What if the insured

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Paying for Large Insurance Premiums
Daniel Capobianco, J.D.
and Ron Ware, J.D.
June 17, 2009
1
Today’s Topic
 Planning
for the high net worth
client often requires the use of life
insurance as an important
component of the plan
2
© Law Offices of Daniel B. Capobianco
Issues to be Addressed

What if annual premiums exceed available
Crummey Exclusions
 What if insured (grantor) has used up
$1,000,000 lifetime exclusion
 How to “roll out” of a premium finance
plan (or private split dollar plan)
 What if the insured “can’t afford” the
annual premium
– Usually this means “I don’t see the value of
buying insurance”
3
© Law Offices of Daniel B. Capobianco
Product Design of Life Insurance
Universal Life
 No Lapse Guarantee
 Whole Life
 Variable Universal Life
 Guaranteed VUL

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Policy Considerations

Rating of Carrier (insolvency risk)
 Use of Multiple Carriers to spread risk
 Use of Multiple Policies
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Methods of Premium Payment

Insured (grantor) gives money to ILIT and
the ILIT makes premium payments
– Crummey Gifts

Insured’s company pays premium directly
to the insurance company
– Split Dollar

Third party loans funds to ILIT and the ILIT
makes premium payments
– Premium Financing
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Split Dollar Rules
Rules were substantially changed,
but the basics remain the same.
 There are two regimes – The
“Economic Benefit” and the “Loan”
 They are mutually exclusive

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Split Dollar Rules

ECONOMIC BENEFIT -- the life insurance policy is
actually owned by the grantor-insured
– Policy equity belongs to the insured (and therefore is in
his or her estate)
– Tax is imposed on the annual term cost (formerly known
as “PS 58 cost”) as dictated by the IRS (Table Rate) or
the insurer’s alternative term rates. In the case of
second-to-die, these amounts must be extrapolated
– The Regulations permit the policy to be owned by an
irrevocable life insurance trust (“ILIT”) and collaterally
assign a security interest in the policy to the grantorinsured, as long as the ILIT does not retain any equity in
the policy
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Split Dollar Rules

LOAN REGIME-- the life insurance
policy is owned by the ILIT
– Policy equity belongs to the ILIT
– Tax is imposed on the interest on the
premium loans
– The interest is measured by the AFR
rather than the Table Rate
– Loan can be demand, short, mid- or
long-term
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“Private Split Dollar”
When Premiums are likely to exceed
gift tax exclusion
 Premiums are Grantor loans
 Carry IRS interest
 Can be given to spouse (marital
deduction)
 Can be funded by company

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Premium Financing

An arrangement in which the Irrevocable
Trust borrows money from a third-party
lender to pay premiums
 The policy is collaterally assigned to the
lender
 Interest due on the cumulative premium
loan can either be paid currently or funded
from the policy (i.e., accrued)
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© Law Offices of Daniel B. Capobianco
Premium Financing (Exit Strategy)

The loan is repaid and the collateral assignment
is released
 Loan can be repaid on death of the insured out of
the death benefits payable
 Loan can be repaid during life from the CSV of
the policy
 Loan can be repaid from collateralized assets
(may be serious gift tax implications)
 Combination of the above
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Components of the Solution

Large cases will not fit neatly into any one
strategy and accordingly two or more
strategies are often integrated together to
achieve the overall goal
 As the prospective client goes through the
planning process, the value of life
insurance becomes obvious and the
“cost” of such insurance is viewed as an
investment in the family legacy
13
© Law Offices of Daniel B. Capobianco
Dynasty Trust


It is an irrevocable trust – e.g., an ILIT
It is designed to span more than one
generation
– Does not terminate until the maximum period
allowed under the law (e.g., 90 years or more in
Massachusetts)
– Value of trust assets not included in the
estates of children or grandchildren

Takes maximum advantage of the
$3,500,000 GSTT exemption
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© Law Offices of Daniel B. Capobianco
Dynasty Trust

Appreciation of assets will be estate tax
free
 Provides a layer of asset protection from
the beneficiaries’ creditors
 Assets appreciate outside of the transfer
tax system
 Can be the remainder beneficiary of a
GRAT
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Family Limited Partnership (FLP)



Limited Partnership with family members as limited
partners and senior members are the general
partners
Securities and real estate are typical assets of the
FLP
Donor makes gifts of limited partnership interests to
next generation
• Annual exclusion gifts
• Lifetime exemption ($1,000,000)
• Gift FLP interests to trusts rather than to children
outright
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FLP Basics
– Valuation discounts are often taken:
• Lack of marketability
• Lack of management control (minority interest)
– Retention of general partnership interest
allows senior generation to retain control
while transferring future appreciation out
of taxable estate.
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Intentionally Defective Grantor Trust
It is an irrevocable trust – e.g., an ILIT
 Contains specific language intended to
“violate” income tax rules, yet NOT violate
the estate tax rules



– Grantor is taxed on the income of the trust
– Value of trust assets is not included in grantor’s
estate
This is both a “freezing” technique
And an “asset burn” technique
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Intentionally Defective Grantor Trust
Grantor cannot be a beneficiary or
trustee
 Spouse & children are beneficiaries
 Requires careful drafting

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Intentionally Defective Grantor Trust

Sale to trust
– Business owner receives cash and installment note for
balance of the selling price
– No capital gain on sale



Interest received on note is not taxable
Installment obligation is paid through income
received by trust
Installment Note
– Self-amortizing
– Demand note
– Interest-only balloon note
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© Law Offices of Daniel B. Capobianco
Grantor Retained Annuity Trust

A GRAT is a split interest trust in which a
grantor retains the lead annuity interest,
while transferring the remainder interest
to non-charitable beneficiaries (e.g.,
children)
 A GRAT is used to transfer substantial
assets out of the estate at zero gift tax
cost and without using any applicable
exclusion amount
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© Law Offices of Daniel B. Capobianco
Grantor Retained Annuity Trust

Whenever the total return on the trust
assets exceeds the applicable IRC §7520
rate, property will pass tax free to the
remainder beneficiaries
 AFR as of June 2009 is 2.8%
 An effective way to GSTT-proof a dynasty
trust without incurring additional gift tax
($3,500,000 GST exemption, but only a
$1,000,000 lifetime gift exemption)
 GST allocation made at GRAT termination
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GRAT Basics

The amount of the taxable gift is the value
of the property transferred to the trust
minus the present value of the retained
annuity interest.
 By setting the present value of the annuity
stream equal to the full value of the
property initially transferred to the GRAT,
the amount of the taxable gift is reduced
to zero (a “zeroed-out” GRAT)
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© Law Offices of Daniel B. Capobianco
GRAT Basics



At the end of the GRAT term, any property
remaining in the trust will pass to the remainder
beneficiaries with no further tax consequences
If the total return the trust assets actually
produce is equal to or less than the rate assumed
by the IRS (IRC §7520 rate) there will be nothing
left in the trust to pass to the remainder
beneficiaries at the end of the GRAT term
If the actual total return substantially exceeds the
IRC §7520 rate, however, very large amounts of
property will be in the trust to pass to the
remainder beneficiaries tax free
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© Law Offices of Daniel B. Capobianco
GRAT Basics

Calculation of the annuity & gift
– Term of the GRAT
– AFR for the month of GRAT formation
– FMV of asset transferred into the GRAT

Where the FMV of the asset can be
legitimately discounted (e.g., FLP interest
or closely held stock) the tax efficiency of
the GRAT is substantially magnified
25
© Law Offices of Daniel B. Capobianco
GRAT Basics

The grantor is responsible for the income
tax on the GRAT’s taxable income
 The grantor may be reimbursed by the
GRAT for any income tax paid on income
in excess of the annuity amount
 If the grantor is not reimbursed by the
GRAT, then the taxes paid by the grantor
are in effect an additional non-taxable
“gift” to the remainder beneficiaries
26
© Law Offices of Daniel B. Capobianco
GRAT Basics

In the event earnings of the GRAT are not
enough to satisfy the required annuity amount,
the GRAT could also distribute GRAT property
back to the grantor with no income tax effect
 Although earnings are more desirable, the
distribution of GRAT assets continues to freeze
growth at the IRC §7520 rate for the property
remaining within the GRAT.
 If GRAT property is paid out in-kind, the grantor
could “Re-GRAT” the in-kind distribution to a
new GRAT
27
© Law Offices of Daniel B. Capobianco
GRAT Example
$3,000,000 FMV asset transferred to GRAT.
AFR is 2.8%. Term = 10 years.
Annual annuity = $348,112
1
2
3
4
5
6
7
8
9
10
Beginning
Balance
$
3,000,000
$
2,741,888
$
2,476,033
$
2,202,202
$
1,920,156
$
1,629,648
$
1,330,426
$
1,022,227
$
704,781
$
377,813
Growth @
3%
$ 90,000
$ 82,257
$ 74,281
$ 66,066
$ 57,605
$ 48,889
$ 39,913
$ 30,667
$ 21,143
$ 11,334
© Law Offices of Daniel B. Capobianco
Payment
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
Ending
Balance
$ 2,741,888
$ 2,476,033
$ 2,202,202
$ 1,920,156
$ 1,629,648
$ 1,330,426
$ 1,022,227
$ 704,781
$ 377,813
$
41,035
28
GRAT Example
What if rate of return were 6%
1
2
3
4
5
6
7
8
9
10
Beginning
Balance
$ 3,000,000
$ 2,831,888
$ 2,653,689
$ 2,464,799
$ 2,264,575
$ 2,052,337
$ 1,827,365
$ 1,588,895
$ 1,336,117
$ 1,068,172
Growth @
6%
$ 180,000
$ 169,913
$ 159,221
$ 147,888
$ 135,874
$ 123,140
$ 109,642
$ 95,334
$ 80,167
$ 64,090
Payment
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
$ (348,112)
Ending
Balance
$ 2,831,888
$ 2,653,689
$ 2,464,799
$ 2,264,575
$ 2,052,337
$ 1,827,365
$ 1,588,895
$ 1,336,117
$ 1,068,172
$ 784,150
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© Law Offices of Daniel B. Capobianco
GRAT Example
1
2
3
4
5
6
7
8
9
10
If the asset could be discounted 33% -- even if there were little
or no rate of return
Beginning
Growth @
Ending
Balance
3%
Payment
Balance
$ 3,000,000 $ 90,000 $ (232,075) $ 2,857,925
$ 2,857,925 $ 85,738 $ (232,075) $ 2,711,588
$ 2,711,588 $ 81,348 $ (232,075) $ 2,560,860
$ 2,560,860 $ 76,826 $ (232,075) $ 2,405,611
$ 2,405,611 $ 72,168 $ (232,075) $ 2,245,705
$ 2,245,705 $ 67,371 $ (232,075) $ 2,081,001
$ 2,081,001 $ 62,430 $ (232,075) $ 1,911,356
$ 1,911,356 $ 57,341 $ (232,075) $ 1,736,621
$ 1,736,621 $ 52,099 $ (232,075) $ 1,556,645
$ 1,556,645 $ 46,699 $ (232,075) $ 1,371,269
© Law Offices of Daniel B. Capobianco
30
GRAT Example
What if rate of return were 6%
1
2
3
4
5
6
7
8
9
10
Beginning
Balance
$ 3,000,000
$ 2,947,925
$ 2,892,726
$ 2,834,214
$ 2,772,192
$ 2,706,448
$ 2,636,760
$ 2,562,891
$ 2,484,589
$ 2,401,590
Growth @
6%
$ 180,000
$ 176,876
$ 173,564
$ 170,053
$ 166,332
$ 162,387
$ 158,206
$ 153,773
$ 149,075
$ 144,095
© Law Offices of Daniel B. Capobianco
Payment
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
$ (232,075)
Ending
Balance
$ 2,947,925
$ 2,892,726
$ 2,834,214
$ 2,772,192
$ 2,706,448
$ 2,636,760
$ 2,562,891
$ 2,484,589
$ 2,401,590
$ 2,313,610
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GRAT – Split Dollar Combo


ILIT
Premiums are financed
–
–
–
–



Traditional split dollar (paid by company)
Private (paid by the insured)
Third Party Financing (financial institution)
both split dollar & §7872 regulations apply
Create a GRAT
GRAT rolls out into ILIT at termination
Proceeds from GRAT used to pay off split
dollar loan
32
© Law Offices of Daniel B. Capobianco
Example





Age 55 -- $2,000,000 whole life; premium
$100,000 for 10 years. Estate is taxable.
Insured has used up his $1 million gift tax
exemption. How do we pay the premium?
Insured contributes $100,000 per year to ILIT
Annual contribution treated as split dollar loan
Insured Forms FLP with $3 million of assets.
Discounted value is $2 million
33
Example

No growth expected - but 3% earned each
year
 Contribute FLP to a 10 year “Zero-GRAT”
 GRAT calculations are based on the discounted
value
 After 10 year term, $1.3 million is transferred to
ILIT (allocate $1.3 million GST exemption at this time)
– Free of gift taxes

Money is then used to repay the split dollar loan
plus interest (almost $1.23 million)
34
Integrated Estate Plan
with Multiple Tax Strategies
Sam Smith FLP
Holds stock, real estate, etc.
Sam Smith GRAT
Life Insurance Trust
(on termination flows to ILIT if
Sam alive / to RLT if Sam dies)
Insert additional special
provisions for IDGT to
permit ownership of
additional assets (initially
funded with $1,000,000)
SCIN and /or interestonly Promissory Note
BY SALE AND/OR GIFT
directly to the ILIT or re-route
through GRAT
Sam Smith
Revocable Trust
QTIP Trust (for Cynthia)
Minimum amount required
to reduce estate to $0
Family Trust
$2,500,000
($3,500,000 less $1,000,000 gifted to ILIT)
Family Dynasty Trust
Mary, Mike and Lisa & their
children/descendants
Trust will be divided into 3 unique trusts
for each child
Each child can be a Co-Trustee
© Law Offices of Daniel B. Capobianco
35
GRAT to Transfer S Corp. and/or FLP
Gift stock to GRAT for specified
term of years (5, 10, 15).
Beneficiary is an Irrevocable
Trust f/b/o Wife, children &
descendants
Sam Smith makes gift of
FLP interests and/or S
Corp. stock (at a discount)
Sam Smith FLP and/or S
Corporation
Cash distributions
based on ownership
transferred
Any “excess” tax incurred by Sam Smith can be
reimbursed by GRAT
Cash received from
GRAT is used to “loan”
money to ILIT
© Law Offices of Daniel B. Capobianco
GRAT pays annuity to Sam
Smith based upon existing
IRS interest rate.
Cash to make payment is
received from Sam Smith
Companies
ILIT – IDGT – Dynasty
for benefit of Wife,
children & descendants of
Sam Smith
At termination of GRAT, cash,
stock and/or FLP interest is
distributed to Trust with no
further gift tax costs
pay
insurance
premiums
36
Sale to Defective Grantor Trust
Sale of Doe Sales Co common stock for
20-year term promissory note. Interest
payable at AFR of 3.88%
Sam Smith gift/sale of
common stock
Interest paid annually to cover tax payments
Principal payable on demand (as needed)
Sam Smith Companies
Distributions
of cash
Gift of $100,000 to Irrevocable
Trust for children/grandchildren.
File gift tax return to allocate GST
Sam Smith Family
“Defective” Dynasty Trust
for benefit of children &
descendants of Sam Smith
Based on the value of the stock sold ($2,000,000), and the monthly AFR (3.88% in June 2009), the annual interest
payment will be $77,600, which will be sufficient to pay income taxes on DSC earnings. This interest is not taxable to
Sam Smith and not deductible by the trust since the trust is a “grantor trust.” Alternatives are a private annuity for life
($115,652 per year) or a SCIN over 20 years ($146,805 per year) or an interest-only SCIN ($86,991 per year).
Sam Smith’s income tax liability is the same before and after the transaction.
Trust can pay down promissory note “on demand” for additional cash flow to Sam Smith.
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