Tier One: Loan-Based Private Split Dollar
Private split dollar is an innovative estate planning technique which can remove the growth of money in an estate and leave that growth to heirs. Structured properly using a loan,
private split dollar can preserve access to the removed capital should there be a need for future liquidity. Peter T. Dziedzic, Jr., General Counsel & COO of Life Insurance Strategies Group, regularly helps wealthy clients take advantage of well-established split dollar funding techniques for flexibility in estate planning. “The ability for a client to loan an irrevocable trust funds where the funds grow outside of the client’s estate is attractive. Plus, a split dollar loan provides access to liquidity through loan repayments and helps them overcome the hesitation to making such a large loan.”
Here are the mechanics: An individual establishes an irrevocable life insurance trust, beneficiaries of which are his or her children, and the trust applies for a life insurance policy with the individual as the insured. Rather than the trust paying the premiums directly via gifts from the client, pursuant to a written and well-documented split dollar agreement, the client, who is the grantor to the trust, pays the premiums directly and such payments are treated as loans to the trust. The policy is the security for the loan repayment, typically through a collateral assignment, and the loan can be repaid upon death, or an earlier stated term.
Under the agreement, at the death of the insured, the trust will ‘split’ the death benefit proceeds and use some of the proceeds to repay the loan balance to the estate. That amount is subject to any applicable estate tax above any exemption amount then available. During the lifetime of the client, he or she can preserve access to some liquidity in the form of loan interest and/or principal payments being made from the trust, which the trustee can support through income tax-free withdrawals and loans from the policy. Traditionally, private split dollar loans are set up to accrue interest at market rates and typically the long-term Applicable Federal Rate (AFR) in effect the month the loan is made is applied to each premium advance. However, if the client has a need for greater access to income, a higher interest rate may be charged.
Dziedzic says planners should note that the interest rate charged to the trust cannot be of such a high rate that it is determined to noticeably impair the value of the assets in the trust. “For example, if trust assets are growing at 4% and the loan rate charged by the client under the split dollar agreement is 10%, that loan rate is likely impairing the ability of the trust to carry out its ultimate duties to the beneficiaries.”
If the client does not have a need for liquidity from the trust, loan interest paid to the client may be paid by the client making gifts to the trust under either the federal estate tax exemption amount or the annual gift tax exclusion amount ($15,000 per donor per beneficiary for 2020; gifts must be of a present interest which can be done through traditional “Crummey” provisions), or by having the loan interest accrued and the cumulative balance being included in, and repayable to, the estate of the grantor upon death. Upon maturity of the original stated term, any accrued loan balance can be renewed for a new term under a new agreement.
If the client is treated as the owner of the trust for income tax purposes, the payment of interest is disregarded and income tax free (IRC §§ 671-678, Rev. Rul. 85-13). Note, any interest amount specifically paid or accrued in the year of the client/grantor’s death would be taxable income to the estate due to the termination of grantor trust status. The Original Issue Discount (OID) rules treat any interest accrued prior to the year of death as imputed in those years during which grantor trust status was active and, thus, income tax free to the grantor (IRC §§ 1271-1275, Rev. Rul. 85-13). End result, whether the loan principal and interest is repaid during life or at death, all or a significant portion of the interest can be received income tax free due to grantor trust status if the policy is the source of the payments.
Private split dollar arrangements between a grantor and an ILIT are subject to the Split Dollar Loan Regulations (Treas. Reg. § 1.7872-15). The IRS has ruled in non-legally binding Private Letter Rulings 9636033, 9745019 and 200822003 that there was no deemed gift by the loan and that the insurance proceeds would not be included in the insured’s gross estate under IRC §2042 by participating in the split dollar arrangement.
Dziedzic makes sure his clients make full use of the benefits of loan-based private split dollar. “Clients can exclude large amounts of money from an estate, minimize gift taxes and have the flexibility to access cash removed from his or her estate.”
Below is a diagram of how the strategy can work:
Read our companion Tier One Interview with Jerry Hester by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.