Take-Away: As we learn more about the prospect of certain tax law changes, such as the dramatic curtailment of annual exclusion gifts and its inevitable impact on irrevocable life insurance trusts (ILITs), third-party premium financing arrangements through loans may become a more efficient way to maintain life insurance policies held in ILITs, providing liquidity to pay larger estate taxes, while avoiding any carry-over basis on death changes.

Background: Historically, funding of life insurance premiums held in an irrevocable life insurance trust (ILIT) has been through the use of annual exclusion gifts ($15,000 per donee/beneficiary) and Crummey withdrawal notices. As has been previously covered, there are a couple of bills in Congress that would cut back on the use of annual exclusion gifts, such as limiting the annual exclusion gift opportunity to two per year, and the amount of each annual exclusion gift limited to $10,000, which would impact ILITs where the annual exclusion gift opportunity is frequently used to pay the ILIT’s annual life insurance premium obligation. [Note, though that if the annual exclusion gift rules are changed, that would obviate the need to provide Crummey withdrawal notices.]  In addition, those same pending tax bills would cause a carry-over basis to assets that are inherited at death, but seemingly they would exclude any death benefit that is paid by a life insurance company from the proposed carry-over basis rule, thus making life insurance a more attractive asset to use to transmit an inheritance tax-free. As a result, while there might be more interest in establishing life insurance trusts to transmit an inheritance, the challenge will be how to fund the premium for such life insurance held in an irrevocable trust.

Loans as Opposed to Gifts: Structuring each premium payment as a loan and not a gift will avoid using the donor’s lifetime applicable exemption amount. Or, if the donor has already used his or her applicable exemption amount, then a loan may be the only option to funding the life insurance policy held in the ILIT. A loan financing arrangement may also be valuable when planning for the generation skipping transfer tax, if the GSTT applicable exemption amount has already been exhausted by the donor.

Premium Financing: An alternative to gifting funds to an ILIT is to use an arrangement known as premium financing. It is an arrangement in which the insured borrows money from a lender, like a bank, and uses the borrowed funds to pay the insurance premiums, typically pledging the policy as security together with a personal guarantee. Alternatively, the ILIT trustee  could borrow the money directly from the lender, with the insured, or perhaps the trust beneficiaries, guaranteeing the loan. While the insured, or another interested party loans funds to the ILIT to pay the premiums, the IRS will often seek to recast the transaction as a taxable gift. However, there is a safe harbor to that risk by using a split-dollar loan under the Final Regulations. There are two broad options for such a loan: a traditional loan and a split-dollar loan.

‘Traditional’ Loan: As has been covered in the past, a direct or ‘traditional loan’ requires that certain factors must exist before the Tax Court will not find a gift: (i) a written promissory note; (ii) a demand for prepayment if a default in the loan occurs; (iii) required payments were actually made on the loan; (iv) the transaction was reported for tax purposes as consistent with a loan; (v) the note has a fixed maturity; (vi) the borrower has a reasonable ability to repay the loan; (vii) the books and records of both the lender and the borrower reflect the transfers as loans; (viii) interest is charged on the loans; and (ix) reasonable security or collateral is provided for the promissory note. Miller v. Commissioner, Tax Court Memo 1996-3 (1996).

Split-Dollar Loans: A split-dollar life insurance arrangement is not a type of life insurance policy. Rather, it is a way in which the proceeds paid on the death of the insured are divided, or split. In some situations, the premium paid on the life insurance policy is divided, or split. Back in 2003 the IRS issued Final Regulations that deal with split-dollar loans with regard to life insurance funding arrangements. [68 Fed. Reg. 54,336, September 17, 2003.]The Regulations identified two detailed, but mutually exclusive, taxing regimes: (i) the economic benefit  (traditional) split-dollar arrangement; and (ii) split-dollar loan regime, which is governed by the principles of IRC 7872 (i.e. intra-family loans and below market loans that can result in implied gifts.) If a lender follows ‘to the letter’ one of these two specified financing regimes, the lender can expect to obtain the tax treatment as described in the Final Regulations.

Economic Benefit Regime: Under the economic benefit regime, the lender gets back, when the insured dies, either (i) the greater of the policy premiums the lender has paid, or (ii) the policy’s cash surrender value at that time of death. In each year the lender will be deemed to have made a gift of the one year cost of the term insurance component associated with the premium obligation that would be paid if the insured had died that year; the amount of the gift made by the lender equal to the IRS Table 2001 rate, or no gift will be deemed made if the ILIT is required to and does reimburse the lender that amount each year.

Split-Dollar Loan Regime: Under the split-dollar loan regime, the lender makes a loan that will be governed by IRC 7872 (which deals with below market loans.) In general, and consistent with IRC 7872, the lender will be treated as making a gift to the extent that the interest provided for under the loan is less than the applicable federal rate (AFR) when the loan is made. Accordingly, by way of example, if the ILIT trustee must pay, or accrue, at least AFR interest [IRC 1274(d)], then no gift will be imputed to the lender, even if it is a term loan. However, the lender will have gross income each year equal to the AFR whether the interest is paid for forgone. Note, though that if the ILIT is the borrower under a split-dollar loan and the ILIT is a grantor trust with respect to the lender, there should be no gross income that has to be recognized and reported by the lender, but this might soon change if either the STEP Act or the For the 99.2% Act become the law which dramatically change the grantor trust rules. [IRC 7872(a).] As long as the borrower is a disregarded entity, e.g. a grantor trust, the accrued interest on the loan will not be included in the gross income of the lender. [Revenue Ruling 85-13.] In short, an existing ILIT that is a grantor trust could be the borrower in a split-dollar loan arrangement without income tax or estate inclusion repercussions. The definition of split-dollar loan merely requires that the loan be secured by the policy’s death benefit or cash value, but not both. [Regulation 1.7872-15(a)(2)(i)(C.)]

Repay the Loan on the Insured’s Death: Under the split-dollar loan regime, the loan need not be made repayable at the end of any particular period of time, but only when the insured, whose life is insured under the policy, dies and the policy proceeds can then be used to repay the loan. This is expressly authorized in Regulation 1.7872-15(e)(5)(i). Unless the insured is really old, the long-term AFR rate will apply if the loan is to be repaid when the insured dies. But that then means that each time a loan is made to an ILIT and used by the trustee to pay the annual life insurance premium, a new loan is made along with a new AFR that goes with that ‘new’ loan.

AFR Used: A split-dollar loan is tested once, on the day that the loan is made, for purposes of determining if a below-market interest rate is used.  [Regulation 1.7872-15(e)(4)(ii).] If the loan interest rate does not equal the AFR, it is considered a below-market demand loan where the ‘foregone interest’ is deemed to be first transferred from the lender to the ILIT as a gift, and then transferred from the ILIT back to the lender as taxable interest income. [Regulation 1.7872-15(e)(3)(iii)(A).]

Loan Repayments: Under the Final Regulations the ILIT trustee cannot decide how to characterize payments made by the ILIT to the lender; accordingly, the ILIT trustee cannot ‘pick and choose’ which loans to repay first. The payments made by the ILIT trustee to the lender are automatically applied in the following order: (i) to accrued but unpaid interest on all outstanding split-dollar loans in the order the interest is accrued; (ii) to principal on outstanding split-dollar loans in the order that the loans were made; (iii) repayments of any amounts previously paid by the donor-lender under the split-dollar agreement that were not considered loans; and (iv) any other payments made by the donor-lender with respect to the split-dollar arrangement. [Regulation 1.7872-15(k).]

Lender-Insured Concerns: An insured uses an ILIT to keep the death benefit from being included in the insured’s taxable estate. In order to accomplish that objective, the insured cannot retain any ‘incidents of ownership’ in the insurance policy. [IRC 2042(2). Instead, the ILIT will retain all ‘incidents of ownership’ in the life insurance policy. If the insured is also the lender of the funds to the ILIT which are used to pay the policy premiums, the split-dollar loan will need to be carefully drafted to avoid any ‘incidents of ownership’ in the insurance policy held by the insured.

  • Incidents of Ownership: The split-dollar agreement must not give the insured the ability to change the beneficiary, to assign the policy, to revoke an assignment, to pledge the policy as collateral for a loan, to surrender or cancel the policy, or to borrow against the policy’s cash surrender value. [Regulation 20.2042-1(c).] Otherwise the death benefit will be included in the insured-lender’s taxable estate.
  • Collateral Assignments: The collateral assignment of the policy as security must be used to repay or secure the loan from either the death benefit or the cash surrender value, but the collateral assignment that secures the policy cannot grant any incidents of ownership to the lender when the lender is also the insured. Consequently, a restricted collateral assignment agreement is normally used that merely secures the lender’s right to be repaid, without granting the lender any direct or indirect incidents of ownership in the policy. Note that most form collateral assignment agreements are insufficient to avoid estate inclusion exposure to the insured-lender under IRC 2042, so a custom drafted collateral assignment will have to be prepared.
  • Interest Payments: The ILIT trustee should make interest payments to the lender-insured from funds that are separate from those gifted or lent by the lender-insured.
  • Accrued Interest: The documents for the split-dollar loan arrangement should require that any accrued but unpaid interest be accounted for and capitalized.
  • Avoid Nonrecourse Loans: A recourse loan is one where the lender can be made whole from the borrower’s assets if the identified collateral is insufficient to repay the loan. With a nonrecourse loan the borrower is generally limited to the stated collateral to recoup the loaned funds. This becomes a critical issue when the split-dollar loan is structured and documented because the Regulations treat non-recourse split-dollar loans as contingent payments, which means that they will be disregarded when the below-market ‘testing’ is done, and not accounted for until actually paid. Accordingly, an otherwise properly structured private loan regime split-dollar arrangement may be considered below-market, even if sufficient interest accrues under the loan, merely because the loans are considered nonrecourse. An easy way around the problem is for the parties to make a written representation with regard to their reasonable expectation that the loan will be repaid, which representation is then filed with their income tax returns. [Regulation 1.7872-15(d)(1)(2).]

Conclusion:  With the threat of tax law changes on the horizon, cutting estate tax exemption amounts, increasing estate tax rates, curtailing annual exclusion gifts, and eliminating a basis step-up on all assets other than life insurance proceeds, ILITs may become far more popular in a post-tax reform world. Private loans used to finance the insurance premiums may become much more important as a way to manage taxable gifts and add flexibility to an individual’s estate plan.