than the amount on a single life.
While good at the outset, this method needs to be monitored. If two lives are initially insured and one dies, the measure of the benefit is now based on the age of the survivor and is much higher than the amount based on two lives. If it’s a single insured, the amount gets higher. The amount of gift (or payment from the trust if the trust is paying the cost) is present, whether actual premiums are paid. There isn’t a recognized mechanism in place to do the accounting if the funder only pays some of the premiums. Further, as the amount of premiums paid and/or the cash value grows, the amount of the death benefit going to the trust decreases. Participating whole life polices present this problem as they become cash rich. An option is to have the face amount increase by the premium payments or a dividend option that will accomplish the same thing. Before using this technique, think of or put in place an exit strategy.
There are a number of exit strategy options. If the ILIT isn’t generation-skipping, a grantor retained annuity trust (GRAT) with the trust as the remainder beneficiary may handle the repayment of the amount due. The term of the GRAT isn’t that important because if the grantor/insured dies, the policy proceeds will be paid. Another is to sell assets to the same trusts. Use the assets and/or the cash flow to pay back the advances. There’s no recognized mechanism to account for the repaying part of the advances. Finally, the arrangement can be switched to a loan. However, any termination (and changing to a loan is considered a termination) of this arrangement requires determining the value of the policy for gift tax purposes.6
Premium Finance
What’s known in the industry as “premium finance” is a transaction in which a commercial lender loans money to pay life insurance premiums. One important note: These transactions are usually structured so that the lender can never ever lose any money. There are a lot of intricacies to the transaction. In addition to the cash value of the insurance policy, most transactions require the borrower to post additional suitable collateral. Interest may be paid or accrued. The interest rate is usually the 1-year London InterBank Offer Rate (LIBOR) plus an additional amount, often 1.75 percent. The interest rate renews at the anniversary of the loan. The loan term is usually five years and needs to be renewed beyond that at new terms. When done with an ILIT, the grantor (often the insured) is either a guarantor of the note or puts up additional collateral above the cash value of the policy to cover the note plus interest. Any interest paid by the grantor is a gift to the trust. If the arrangement is terminated and some or all of the grantor’s collateral is called, that’s also a gift to the trust.
The insurance policy most often used is equity indexed universal life. This comes with its own complications. The amount credited to the cash value is based on a securities index, usually the S&P. There’s a floor as to what can be credited (usually zero) and a ceiling, called a “cap rate.” The cap rate, controlled by the insurance company, changes monthly. Any money going into the policy or any money in a segment that’s matured will be credited using the new cap rate. The insurance company can change any of the other variables including the cost of insurance internally charged in the policy. Lastly, although there’s a zero floor on what’s credited (meaning if the index goes negative, your client doesn’t experience the negative return), there are always expenses taken from the policy. Assuming that your client was credited zero based on the index, the value of the policy will still go down because of the internal charges.
This strategy is best suited for clients who are using arbitrage against the earnings on their investments, are familiar with the stock market, understand borrowing and are willing to take the risk. It isn’t good to arbitrage against the return of the policy. I’ve seen a lot of presentations that look as though the client isn’t paying anything out of pocket—just putting up collateral. As an expert witness, I’ve been involved when those transactions have gone bad. Even if the gross return averages 7.5 percent, the internal charges averaging 1.75 percent will bring that return down to 5.75 percent. LIBOR as of this writing is at 2.94 percent. Add 1.75 percent and you’re at 4.69 percent. If LIBOR goes higher than 4 percent (and historically, it’s done so many times), you have negative arbitrage.
If doing premium finance, your client MUST have an exit strategy other than the policy paying off the loan or the loan getting paid off at the insured’s death. There are several, as pointed out in the section on split-dollar arrangements. Your client can pay off the loan, which entails making a gift. Your client can loan money to the trust so it can pay off the loan. He’s now in the private finance scenario described above. He can sell assets to the trust or create a GRAT with the trust as a remainder beneficiary. Because of all of the complexities, before he does a premium finance transaction, he should hire a consultant who understands all the facets and how they work.
Endnotes
1. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).
2. Estate of Cristofani, 97 T.C. 74 (July 29, 1991).
3. Estate of Clyde W. Turner, Sr. et al., T.C. Memo. 2011-209 (Aug. 30, 2011).
4. Crummey, supra note 1, at p. 88.
5. Larry Brody and Don Jansen have written an excellent book on the subject: Leveraging Life Insurance Premium Payment, ABA Real Property Trust & Estate Law Committee (2017).
6. See Richard L. Harris, “Transferring Life Insurance by Gift or Sale?” Trusts & Estates (April 2011) for a discussion of fair market value and life insurance policies.