Premium Financing Can Help Affluent Clients Get Life Insurance Tax Efficiently

When affluent families consider acquiring life insurance, there may be a concern about having to liquidate profitable assets in order to meet their premium payment obligations for the larger policy they require. And that’s not the only issue – it’s vital that the policy be arranged so gift taxes are not levied on the premium payments, and estate taxes not levied on the death benefit proceeds.

One way to address these issues is to structure the arrangement using an irrevocable life insurance trust (ILIT) and a premium financing program.

The ILIT owns the policy and borrows money from a third-party lender in order to make premium payments. By borrowing money to pay the premiums, the insured/grantor avoids making gifts to the trust – thereby avoiding the federal gift tax (or using up their estate tax exemption). They also can avoid the need to liquidate highly profitable assets, and possibly incurring capital gains taxes, in order to meet the premium obligations. Since the policy is owned by the ILIT from the outset, the death benefit proceeds will not be included in the grantor’s estate for estate tax purposes.

But like other transactions that involve financial leverage, premium financing adds a level of risk and complexity. Implementing a premium financing strategy is not appropriate for all clients and requires attention to details and an understanding of ways to mitigate the added risks.

The design aspects that financial professionals and their clients, along with the client’s tax advisor and/or attorney, should consider include:

• Combining premium financing with annual gifts: The grantor of the trust may contribute gifts to the trust in order to keep the loan balance as low as possible. Each grantor may gift $15,000 (2020 annual gift tax exclusion) to each beneficiary without being subject to the federal gift tax. For example, in a trust with two grantors and three beneficiaries, the grantors may gift $90,000 per year gift tax free.
• Interest rates: Typically, commercial lenders will charge interest based on LIBOR (London InterBank Offered Rate, a benchmark rate for short-term loans) plus a spread. We are currently experiencing a period of historically low interest rates, making premium financing a very appealing option. Keep in mind, most bank loans supporting the purchase of life insurance policies must be renewed. Failure to provide adequate documentation or collateral could jeopardize the loan renewal. It is important to work with experienced premium financing vendors who are familiar with bank renewal procedures; have a process for helping to ensure loan renewals; and can work with multiple banks in the event that one lender decides not to renew the loan.
• Locking in low interest rates: If a single loan is made, the interest rate charged may be locked in for the duration of the loan. However, if loans are made to the trust each year as premiums come due, the interest rate the trust is charged fluctuates from year to year. One option is to consider a policy that offers a premium deposit fund rider allowing the trust to borrow a lump sum, deposit it into the policy to pay the annual premiums for a specified number of years, and help prevent triggering modified endowment contract taxation. This type of rider may be offered within a policy at an additional cost. Clients should consult a tax advisor if considering this type of premium funding.
• Accruing or paying interest: The lender may offer a number of options with regards to interest payments. They may allow the interest to accrue or they may require the trust to make interest payments. Accruing interest may look appealing from a cash flow standpoint, but may place a strain on the life insurance policy if cash values are to be used to repay the loan. Clients should be shown both options.
• Collateral requirements: Lenders will typically require collateral equal to the loan balance. Most lenders will look to the cash values in the policy as collateral and require additional collateral if the cash values are not sufficient. It is important to understand what assets the lender will accept before entering into the financing agreement. Certain assets may only be accepted if the borrower obtains a letter of credit (at their cost) from an approved bank. The more liquid an asset is, the more likely it is the lender will accept it as collateral. This is one more reason to consider options for keeping the loan balance low and using reasonable policy assumptions.
• Call options: Many third-party loan agreements grant the lender the option of calling the loan under certain circumstances. It is important to understand what these circumstances are, especially when the loan proceeds are funding a life insurance contract. Any unexpected distributions from the policy may put the death benefit in jeopardy.
• Prepayment Penalties: Some third-party loan agreements contain prepayment penalties. It is important to understand what these penalties are to avoid an accidental triggering of substantial fees.
• Policy performance: The actual policy crediting rate experienced will likely be higher or lower than initially assumed in the policy illustration. To mitigate the potential impact of lower-than-expected performance, use realistic assumptions, stress tests and diversification strategies; well-designed policies that are designed to be more resilient to poor policy performance; and annual policy maintenance reviews to keep the policy on track.
• Designing an appropriate “exit strategy”: When and how will the loan be paid off? There are a number of exit strategies that may be implemented. The loan may be paid off with death benefit proceeds from the life insurance policy, or the loan may be paid off during the life of the grantor(s). If the amount of the loan to the trust exceeds what is needed to pay annual premiums, the investment growth on any excess may be used to make loan and interest payments when due. Two common exit strategies are Grantor Retained Annuity Trusts and Charitable Lead Trusts. Both GRATs and CLATs may be designed to transfer substantial wealth to an ILIT without triggering gift taxes or needing to use up a client’s estate tax exemption. Those dollars may then be used by the ILIT to repay the loan.

Finally, while it is important to mitigate risks, don’t forget to plan for a successful outcome. If all the premiums have been paid, the loan is repaid, and the policy is performing as expected, what then?

With constant changes in the tax laws, changes in family dynamics, and changes in family goals, clients should work with their tax and legal advisors from the beginning to incorporate flexibility into their plans. An ILIT may be designed to provide all the desired benefits (estate tax exclusion, creditor protection, professional administration of trust assets, etc.) while allowing the grantor to retain a level of flexibility – such as limited access to trust income, use and enjoyment of trust property, the right to swap personally owned assets with trust assets, and the power to change trust beneficiaries.

Premium financing may be a powerful option for affluent clients looking to protect and transfer wealth. A key is to design the program properly, consider the potential risks and how to mitigate them, and have a long-term plan for success. The Life Case Design Team at Allianz can answer any premium financing question you have, and can be contacted at 800-950-7372. You can also access premium finance materials at allianzlife.com/lifesalestools.

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Life insurance requires health and financial underwriting.

A premium finance strategy is not suitable for all clients, and subject to meeting affordability guidelines and other qualifications. As with any borrowing strategy, there are risks associated with life insurance premium financing that must be explained to the client. In all cases, clients should consult with their tax advisor and attorney before entering into this or any other arrangement involving tax, legal, and economic considerations.

This content is for general educational purposes only. It is not intended to provide fiduciary, tax, or legal advice and cannot be used to avoid tax penalties; nor is it intended to market, promote, or recommend any tax plan or arrangement. Allianz Life Insurance Company of North America, its affiliates, and their employees and representatives do not give legal or tax advice. Customers are encouraged to consult with their own legal, tax, and financial professionals for specific advice or product recommendations.

Life insurance policies are issued by Allianz Life Insurance Company of North America.

Product and feature availability may vary by state and broker/dealer.

Life insurance guarantees are backed solely by the financial strength and claims-paying ability of the issuing insurance company.