For clients with significant assets who want to protect their families and businesses, minimize estate taxes, and preserve the legacy they pass on to future generations, the most transfer tax-efficient way to own the substantial life insurance they need is by establishing an Irrevocable Life Insurance Trust (ILIT) as the policy owner.
A key benefit to having the life insurance policy properly owned by an ILIT is that this removes the death benefit from the trust grantor’s taxable estate. But there are other benefits as well, including protecting the insurance assets from creditors,¹ divorce, and/ or legal action; managing distributions to beneficiaries; equalizing an inheritance; replenishing a trust; and providing liquidity to fund a business succession plan.
The challenge: Finding tax-efficient ways to pay premiums and preserve cash flow
While it’s usually appropriate for wealthy families to fund irrevocable trusts with life insurance, it can be a challenge to pay the insurance premiums in a manner that:
aligns with the client’s other financial goals,
relieves financial pressure on their cash flow and liquidity,
eliminates the need to liquidate investments and incur capital gains taxes, and
minimizes income and transfer tax liabilities.
Because clients typically do not want to pay a 40% gift tax on top of a large
insurance premium, an important goal for any funding strategy is to get sufficient funds into the ILIT to enable the trust to pay premiums without incurring gift taxes. But it’s also important to recognize that, for some clients, simply paying the gift tax now will have less impact than paying the estate tax later on.
Ultimately, the acquisition of large blocks of life insurance is more palatable for clients when the source of the premium is not their own cash flow or investment gains. Visualizing other potential funding sources as distinct “buckets” of funds that a client can access to pay premiums can help move the discussion forward. Here’s an overview of three common funding options.
Bucket #1: The annual gift exclusion or lifetime gift tax exemption
When the insurance is owned by a trust, it may make sense to utilize annual exclusion gifts. If the client has sufficient financial security to maximize the current lifetime gifting exemption, the gifted principal and its future earnings provide an excellent source of premium funding.
With the lifetime gift tax exemption at historic highs, married couples today also have over $23 million² to contribute to the trust without incurring estate or gift taxes. If they have sufficient liquid assets, this can be a very simple, straightforward way to provide an excellent source of capital to fund the ILIT which, in part, can be used to fund insurance premiums.
Bucket #2: A private/family loan to the ILIT
It’s not unusual to have the annual premiums for a substantial permanent life insurance policy far exceed a client’s available annual gift exclusion. Other clients may not want to use their lifetime gift tax exemption, or they may have used it in other ways.
In these situations, a private loan is a technique to help clients pay the large premiums without triggering substantial gift taxes. With a private intra-family loan:
the grantor/client loans money to the ILIT at the Applicable Federal Rate (AFR)³.
the trust uses the loan proceeds every year to write a check to the insurance company to pay the premium for a policy on the life of the insured.
Two potential upsides to a private loan . . .
One of the benefits of a private loan is the transfer tax savings it provides to the grantor. For example, let’s say the client loans $20 million to an ILIT (instead of making an outright $20 million gift) and the trust pays interest at the current long-term AFR, which is hovering around 1%.³ The amount of the loan interest that the trust must pay would be $200,000 (20 million * 1.00%), which is considerably less than the $8 million that would be owed (assuming a 40% tax rate) if the grantor had given the money to the trust outright and had no gift tax exemptions left.
The other upside is the potential positive rate arbitrage that the loan creates for the ILIT. If the trust corpus earns 3% on the $20 million (or $600K) but pays AFR interest on the loan at 1% ($200K), the trust has free cash flow of $400K, less any income taxes,⁴ to use toward premium payments.
. . . and two potential downsides
Of course, there is always the risk that the difference between the interest rates will narrow substantially – or disappear entirely – and the positive value of the interest rate arbitrage will be lost. In that case, the trust grantor might need to add assets to the ILIT to assure that the funds required to cover the insurance premiums are available.
Another potential downside to this payment method is that the outstanding amount of the loan must be dealt with at some point, either during the insured’s lifetime or at death. Common methods to retire private ILIT loans include repaying the loan with cash from the trust, transferring the note to the trust via a gift or a sale, or eventually forgiving the note entirely.
Private split-dollar loan arrangements
For clients who have exceeded their lifetime exemption and don't have enough annual exclusions, more complex loan strategies such as private split-dollar arrangements may come into play.
With a private split-dollar approach, the cost and benefits of the insurance policy are shared between the trust grantor/client and the trust by entering into a legal agreement about how the trust will benefit from the life insurance policy.
In any split-dollar arrangement, the premiums are effectively “loaned” and the insurance policy functions in part as collateral for the arrangement. The agreement specifies how the rights to the values held in the policy will be assigned to each party.
Gift tax impact of a private split-dollar plan
The IRS spells out two methods or “regimes” for determining the value of a split-dollar arrangement and this impacts how gift taxes, if any, will be calculated.
Under the loan regime:
The ILIT has the right to (i.e., “owns”) both the cash value and the death benefit of the life insurance policy.
The grantor’s gift tax impact for a loan to the ILIT is based on the loan interest associated with the arrangement. Generally, the interest rate for the loan is the AFR which is usually much lower than prevailing commercial interest rates.
Under the economic benefit regime:
The grantor owns the policy and retains the right to the insurance policy’s cash value, but gives the ILIT Trustee the right to name the beneficiary of the death benefit which is typically the ILIT itself.
The grantor’s gift tax impact for splitting off the death benefit, is calculated based on the economic benefit cost, a mortality measure for the ILIT’s use of the death benefit.
The choice of which regime to use comes down to control/ownership of the life insurance policy’s cash value and death benefit and the resulting gift tax impact.
If the goal is to have the policy’s cash value inure to the trust, the loan regime is usually the best option.
At younger ages, or when two lives are insured, the “economic benefit” amount can be extremely small, so the impact of the gift tax will be considerably less than the tax impact under the loan regime.
At older ages, or after the first death for a policy with two lives, the economic benefit regime can be extremely expensive due the increased probability of a single life dying in any given year. For this reason, split-dollar arrangements can be designed to switch from the economic benefit regime to the loan regime as the insured ages.
Both regimes usually result in a gift tax impact for the grantor that is considerably lower than it would be with an outright gift of the entire annual premium. However, if the grantor forgives the loan later on, then the total amount of the loan is a taxable gift to the extent that it exceeds any available annual exclusion or lifetime exemption.
Bucket #3: Commercial Funding
If clients can benefit from positive arbitrage, lack liquidity -- or simply don’t want to pay gains on assets they must liquidate to fund the insurance premiums -- they can pursue funding from a third party by securing a loan from a bank or other lending institution.
With a commercial funding solution, the bank loans funds to pay the premium every year to the grantor or the ILIT and the trust uses that money to pay the premium. The lender will generally require the policy death benefit and cash value as collateral. The amount that the bank loans is not counted as a gift.
The potential drawbacks to this strategy:
The commercial bank must be repaid.
The client may need to re-qualify as premiums come due and the loan renewed.
Each subsequent loan may have a new interest rate.⁵
If rates start to rise, the client could lose any favorable rate arbitrage.
If the cash value does not perform as anticipated or the interest rates charged by the lender increase (making the aggregate loan amount larger), the client/ grantor may need to provide more collateral.
To adequately prepare a client for any downside, it’s important to stress test the life insurance illustration against a commercial loan model with conservative performance assumptions about interest rates, tax rates, fluctuating secondary collateral value, and best- and worst-case scenarios. Stress testing identifies and demonstrates potential collateral inadequacies as well as the effect of interest rates on the insurance policy’s performance and loan repayment.
In addition, clients who are interested in commercial financing may want to consider paying some of the premium instead of financing all of it. Much like a down payment on a home, in the long-term, the equity in the policy will support a lower need for collateral and will decrease the size of the loan. Additionally, the collateral can be set aside in a side fund to be used to pay back the loan at a future date.
Every solution needs an exit strategy
The architecture of an effective funding transaction using private or commercial loans requires an exit strategy so any outstanding loans to the ILIT don’t end up causing policy performance issues and additional value in the estate. A decision must be made upfront about what to do with “receivables” that flow back into a client’s estate.
As noted earlier, the exit strategy for private ILIT loans may be to repay the loan with cash from the trust, transfer the note to the trust via a gift or a sale, or eventually forgive the note entirely. Where the receivable flows back to the estate, this usually can be managed by the implementation of a GRAT or CRT.
The right solution depends on the client situation
There are many premium funding techniques to use with clients. Depending on the amount of insurance needed and the client’s liquidity situation, it is likely that several techniques will apply.
Finding the right insurance premium funding solution -- or combination of solutions -- for each unique client situation requires a considerable amount of creative problem solving. There is no “one-size-fits-all” solution. But purchasing the high-value insurance clients need by incorporating the benefits of an ILIT can give them an impressive array of effective strategies to optimize their wealth management decisions.
[1] In some states, creditors may be able to access distributions made from the ILIT.
[2] Assuming no prior taxable gifts have been made and using 2020 lifetime transfer exclusion. Under current law, on December 31, 2025 the exclusion amount will return to its previous 2017 level of $5 million, indexed for inflation.
[3] The Applicable Federal Rate (AFR) for long-term loans was 1.12% as of October 2020. See https://apps.irs.gov/app/picklist/list/federalRates.html
[4] If the trust is a grantor trust, the taxes will be picked up by the grantor which may provide additional efficiency for the trust.
[5] This is also the case in a loan regime split-dollar where each premium payment must be counted as a separate loan. Treas. Reg. § 1.7872-15(a)(1) and (2)(iv), Ex. 1.
This material is intended for informational purposes only and should not be construed as legal or tax advice. It is not intended to replace the advice of a qualified attorney, tax advisor, or financial provider.