4 Ways to Pay Premiums Using A Client’s Own Assets

Many high net worth clients need liquidity for which life insurance is the solution. However, when it comes to paying the premium, cash is required.  Often, clients, regardless of wealth, have a hard time giving away large amounts of cash, especially when they consider that they will not see it again.

However, even if cash is available and the client has no problem using it to pay premiums, the next challenge is to avoid gift taxes when doing so. Although the gift tax exemption has increased to $11.18M per person ($22.4M per couple) under 2017 tax reform, this increase is only available for the next 7 years, after which the exemption amounts fall back to approximately $5.6M per individual ($12M per couple)—unless, of course, legislation changes to lower the exemption amounts, or even to eliminate estate and gift taxes all together.

Now consider the client who doesn’t have cash.

What to do?  Wealthier clients today need flexibility to account for all this uncertainty, to grapple with their own philosophy about the best time to transfer their wealth, and to use assets other than cash to pay premiums.

To put this in context, there are 4 common ways to fund large life insurance premiums—2 of which are straight gifts of cash or an income-producing asset, and 2 of which leverage the client’s own assets by renting them out instead of giving them away–offering tremendous flexibility.

4 Common Ways to Fund Life Insurance for Wealthy Families

  1. Making a completed Gift of Cash to an Irrevocable Life Insurance Trust (ILIT)

  1. Making a complete Gift of an Income-Producing asset to a Defective Grantor ILIT

  1. Renting-Out the Cash via an Intra-family Loan to a Defective Grantor ILIT

  1. Selling the Asset via an Installment Note Sale to a Defective ILIT

Renting- Out the Cash Via an Intra-Family Loan

When the client has cash but does not want to give it away, it is possible to structure a fair market loan arrangement between Mom/Dad and the ILIT. The loan must be a bona fide loan and use a fair market rate of interest, typically the applicable Federal Rate (AFR) as published by the government monthly for the month in which the loan is established.

The cash loan can be in the form of annual premium payments, or as a lump sum loan from which annual premium payments will be made by the trustee.  The loan interest will be paid throughout the year, or can be accrued. Principal can be paid at the end of the note term. Typically the loan is a lump sum created as a sinking fund so that the principal payment will be available at the end of the note term.  When an annual premium loan is made, it is not uncommon to have the ILIT be a beneficiary of another family trust that pours into the ILIT and provides the fund to repay the note. Types of trusts used for these types of exit strategies are Grantor Retained Annuity Trusts (GRATs) and Charitable Lead Trusts (CLT).

In many circumstances when it is determined that little or no cash gifts will be made to the trust, income producing assets, such as:

  • a closely-held business,
  • commercial rental properties, or
  • municipal bonds,

can be made as a direct gift or as a sale to the next generation during lifetime.  The income spinning off of these assets is then used inside the trust for planning purposes, while the principal remains intact. In the case of an intra-family loan or installment note sale as in #3 and #4 above, repayment of the value of the note will be made to Mom/Dad at the end of the note term. The principal returned can be like-kind.

Selling The Asset Instead of Giving It Away

For clients with businesses or portfolios of stock, who are waiting to see what happens with tax law, the sustained low interest rate environment, along with these loan strategies can help provide them flexibility. However, the window of opportunity is closing as interest rates are starting to climb. Therefore, to use low interest rates in combination with some of these premium paying strategies, the urgency to plan is greater now than it has been over the past ten years.

That is, clients can rent cash or sell an income-producing asset (as in #3 and #4 above) to a trust at a low interest rate currently, instead of giving it away. In this way, they buy time to decide what they want to do regarding the ultimate repayment of the loan. They can decide later whether to:

  1. Accept the loan repayment
  2. Refinance the loan to buy more time
  3. Forgive the note in the form of a gift– either using the increase in the gift tax exemption or because estate and gift taxes have been repealed.

The loan strategy allows the family to take advantage of favorable planning conditions while buying time to decide if, and when, they should complete the transfer.

Transferring the Closely-Held Business Using an Installment Note Sale

If the asset is a closely-held business, an installment note sale of the business to a grantor trust is a commonly used technique to transfer the asset– especially highly appreciating assets– to family members working in the business. Unlike third party sales transactions, when the asset is transferred to a properly drafted grantor trust:

  • the sale escapes taxation on the gain,
  • the appreciation remains outside the taxable estate,
  • Mom/Dad are responsible for the trust’s income taxes–presumably subject to a lower rate than that of the trust—leaving more income in the trust to do planning,
  • the generation-skipping transfer tax (GST) exemption amount can be allocated at the time of the sale, exempting all future appreciation from the GST tax. The GST is a tax on transfers to trust beneficiaries, that skip a generation, such as grandchildren.

Types of Assets Suitable for an Installment Note Sale

Many types of assets, including portfolio of securities and business interests, can be sold utilizing an installment note sale.  Assets that may be sold at a discounted value in a note sale, due to lack of marketability and/or minority interests, include:

  • limited partnership interests,
  • non-voting LLC member interests, and
  • closely-held non-voting S-Corporation stock

The way it works is that Mom/Dad sell all or a portion of the business asset to the grantor trust, the beneficiary of which is the family member working in the business (or who is to inherit the portfolio of securities). The income from the business is now inside the trust and is used to fund a life insurance policy on Mom/Dad. The growth of the business is outside the taxable estate, effectively freezing the business value in the estate of Mom/Dad. During the note term, Mom/Dad continue to run the business.

The installment note is a bona fide sale of the business interest. It is not a gift. The installment note is often established as interest-only for the term of the note, with a balloon payment of the principal at the end of the term.  The principal can be paid from the life insurance proceeds, or using like-kind assets from the trust’s portfolio, including the actual business that was sold.

Typically, a “seed” gift is made to the trust in advance of the installment note sale to ensure that the trust’s ratio of debt to assets is not ‘too’ high and that the note is considered bona fide debt. Since there is little guidance from the IRS as to what ratio constitutes a bona fide loan arrangement, especially in the context of family transactions, a seed gift is typically recommended to give the trust economic substance.