PERSONAL FINANCIAL PLANNING

December 1999

SPLIT-DOLLAR EXIT STRATEGIES

By Michael A. Kirsh

In light of several recent favorable letter rulings by the IRS, private split-dollar is clearly emerging as one of the premier strategies for wealth preservation planning. The primary advantage of split-dollar life insurance is that the annual gift is reduced to the cost of pure life insurance coverage. Since the measure of the gift is the term cost and not the premiums paid, clients can leverage their annual exclusion gifts and generation-skipping exemptions. One disadvantage is that as the insured ages, the term cost increases substantially. In the case of survivorship policies, the low P.S. 38 rates will revert to the much higher P.S. 58 rates upon the first death. Another disadvantage is the gradual erosion of the death benefit over time due to the payback of the premium advances. The objective is to terminate the split-dollar plan before these problems become significant. Thus, good planning dictates that a viable exit planning strategy be considered when a split-dollar plan is implemented.

What Is Private Split-Dollar?

In general, private split-dollar is a shared premium arrangement between two parties in a nonemployment context. Typically, an irrevocable trust is created to be the owner and beneficiary of the policy. If the policy is not subject to a split-dollar arrangement, the insured will have to make a gift of the entire premium each year to the trust. On the other hand, if a third party (insured spouse, family limited partnership, or other person or entity) agrees to advance the bulk of the premium in return for rights in the cash value, the annual gifts to the trust can be limited to the economic value (term cost) of the insurance protection provided to the trust in the particular year. The premium advance payback may occur during the insured's lifetime or upon death. An individual can minimize or avoid estate, gift, and GST taxes on the funding of a life insurance policy by allowing the trustee to obtain the bulk of the necessary premiums from any available source. The client's gift to the trust each year will only be the annual P.S. 58 rates (or the so-called P.S. 38 costs for a survivorship policy) or the insurer's alternate term rates. The support for this concept is found in PLRs 9636033 and 9745019.

Exit Strategy

The gift element for the term cost continues until the premium advances are paid back--a so-called policy rollout. Once the rollout has taken place, the annual increasing term cost, the erosion of the death benefit, and any potential tax problems are eliminated. Therefore, any exit strategy should focus on the most economical method to accumulate sufficient cash in the irrevocable trust to fund the policy rollout.

The estate planner may consider the policy itself as a source of funds. However, the amount of premiums necessary to build a cash value large enough to support and maintain the policy for life becomes prohibitive.

Gift Account

The objective with a gift account is to build a reserve account over time that will be used to reimburse the premium payor and unwind the split-dollar arrangement. The annual funding is determined by averaging the economic benefit cost over a certain number of years at an assumed rate of interest. The answer is determined by computing the net present value of the economic benefit cost and the level amount needed to amortize this amount at an assumed rate of interest. Most insurance professionals have access to software that can provide this information.

The split-dollar plan should be designed so that no further premiums are required after 10 to 15 years. The amount gifted to the trust in excess of the current economic benefit accumulates in the trust. Once the premiums have stopped, funds will be withdrawn from this account to offset the current economic benefit and to gradually repay the premium payor. The amount gifted to the trust can be increased to maximize available gift tax exclusions. Thus, if the level amount is $50,000 and there are six beneficiaries, the level amount should be increased to $60,000 (six times the annual gift tax exclusion amount).

This would provide additional funds in the event one of the insureds dies and the economic benefit is determined using the higher P.S. 58 rates. Assuming a 10-pay policy design, the split-dollar plan should be fully unwound by the 22nd to 25th year.

Qualified Personal Residence Trust

A deferred gift, such as a qualified personal residence trust (QPRT), used in conjunction with an intentionally defective irrevocable life insurance trust, can provide an attractive solution and offers unique advantages not available through other rollout strategies.

Let's assume a taxpayer, age 55, owns a vacation residence valued at $1 million. She gifts the house to a QPRT and retains the use of the house for 15 years. At the end of the 15-year period, the house is passed to the irrevocable insurance trust as the remainder beneficiary. This residence will now be the asset that funds the policy rollout.

The taxpayer will now pay rent to the owner of the residence, the irrevocable trust. Since these payments are for use of the residence, they are not considered to be gifts to the trust. If the residence appreciates by five percent a year, it will be worth a little over $2 million when transferred to the trust. Rental payments of $150,000 per year could be justified.

Under normal circumstances, the rental payments would represent taxable income to the owner of the residence. However, by making the trust a grantor trust, any transactions between the grantor and the grantor trust are ignored for income tax purposes. The trust uses the rental payments to repay the premium payor. In effect, the rental payments to the trust are immediately returned to the taxpayer as part of the split-dollar rollout. The end result is that the taxpayer has no net outlay and the premium advances are reduced each year until they are fully paid back. The QPRT provides a leveraged gift, and the subsequent rental payments allow the rollout to be funded without gift or income tax consequences.

Charitable Lead Unitrust

The charitable lead unitrust (CLUT) can be an attractive option to fund the rollout, especially when the insurance trust is structured to be a generation-skipping trust. Unlike charitable lead annuity trusts, the GST inclusion ratio for CLUTs is determined when the gift is made. Allocating a sufficient amount of the GST exemption will result in a zero inclusion ratio. The CLUT would pay a specified percentage of its assets to a charity, typically the taxpayer's own private foundation, for a specified term of years. At the end of the term, the CLUT assets would pass to the irrevocable trust. These assets will provide the irrevocable trust with a source of funds to reimburse the premium payor. Should the grantor die during the trust period, the CLUT assets would pass immediately to the irrevocable trust and would not be includable in the grantor's estate.

Grantor Retained Annuity Trust

A grantor retained annuity trust (GRAT), structured with a short-term and high annuity payout on a layered arrangement, can provide an opportunity to fund the rollout of the policy. Each two-year GRAT would pay out a total of 100% of the effective IRC section 7520 interest rate. Any growth in excess of the payout would pass to the irrevocable trust. The death of the grantor would only cause the existing two-year GRAT to be includable in the estate. Any GRATs previously completed would have already transferred the excess growth to the irrevocable trust.

Sale to a Defective Grantor Trust

A sale to a defective trust involves a current gift in conjunction with an installment sale. The gift portion must be equal to at least 10% of the overall value of the asset being transferred. The remaining value of the asset would be sold to the trust for an installment payout, interest only, based on the applicable IRS rate. The asset gifted or sold to the trust will be used to fund the installment payout to the grantor. Earnings in excess of the amount needed for the installment note would accumulate within the trust and would eventually be used to fund the rollout of the policy. If the asset sold is subject to valuation discounts, this excess income could be quite substantial. This type of strategy would work well with a generation-skipping trust. There are no income tax consequences applicable to the sale of the asset or to the installment payout because of the grantor trust status. The grantor will be taxed on the earnings received by the trust. *