How to Take Advantage of the Estate and Gift Tax Benefits of Premium Financing

​The estate and gift tax benefits of premium financing are the most attractive components of this life insurance strategy. There are several ​methods within premium financing you might employ to avoid these taxes. Which ones you pick will depend on your financial situation.

​These financial strategies will apply in different circumstances. Keep in mind that there are potential pitfalls with any wealth management strategy. This is long-term financial planning. It would be wise to discuss any premium financing you want to do with your financial and estate advisor.

​Quick Summary

​The primary purpose of using premium financing for life insurance is to have your life insurance policy (or multiple policies) provide tax-free liquidity to your heirs when you pass away.

​You can separate the life insurance policy proceeds from your estate’s assets. This way you can avoid both state and federal estate taxes on your life insurance and reduce the overall value of your estate in the eyes of the IRS.

​As of 2018, the maximum estate tax exemption for an individual is $5.6 million. The maximum estate tax for a couple is $11.2 million.

​If you landed here, don’t miss our Easy How-to Guide for Premium Financing. It gives you all the background information you need to get started. If you come up with any questions during the read, either leave them in the comments or give us a call at (858) 703-6178. 

​Using Life Insurance to Provide Estate Liquidity

​As long as you are not the owner of the life insurance policy, any life insurance proceeds payable to your beneficiaries will not be taxable.

​On top of that, if you buy a permanent life insurance policy (like the recommended indexed universal life policies for premium financing), you will have the added bonus of the cash value accumulation portion. You can use the cash value accumulation to pay for the loan your irrevocable life insurance trust uses to buy the policy. The cash value accumulation of the policy also grows tax-deferred.

​Since you will be looking at a policy worth several million dollars in coverage, you should avoid liquidating assets to pay for premiums to the best of your ability.

​With premium financing, you use a third-party lender to take out a loan for your insurance premiums.

​The most popular strategy ​involves an indexed universal life insurance policy that uses the cash value accumulation ​to pay off the premium financing loan in full. There are a variety of ways you can do this to maximize the tax benefits of premium financing.

​Keep in mind that each situation varies. You will need a premium financing strategy that matches your financial situation.

​Options to Pay Premium Financing Loans for Life Insurance

​There are three common strategies for paying off a premium financing loan. Most people will use one of these or a combination of the following:

• ​Pay the loan down over time as liquid funds become available
• Have the trust pay the outstanding balance from the life insurance proceeds
• Use tax-free policy withdrawals or loans to pay the principal

​It’s important to work with a financial and tax advisor to determine which payment strategy is best for you.

​Using an Irrevocable Life Insurance Trust as a Life Insurance Tax Exemption

​An irrevocable life insurance trust (ILIT) is one vehicle you can employ to avoid taxes on life insurance proceeds.

​You cannot use a “revocable” trust for ​premium financing. Revocable trusts allow you to have direct control over them. They are not tax or creditor protected. The trust must be entirely separate from your estate.

​When choosing a trustee for your premium financing ILIT, do not name yourself. That creates another control problem. You also must not name your spouse, child, or family friend as trustee. In this scenario, the courts could deem that the trustee ​is merely your alter ego and find that you still retain control of the trust. If this happens, then your assets become exposed to taxation and creditors.

​You can set up the terms of the ILIT so that you may use to the trust to:

• ​Transfer existing life insurance policies (a 3-year exemption applies where you must survive, or the IRS considers the proceeds part of the estate)
• Use the ILIT to purchase a new policy on your behalf
• Establish how the trust distributes the life insurance proceeds

​Once you have set up an ILIT, you relinquish control and ownership of your life insurance policy(s) to the trust.

​The trustee will make the premium financing arrangements with a third-party lender to finance the cost the life insurance policy.

​Most lenders ask that you provide a personal guarantee or collateral for the premium financing loan. However, the providing collateral to secure the loan does not mean that the IRS will consider you an owner of the policy.

​Points to Keep in Mind About the ILIT

​The typical strategy is to pay the loan in full within seven to ten years.

​Keep in mind that an irrevocable life insurance trust is irrevocable. This means that once you set it up, you cannot change the terms of the trust.

​However, if your circumstances change, you can move your life insurance policy with premium financing to a new trust.

​All you do to protect your new set of circumstances is set up a “subsequent irrevocable life insurance trust.” It just involves setting up another trust better suited to your new circumstances. Then you can transfer your existing life insurance policy(s) to the subsequent ILIT.

​The trustee of your original ILIT can then terminate the original ILIT.

​Split Dollar Premium Financing for Life Insurance

​One approach to making loan payments and funding the ILIT is through using the gift tax exemption. As of 2018, the exemption is $15,000.

​You and the ILIT trustee would enter into a non-equity collateral assignment arrangement. This arrangement could include one or both the gift tax exemption or non-gift tax exemption payments. You would make these payments to the ILIT.

​The trustee pays a portion of the premium, and you (the grantor of the trust) pays the balance. You can also implement a restricted collateral assignment. This provides you with an interest in the policy which would be equal to either the greater of the cash value of the policy or the total premiums paid.

​Approach this strategy with care. Have a tax specialist confirms the draft conforms to all IRS regulations.

​The gift tax exemption for funding the ILIT works best when there are multiple beneficiaries. Then you can gift $15,000 per beneficiary to the ILIT.

​Funding the ILIT with Multiple Beneficiaries

​The way this works is you provide the maximum gift exemption to ​each beneficiary and place these funds in the ILIT. The more beneficiaries you have, the more you can contribute.

​The trustee of the ILIT provides notification to the beneficiaries of the gift tax exemption. This notification is commonly called the Crummy Notification. As long as the beneficiaries do not elect to receive the cash gift, the ILIT can use the funds to pay the premium financing loan.

​Taking the gift tax exemption approach is a means to allow you to leverage your annual gifts and generation-skipping transfers.

​Another approach is the “bypass generation gift.” This can provide a means to accelerate your gifting. However, this type of gifting procedure can result in a generation-skipping transfer tax of 50%. To avoid this, you need to set up a generation-skipping trust.

​Most financial advisors recommend only gifting assets which could be vulnerable to creditors. Keeping the assets exempt from the claims of creditors adds another layer of protection to your estate.

​If you do not have multiple beneficiaries or the beneficiaries do not agree to leave the gift in the trust to pay the lender, there are other ways you can take advantage of the estate and gift tax benefit of premium financing.

​Trust Options for Maximizing Estate and Gift Tax Benefits of Premium Financing

​There are a couple different trust options that lend themselves well to premium financing. While the irrevocable life insurance trust (ILIT) is the most common one, there are other options it can be worthwhile to explore.

​There are risks involved with premium financing for life insurance. For example, if you survive long enough, the loan could grow more substantial than the death benefit on the policy. Having a financial advisor and an estate attorney help choose the best type of trust for you can minimize some of these hazards.

​Make sure you have a contingency plan so you can repay the loan under the premium lending arrangements or the split dollar arrangements.

​In addition to the most common choice, the irrevocable life insurance trust (ILIT), there are two other options that offer advantages in some situations.

• ​Grantor Retained Annuity Trust (GRAT)
• Intentionally Defective Irrevocable Trust (IDIT)

​How a GRAT Provides Premium Financing Tax Exemptions

​The Grantor Retained Annuity Trust functions just like its name suggests. It’s an annuity.

​The basic structure of a GRAT is as follows. You place assets in the trust. Then you receive an annual income from the trust. You can do this without having to use your gift tax exemption.

​Basically, you have an income stream which is equivalent to the amount you placed in the GRAT. So there is no gift tax whatsoever when it comes to paying for the premium financing loan. You place assets in the trust that in turn pay for the premium financing.

​One potential drawback for this type of trust is that if you do not survive the annuity period, a portion of the GRAT value returns to the estate.

​Since you design a GRAT to exist for a specific period of time, most attorneys who draft these annuities avoid this problem through preparing 2-year annuities.

​How an IDIT Provides Premium Financing Tax Exemptions

​An Intentionally Defective Irrevocable Trust is​ another common method for funding premium financing without incurring substantial tax obligations. It allows you to put assets in a trust which you intend to grow sufficiently to pay off the life insurance premium financing loan.

​However, instead of receiving an annuity like the GRAT, the IDIT sells the assets within the trust to pay for the premium financing loan. The trust then distributes the yearly payments made to the trust. Because the trust owns the assets, there are no capital gains taxes.

​Using Trusts to Pay for Premium Financing with Life Insurance

​The descriptions above on how you might pay for a significant life insurance policy through premium financing should only be taken as a guide. It is not financial or legal advice on how to manage your premium financing for your life insurance policy. You need personalized advice for that.

​Although there are many estate and gift tax benefits of premium financing, your financial, life insurance, and estate needs will vary significantly from other people. Once you reach a level where premium financing is a viable option, no two estates are the same. Each one needs a custom strategy.

​Carefully setting up the terms of any trust requires the help of an experienced estate planner/attorney. There are additional tax considerations that vary with each individual and are beyond the scope of this article.

​IRS guidelines also vary for different types of trusts and gift taxes. Taking the time to avoid potential tax pitfalls is imperative.

​Conclusions on the Estate & Gift Tax Benefits of Premium Financing

​Making gifts to your ILIT is one of the best ways to fund your premium financing. You can take advantages of the gift tax allowances by gifting per beneficiary. Having multiple beneficiaries makes this worthwhile.

Make sure to consult with a tax professional, no matter what method you choose. IRS guidelines seem to be constantly changing. Keeping abreast of those rule adjustments prevents you from running into several of the risks of premium financing.

​How Abrams Insurance Solutions Can Help

​Our experienced life insurance agents can provide you with some guidelines when it comes to premium financing for life insurance. There are several life insurance companies offering products specially designed for premium financing. Since underwriting guidelines vary between companies, we can help you choose the company that’s best for your situation.

​Our expertise is providing our clients with the most robust life insurance solutions at the most affordable rates. Finding the best indexed universal life policy to fit your premium financing model is where we excel.

​For customized life insurance options to maximize the estate and gift tax benefits of premium financing, give us a call today at 858-703-6178.