Split-Dollar Loan to a Grantor Irrevocable Life Insurance Trust Is there an alternative to grantor retained annuity trusts and installment sales to intentionally defective grantor trusts? The split-dollar Regulations provide new tools and offer new possibilities for estate planning.
RICHARD L. HARRIS, CLU AEP
T
he difficulty lies, not in the new ideas, but in escaping from the old ones…. —John Maynard Keynes
Very often in estate planning, multiple techniques are used at the same time. Grantor retained annuity trusts (“GRATs”), irrevocable life insurance trusts (“ILITs”), and/or installment sales to defective grantor trusts (“IDGTs”) are used together. Especially if one of those elements is an ILIT, with a new technique using a split-dollar loan, the whole can be made greater than the sum of the parts. To understand how that is possible, it is necessary to examine the parts, construct the whole, and then weigh the pros and cons of each strategy. (See Exhibit 1 for highlights of each technique.)
Grantor retained annuity trusts In a GRAT, 1 the grantor receives an annuity based on the term of the GRAT and the Section 7520 rate. The remainder interest calculated is
the gift element. In a zeroed-out GRAT, the payments based on those assumptions will exhaust the GRAT so that at inception the remainder interest is valued at zero. If the asset grows by more than the Section 7520 rate, there will be a remainder that will go gift tax-free to the remainder party. Often, GRATs are funded with business interests that are discounted, such as an interest in a limited liability company (“LLC”) or S corporation stock. That increases the likelihood of success. There are a number of factors that affect GRATs: • If the grantor dies during the term of the GRAT, under Reg. 20.2036-1 either the
RICHARD L. HARRIS, CLU AEP, is the managing member of BPN Montaigne LLC, a life insurance sales and consulting firm in Clifton, New Jersey. He is a frequent author and lecturer, and has previously written for ESTATE PLANNING. The author wishes to thank Larry Brody of the law firm of Bryan Cave LLP in St. Louis, for his help in preparing this article. Copyright © 2009, Richard L. Harris.
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amount necessary to generate the annuity payment at the Section 7520 rate at the time of death without using principal, or the corpus if less, is included in the estate of the grantor. • An allocation of generationskipping transfer (“GST”) tax exemption cannot be made until the end of the GRAT.2 Some practitioners advocate selling the remainder interest to a GST trust as a way of dealing with this situation.3 • The annuity payments must be paid at least annually.4 • Annuity payments have to be made in cash or in-kind assets. If there is no cash, assets may have to be liquidated. An unrelated third party could make a loan to the GRAT. (A note directly or indirectly from the GRAT to the grantor does not constitute payment of the annuity amount.5) Payment can be made “in kind.” The in-kind assets may have been
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EXHIBIT 1 Estate Planning Techniques’ Highlights Feature
GRAT
Sale to IDGT
Loan to GILIT
Death during term: Inclusion in grantorʼs estate
Lesser of corpus or principal needed to make annuity payment based on §7520 rate at time of death without reducing principal.
Note is included unless it was a SCIN.
Note plus accrued interest included in estate.
GST
GST allocation cannot be made for remainder interest. Some practitioners advocate selling the remainder interest to a GST trust.
Can be allocated to grantor trust.
No GST inclusion.
No bright line.
Interest can be accrued. Principal payment is at the end of note.
No bright line.
None required under Reg. 1.7872-15.
AFR based on term of note.
AFR based on term of note.
Unclear.
If policy used as collateral and Reg. 1.7872-15(d)(2) is followed, it is a loan.
Payments
ʻSeed moneyʼ
Interest rate used Loan status
Annuity payments must be made at least annually based on the term of the GRAT and the §7520 rate at inception. N/A
Grantor cannot make loans to cover annuity payments. Transaction is not a loan.
Installment sales to defective grantor trusts A successful IDGT involves the sale of an asset for a note that bears interest at the applicable federal rate (“AFR”). The success depends ESTATE PLANNING
Many practitioners have interest paid at least annually. Principal may also be paid in installments. Practitioners currently use a gift of 10% of the value of the asset to be sold and/or guarantees from the beneficiaries.
§7520 rate at inception.
discounted when the GRAT was formed. Those assets will have to be appraised and given the appropriate discount when used as an annuity payment. • There are storm clouds on the horizon. The Administration’s “Green Book” 6 is proposing that a GRAT term be a minimum of ten years, greatly increasing the mortality risk of the transaction. Also, legislation was introduced (H.R. 436, “Certain Estate Tax Relief Act of 2009”) that would deny discounts to “non-business assets.”
Any excess in value of the asset Life insurance proceeds not after paying off loan is also not in in estate. the estate. Any excess in value of the asset after paying off loan is also not in the estate.
on the value of the asset sold at a discount and/or growing by a greater amount than the sales price plus the interest paid. The notes can be either a payment of principal plus interest or a balloon note with only interest being paid. Sometimes with older clients, the note is a self-cancelling installment note (“SCIN”), which terminates at the death of the note-holder. The self-cancelling feature is accounted for by either a premium on the value of the asset or a higher interest rate on the note.7 These transactions travel in uncharted waters—apart from Sec1
2
Steve Akers has created an exceptional treatise on the subjects of GRATs and IDGTs: “Transfer Planning, Including Use of GRATs, Installment Sales to Grantor Trusts, and Defined Value Clauses to Limit Gift Exposure,” State Bar of Texas Advanced Estate Planning Institute, 6/12/2008. Copies are available to members on the National Association of Estate Planners and Councils website: www.naepc.org. Reg. 26.2632-1.
tion 7872 and the Regulations, there is no bright-line method for structuring them. The main issue is whether the arrangement is a real loan. Many practitioners believe that there must be evidence of the trust’s ability to pay the note. There is no guidance in Section 2036. While there is no official pronouncement to support it, many practitioners have taken the 10% approach—give 10% of the value of the asset to “seed” the trust before the sale for a note is made. Others use loan guarantees from the beneficiaries of the 3 4 5 6 7
See Handler and Oshins, “The GRAT Remainder Sale,” 141 Tr. & Est. (Dec. 2002). Section 2702(b)(1). Reg. 25.2702-3. General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals, Department of the Treasury, p. 123 (May 2009). It is highly advisable to get an independent appraiser to determine the amount of the premium.
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5 trust or a combination of seed money and the guarantee.8
Irrevocable life insurance trusts For purposes here, there are several things to note about ILITs. They are trusts created to hold life insurance while keeping the proceeds out of the insured’s estate. Life insurance provides leverage because the premiums are a fraction of the death benefit. Life insurance achieves its full value only at the death of the insured(s). In many cases, the income tax-free internal rate of return at the insured’s life expectancy is 5% or greater. 9 Coupled with the facts that at death it produces cash and that annual premiums are a small percent of the ultimate face amount, it is an important tool in estate planning. ILITs usually are structured as grantor trusts. It is often argued that a provision normally used in ILITs to allow income of the trust to be used to pay premiums creates grantor trust status. In a situation where that was called into question, the IRS issued Field Advice 20062701F in which it stated: “Article II of B Trust Agreement authorizes the trustee to purchase life insurance on taxpayer. There does not appear to be any limit on the amount the trustee may apply to the pay8
9 10
11
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13 14 15
The guarantors are entitled to a guarantor fee payable by the trust. Practitioners often look at the cost for letters of credit to determine the amount of the fee. See Harris, “Life Insurance and Wealth Management,” 11 J. of Wealth Mgt. 114 (Spring 2009). Howard Zaritsky made an excellent presentation at the 2009 Heckerling Estate Planning Institute about grantor trusts. For a good summary of his presentation, see Shenkman, “Notes from Heckerling,” Steve Leimberg’s Estate Planning Email Newsletter #1404 (1/22/2009) (www.leimbergservices.com). Section 2503(b). For a complete discussion of Crummey powers, see Leimberg and Doyle, Tools & Techniques of Life Insurance Planning, 4th Edition (The National Underwriter Company, 2007). 1964-2 CB 11. 2001-1 CB 459. The most important of those Regulations are Regs. 1.61-22 and 1.7872-15, along with Rev. Rul. 2003-105, 2003-2 CB 696.
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ment of premiums. Therefore, pursuant to section 677(a)(3), taxpayer is treated as the owner of B.” Many attorneys do not feel that the provision to allow trust income to pay premiums is sufficient for the whole trust to be treated as a grantor trust, so other provisions are used.10 A provision that is most useful for other purposes as well is the power to substitute property under Section 675(4)(C). Care must be taken in drafting to specifically deny the grantor the ability to substitute for the life insurance policy. Otherwise, the proceeds of the policy in the ILIT may be included in the insured’s estate (if the insured was the grantor) under Section 2042. If there are gifts to an ILIT to pay premiums, in order to be considered gifts of a present interest (using annual exclusion gifts rather than lifetime gifts of a future interest), the beneficiaries must have a withdrawal power. Based on the celebrated Crummey case, such a power will make the premiums present interest gifts and the trust will then be called a Crummey trust. A notice has to be given to each beneficiary with withdrawal rights (known as Crummey rights or Crummey powers) at the time the funds are given to the trust, advising the beneficiaries of their right to make withdrawals. The withdrawal amount is limited to the greater of $5,000 or 5% of the trust corpus. There is a disconnect between the Crummey withdrawal amount and the annual gift tax exclusion. 11 If there is a difference between the Crummey amount and the annual exclusion amount, “hanging powers” are used in the trust to correct the disconnect by allowing the balance of the annual gift amount to be apportioned later when there are either no contributions to the trust or when 5% of the trust asset value is greater than $5,000.
Example. The 2009 annual exclusion amount is $13,000 per donee. The annual premium on a policy is $20,000. There are two beneficiaries. While the total Crummey amount is $10,000, the gift is $20,000, within the annual exclusion amount. The $10,000 above the Crummey amount is held for the beneficiaries by the “hanging powers.” The IRS is a stickler for the rules. If a decedent’s life insurance was in an ILIT and any gifts were made to that trust, an IRS audit could include an examination of all Crummey notices, to see if they were timely given and properly acknowledged.12
Private premium financing— AKA split-dollar loans Split-dollar describes an arrangement used to fund a life insurance policy. There are two parties to the transaction: the entity or person that provides the funds to pay for the insurance and the individual or trust that controls the death benefit of the policy. Originally, splitdollar began with the issuance of Rev. Rul. 64-328,13 and continued with additional Revenue Rulings and private letter rulings. Most estate planning practitioners were familiar with the technique and it was commonly used. Beginning in 2001 with IRS Notice 2001-10, 14 the IRS changed the rules, culminating with final Regulations issued in September 2003.15 The entire publication with its Preamble is long and daunting. A major tax benefit available in previous arrangements, “equity” splitdollar, was ended. Few practitioners profess to understand these rules today. Thus, split-dollar arrangements are used much less frequently than in the past. But it is within those unmined Regulations that new opportunities arise—specifically in loan split-dollar. S P L I T- D O L L A R I N S U R A N C E
6 Many practitioners try to avoid split-dollar loans. That may not be the wise thing to do. In fact, while some believe they have avoided the Regulations, they have not. To differentiate between “old” split-dollar methodology—economic benefit split-dollar—and the new additional methodology created by the Regulations, loan split-dollar, the term “private premium financing” is often used. Unfortunately, many practitioners do not realize that private premium financing is governed by the loan split-dollar Regulations in Reg. 1.7872-15. There are two issues. One is that if a loan is made to an ILIT for the purpose of paying premiums on a life insurance policy, it falls under the split-dollar Regulations. The second is that the Regulations actually provide comfort for those loans and it is better to comply and have the guidance of the Regulations than not having them. In Reg. 1.61-22(b)(1), split dollar is defined as follows: A split-dollar life insurance arrangement is any arrangement between an owner and non-owner of a life insurance contract that satisfies the following criteria— (i) Either party to the arrangement pays, directly or indirectly, all or any portion of the premiums on the life insurance contract, including payment by means of a loan to the other party that is secured by the life contract;
General rule. A payment made pursuant to a split-dollar life insurance arrangement is treated as a loan for Federal tax purposes, and the owner and non-owner are treated, respectively, as the borrower and the lender, if— (A) The payment is made either directly or indirectly by the nonowner to the owner (including a premium payment made by the non-owner directly or indirectly to the insurance company with respect to the policy held by the owner); (B) The payment is a loan under general principles of Federal tax law or, if it is not a loan under general principles of Federal tax law (for example, because of the nonrecourse nature of the obligation or otherwise), a reasonable person nevertheless would expect the payment to be repaid in full to the nonowner (whether with or without interest); and (C) The repayment is to be made from, or is secured by, the policy’s death benefit proceeds, the policy’s cash surrender value, or both.
For this discussion, what is important here is that, even if the arrangement is not a loan under federal tax law, it will be considered a loan if “a reasonable person nevertheless would expect the payment to be repaid in full to the non-owner (whether with or without interest).” The Regulations then give a road map that, if followed, assures loan treatment of the transaction. Reg. 1.7872-15(d) states:
(ii) At least one of the parties to the arrangement paying premiums under paragraph (b)(1)(i) of this section is entitled to recover (either conditionally or unconditionally) all or any portion of those premiums and such recovery is to be made from, or is secured by, the proceeds of the life insurance contract; and
(2) Exception for certain loans with respect to which the parties to the split-dollar insurance arrangement make a representation. (i) Requirement. An otherwise noncontingent payment on a split-dollar loan that is nonrecourse to the borrower is not a contingent payment under this section if the parties to the splitdollar insurance arrangement represent in writing that a reasonable person would expect that all payments under the loan will be made.
(iii) The arrangement is not part of a group-term life insurance plan described in section 79 unless the group-term life insurance plan provides permanent benefits to employees (as defined in § 1.79-0).
(ii) Time and manner for providing written representation. The Commissioner may prescribe the time and manner for providing written representation required by paragraph (d)(2)(i) of this section.
ESTATE PLANNING
Until the Commissioner prescribes otherwise, the written representation that is required by paragraph (d)(2)(i) of this section must meet the requirements of paragraph (d)(2)(ii). Both the borrower and the lender must sign the representation not later than the last day (including extensions) for filing the Federal income tax return of the borrower or lender, whichever is earlier, for the taxable year in which the lender makes the first split-dollar loan under the splitdollar life insurance arrangement. This representation must include the names, addresses, and taxpayer identification numbers of the borrower, lender, and any indirect participants. Unless otherwise stated therein, this representation applies to all subsequent split-dollar loans made pursuant to the split-dollar life insurance arrangement. Each party should retain an original of the representation as part of its books and records and should attach a copy of this representation to its Federal income tax return for any taxable year in which the lender makes a loan to which the representation applies.
In Reg. 1.7872-15(a)(2)(i), loan treatment is described as follows:
Interest, calculated on either a demand or a term loan is sufficient if it equals the appropriate AFR. It is also important that the borrower can accrue rather than pay interest on the loan. An economic benefit arrangement that is not between a business entity and another party is referred to as private split-dollar. A loan arrangement is often referred to as private premium finance (as opposed to a loan from a third-party lender). An explanation as to whether either private arrangement with a trust is considered a gift, in the section of the Preamble titled “Background and Explanation of Provisions,”16 states: 5. Gift Tax Treatment of Split-Dollar Life Insurance Arrangements The final regulations apply for gift tax purposes, including private splitdollar life insurance arrangements. Thus, if an irrevocable trust is the owner of the life insurance contract underlying the split-dollar life insurance arrangement, and a reasonable person would expect that the donor, 16
TD 9092 (9/11/2003).
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7 or the donor’s estate will recover an amount equal to the donor’s premium payments, those premium payments are treated as loans made by the donor to the trust and are subject to § 1.7872-15…. If however, the donor makes premium payments that are not splitdollar loans, then the premium payments are governed by general gift tax principles. In such a case, with each premium payment, the donor is treated as making a gift to the trust equal to the amount of that payment.
Finally, for life insurance not to be included in the insured’s estate under Section 2042, the loan agreement and collateral assignment have to be carefully drafted. In a recent private letter ruling on an economic benefit split-dollar arrangement, Ltr. Rul. 200910002, the Service ruled that the arrangement was set up so that the insureds had no incidents of ownership. This is the same result as in rulings prior to the new Regulations. To summarize, a loan can be made to a trust that owns life insurance, the loan is used directly or indirectly to pay for the life insurance, the life insurance is used as collateral for the loan, and the appropriate representation is made with the original loan, with copies of the original representation filed if any further loans are made. In other words, this is a legitimate loan even though there is no seed money or collateral other than a life insurance policy. Further, even if the policy has no cash value, this is considered a legitimate loan if it is secured by the death benefit of the policy.17 17
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See Reg. 1.7872-15(a)(2)(i)(C). An SGUL policy is guaranteed by the issuing insurance company not to lapse during the guarantee period as long as the required premiums are paid on a timely basis. Guarantee periods can go out to the insured’s age 121. The guarantee provided, as with all guarantees, comes from the insurance company. It is important to make sure that the insurance company is financially strong and highly rated. The annual premium of $355,000 is 3.55% of $10 million and the interest on the loan is 1.65%. The total is 5.2%. Thus, a return of 5.3% will be enough to pay the premiums, the loan, and the accrued interest.
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In the Preamble’s “Background and Explanation of Provisions” that accompanied the Regulations, it states: “The IRS and Treasury recognize that, in the earlier years during which a split-dollar life insurance arrangement is in effect, policy surrender and load charges may significantly reduce the policy’s cash surrender value, resulting in undercollateralization of a non-owner’s right to be repaid premium payments. Nevertheless, as long as a reasonable person would expect the payment to be repaid in full, the payment is a split-dollar loan under § 1.7872-15, rather than a transfer under § 1.61-22(b)(5).” In fact, many secondary-guaranteed universal life policies are term insurance through the guarantee date— that is, payments are structured so that if there is cash surrender value at any time, it ultimately disappears.
Putting a grantor ILIT and loan split-dollar together Now, how about a dynasty trust that involves no gifts—no annual exclusion, lifetime, or GST gifts? Let’s look at an example of a split-dollar loan transaction with an ILIT that is a grantor trust to see how it works. Example. A Grantor ILIT (“GILIT,” to emphasize that it is deliberately set up to be a grantor trust) is domiciled in Delaware as a dynasty trust. The GILIT is the owner and beneficiary of a $10 million second-todie life insurance policy on the grantor, age 73, and his spouse, age 67. The policy is a secondary-guarantee universal life 18 (“SGUL”) designed to be paid for over nine years with the death benefit guaranteed to age 121. Because of the health issues of the respective insureds, the annual premium is $355,000. The husband is reasonably healthy, but the spouse is not. The nine-year term was used because the client did not want to pay pre-
miums forever and to capture the mid-term AFR. The same policy with premiums continuing until death would cost $162,000 per year. Separately, the grantor makes a loan of $10 million to the GILIT secured by the life insurance policy. The grantor has no right other than to the repayment of the loan plus interest to be made at the discretion of the trustee to avoid inclusion of insurance proceeds under Section 2042. The loan is for nine years at a mid-term rate (February 2009) of 1.65%, with interest accrued. (A loan for life expectancy [see below] would use the longterm AFR, which is 2.96%.) The interest may be paid or accrued at the trustee’s discretion. The loan can also be pre-paid at the trustee’s discretion without penalty. The loan is renewable at the option of the trustee. $355,000 is used to pay the first annual premium. The balance is invested in a portfolio designed to (hopefully) return 5.3% before taxes. Because this is a grantor trust, the grantor will pay the income taxes. If the investment does return 5.3%, there will be enough money to pay the annual premiums and repay the loan plus accrued interest at the end of nine years.19 At the time the loan is made, both the grantor and the trust file required notices under Reg. 1.787215(d)(2) with their tax returns. Since there are no further loans, these have to be filed only once. For the belt and suspenders approach to dealing with the GST, a small gift can be made to the trust to which there is an allocation of GST exemption. A Form 709 is filed reporting the GST gift so that the statute of limitations runs. For a belt and suspenders approach to the loan, what if the loan is secured by both the life insurance and the assets, and the above notice is also filed? Analyzing the transaction, we can see that this is a split-dollar S P L I T- D O L L A R I N S U R A N C E
8 arrangement as defined in Reg. 1.61-22(b)(1) above. It is a loan split-dollar transaction according to Reg. 1.7872-15(a)(2)(i) above. Also, because this is a legitimate loan with all the requirements observed (including Reg. 1.787215(d)(2)), there is no taxable gift. Voila! A transfer tax-free dynasty trust funded with $10 million of life insurance. Since there were no gifts, there are no Crummey notices required. Moreover, if the loan is outstanding at the insured’s death, the loan can be paid off from the insurance proceeds, providing liquidity to the estate while keeping the other assets in trust.
Potential problems What can go wrong? For one, the grantor could die before the loan is repaid. If the grantor is the only insured, there is no issue. However, in the example above with two insureds, if the husband is the grantor and he dies, the trust is no longer a grantor trust and the earnings on the assets are now taxed to the trust. Furthermore, if the interest continues to be accrued, there will be original issue discount that has to be taken into account at the grantor’s death going forward. Finally, any interest on the loan after the grantor’s death is no longer income tax-free. 20 The amount accrued before the grantor’s death is not a problem. The trustee will start paying income tax on the earnings of the trust. Because it is a Delaware trust, there will be only federal income taxes. The trustee has the option to pay the interest, and does so to the grantor’s estate. The estate will pay income taxes on the interest. All of this is detrimental to paying the premiums and paying off the loan based on the original assumptions. If the investments had a high enough rate of return to cover the payment of premiums, interest payments, and ESTATE PLANNING
the income taxes for the balance of the nine years, the loan plus the interest accrued before the grantor’s death can be repaid. Whether because of the death of the grantor, as above, or just poor performance of the investments, if the earnings of the investments are not enough to cover the premiums, interest, taxes, and loan repayment, there are several options. • Since the policy premiums stop in nine years, there is no longer the $355,000 annual cost beginning in year 10. The trustee could renew the loan at the then effective AFR with the idea that the shortfall plus the future interest can be made up by the investment. • The grantor could make an additional loan hoping for the same result after the premiumpaying period. • To the extent there are assets available, the loan could be paid off. The balance would be repaid at the death of the insureds. • The policy face amount can be reduced; the premium payment period can be lengthened; or a combination of both. That will reduce the premium costs in the GILIT, making it easier to pay off the loan and interest. • If the interest rate on the original loan is higher than the current AFR, it may be possible to substitute a note at the lower AFR.21 Another possibility is that the IRS says that the full $10 million loan is not a split-dollar loan because it is greater than the premiums. The response is that it is still “…a loan under the general principles of Federal tax law” as is stated in Reg. 1.7872-15(a)(2)(i). Using the life insurance policy as collateral for the loan should satisfy the requirements
of that section, especially when the procedure in Reg. 1.7872-15(d) is followed. Even if that is disregarded, wouldn’t it still be tested against Section 7872? What if both the insurance policy and the assets are offered as collateral and/or there are personal guarantees from the beneficiaries?
Loans to GILITs, GRATs, and sales to IDGTs The next question is, what does the above loan transaction with a GILIT have to do with GRATs or IDGTs? (Review the highlights of each in Exhibit 1.) Three other important points will bear on the next topic: An ILIT can purchase assets, including those from the grantor, at the trustee’s discretion, and as long as it is an arm’s-length transaction for fair value. Second, a loan does not have to be in cash. In Frazee,22 the Tax Court stated “Nowhere does the text of section 7872 specify that section 7872 is limited to loans of money.… The term ‘loan’ under section 7872 is interpreted broadly to include any extension of credit.” In Ltr. Rul. 9535026, the IRS reiterated those results. The final point is that in estate planning, GRATs, ILITs, and sales to IDGTs are often done at the same time. GRAT compared with loan to GILIT The goal of a GRAT is to transfer assets out of the insured’s estate by having the assets in the GRAT outperform the Section 7520 rate. 20
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As to whether the interest payments are deductible by the trust, the author has heard the question: “Is the interest paid by the trust interest to finance life insurance under Section 264(a); is it interest to carry investments under Section 163(d)(4); or a combination of both?” This author’s inclination is that if one is going to make the argument that this is a legitimate loan under Reg. 1.787215(d), one should not attempt to deduct the interest because the loan is for the purpose of paying for life insurance. Blattmachr, Crawford, and Madden, “How Low Can You Go? Some Consequences of Substituting a Lower AFR Note for a Higher AFR Note,” 109 J. Tax’n 22 (July 2008). 98 TC 554 (1992).
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9 Because of the inclusion in the estate of the corpus (unless greater than the amount needed to pay the annuity payments at the Section 7520 rate without reducing principal), many practitioners favor shorter-term layered GRATs rather than a single longer-term GRAT, spreading the assets among them to assure the least amount includable in the estate if the grantor dies during the term. Also, by putting separate assets into each GRAT the likelihood of success is increased.23 What if, instead of a short-term GRAT, a short-term loan is made to a GILIT? It is important to note that if the GRAT is going to be funded by an existing asset, to get the same asset into the GILIT, one of two things can be done: a cash loan followed by the purchase of the asset by the trustee from the grantor or a loan of property, relying on the Frazee case to be considered a legitimate loan. If the practitioner prefers a loan in cash and the grantor does not have the amount required, many lending institutions will make a very short-term loan to the grantor. Because the terms of the loan to the grantor will be different from the loan to the GILIT, the grantor borrows from a lender and in turn loans to the GILIT. When the asset is sold by the grantor to the GILIT, the grantor uses the proceeds to repay the loan to the third-party lender. There is no advantage to a short-term loan to a GILIT other than the lower interest rate, because what is included in the grantor’s estate is only the loan plus accrued 23
24 25 26
See Kwon and Loewy, “GRATS: On a Roll,” 144 Tr. & Est. (June 2005); Weinreb and Singer, “Rolling Short-term GRATs Are (Almost) Always Best,” 147 Tr. & Est. 18 (Aug. 2008); and Melcher, “Are Short-Term GRATs Really Better Than Long-Term GRATS?,” 36 ETPL 23 (Mar. 2009). Section 7520. The annuity payment is $515,000. Since the Section 7520 rate is 2%, the principal necessary to make that payment is $25,750,000. Reg. 25.2702-3(b)(1)(i). Steve Akers goes into greater detail in his treatise; see supra note 1.
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interest. A mid-term loan can be made using the mid-term AFR, which is still lower than the Section 7520 rate. Apart from the higher interest rate, a loan can be made until life expectancy. (See below for more on that subject.) Here is the comparison: • They both are grantor trusts. • Because the Section 7520 rate is calculated as 120% of the mid-term AFR,24 it is always more than either the shortterm or mid-term AFRs. For example, if the loan to the GILIT is for less than three years, it is a short-term loan. The short-term AFR in February 2009 was .6% versus a Section 7520 rate of 2%. • With the GRAT, either the corpus or an amount necessary to pay the annuity at the then Section 7520 rate without invading principal, if less, is included in the estate. So in most cases, if the grantor dies and there is a gain on the asset, the entire value, including the gain, will be in the estate. Example. Using a two-year GRAT with assets put in with a value of $1 million, assuming the Section 7520 rate is still 2% at the grantor’s death and the GRAT was still in effect, any value up to $25,750,000 would be in the grantor’s estate!25 Example. Using a ten-year GRAT as above for $1 million and assuming the grantor dies during the term, the amount included in the estate can be up to $5,566,300. If the grantor dies with a loan to a GILIT, even if the value of the asset has grown significantly, only the loan is in the estate. • Annual annuity payments have to be made on the GRAT. With a two-year, zeroed-out GRAT as an example, even if the GRAT is
successful, the annual annuity payment is 50%+ of the initial value of the asset. (At a 2% Section 7520 rate, it is 51.5%.) That means that only half of the value of the asset can grow inside the GRAT for the two years. With the split-dollar loan to the GILIT, the loan plus accrued interest is payable at the end of the term so that the entire value of the asset can grow for the full term. • No money can be loaned directly or indirectly to a GRAT to fund the annuity payments. 26 Money can be loaned to a GILIT. A loan might even be made in kind per Frazee and Ltr. Rul. 9535026. • If a GRAT fails, the grantor gets back the value of the asset without any consequence. If the same asset in the GILIT loses value, the grantor is still owed the full value of the note, a negative for a loan to a GILIT vs. the GRAT. (The life insurance policy may be structured to always pay at least the value of the loan plus accrued interest so that the remaining asset stays out of the estate, whatever its value.) • However, if the asset grows, the GILIT has more of a chance of being successful and/or more successful than a GRAT because there are no annuity payments; all payments, including interest, are due at the end of the loan; the interest rate for the loan is lower than the Section 7520 rate, giving the loan to the GILIT a better chance of success; since the trustee has the right to prepay, a gain can be locked in at any time by selling the asset and repaying the loan; if the rules change and a S P L I T- D O L L A R I N S U R A N C E
10 GRAT can no longer have a zero remainder, the loan to the GILIT still requires no gifts; the loan to the GILIT creates no GST gifts. Unless the remainder interest in the GRAT is sold (and that transaction is not guaranteed to work), the remainder interest at the end of the GRAT is fully includable for GST purposes.
Sale to IDGT compared with loan to GILIT Again, the goal of a sale to an IDGT is to transfer assets and appreciation out of the estate. Like the GRAT, primarily discounted assets are used. The terms of the note generally require payment of interest at least annually. A balloon payment at the end is used to capture as much growth from the asset as possible. In the case of older grantors who are not likely to live to their actuarial life expectancy according to the appropriate government table, a self-cancelling installment note can be used for the repayment of the note. Either the principal of the note or the interest rate is adjusted upward to reflect the self-cancelling feature. There are no Regulations specific to this transaction. Practitioners hope that the transaction will be considered a legitimate sale repayable by a note with terms designed to meet the tests in Section 7872. Instead of a sale to an IDGT, what if the transaction was a loan to a GILIT? (See comparison with GRATs above as to how the loan can be structured.) Regardless of how the sale transaction is set up, here is the comparison: • A sale to an IDGT is often initiated by a taxable gift of 10% of the value of the asset to provide substance that this is a legitimate transaction. The ESTATE PLANNING
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GILIT transaction requires no “seed money.” There is no “bright line” to follow in the sale to the IDGT. If the Regulations are followed, a loan to a trust collateralized by life insurance is a loan by definition in the Regulations. 27 To further support the contention that the sale to the IDGT is a legitimate loan transaction, interest is paid annually. With the loan to the GILIT, interest can be paid or accrued. Both use the appropriate AFR. Many practitioners prefer that the loan to the IDGT is paid off before the grantor dies. Splitdollar loan transactions can be structured to be paid off at the grantor-insured’s death.
A loan to a GILIT can be repayable at the death of the insured. 28 The term of the loan is measured by the insured’s life expectancy using the appropriate table in Reg. 1.72-9 (Annuity Tables) on the day the loan is made.29 The AFR to be used is determined by that life expectancy. So if the life expectancy is longer than nine years (up to age 76 for males or 81 for females in the one life table), the long-term AFR is used. Under Reg. 1.7872-15(e)(5)(ii)(D), if the insured lives past life expectancy, the loan is considered retired and reissued at the demand rate in effect on the date the original loan was made. In effect, there is a bonus for longevity in the form of a significantly lower interest rate going forward. • A split-dollar loan cannot be a SCIN, but the note in a sale to an IDGT can be—an advantage to that transaction. • In either a sale to an IDGT or a split-dollar loan to a GILIT, the beneficiaries of the trust
will not get a stepped-up basis in the asset. Some practitioners are using the IDGT to buy life insurance after it has purchased assets from the grantor. Because there is a note (loan) involved in the purchase of the assets and the IDGT now owns life insurance, the transaction may already fall under the split-dollar Regulations. Instead of viewing that as a disadvantage, based on the previous discussion, it can be turned into an advantage. Filing the proper notice with the tax returns can assure loan treatment, especially if the loan and the purchase of the insurance are done in the same tax year. It is less clear that this is valid if the loan and the insurance purchase occur in different tax years without there being an additional loan made at the time the insurance is bought. At the least, it gives the taxpayer more to offer the IRS to support the transaction if it comes into question.
Case study To give some additional perspective on what can be done, the following is based on an actual case. Example. A husband and wife have one child and an estate of $55 million; $50 million was in residential real estate, with two of the properties rented out. The cash return on the rental realty based on gross values was 2%. The couple needed the rental income for living expenses. Other assets included IRAs and brokerage and bank accounts. There were existing single life policies on each spouse for total of $1.5 million. The couple’s estate planning goals were to reduce the value of the taxable estate; maintain the current income stream; and fund as much 27 28 29
It makes sense that the amount of insurance is at least equal to the amount of the loan. Reg. 1.7872-15(e)(5). Reg. 1.7872-15(e)(5)(ii)(D).
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11 second-to-die life insurance as possible without paying premiums for at least ten years. Section 1035 could not be used to turn the single life policies into a joint life policy. The existing policies had taxable gains. The couple did not want to incur any unfunded tax liability. Some of the ideas discussed included: • Putting the rental properties into an LLC. • Looking at a qualified personal residence trust (“QPRT”) for residences. • Giving GRAT LLC interests to the child. • A sale to an IDGT. • A loan split-dollar arrangement. Because the value of the properties that could be put into a QPRT was so high, gift taxable remainder interests would exceed the lifetime exemption amounts. The clients did not want to pay gift taxes. GRATs were not workable because of the minimal cash flow available for annuity payments. Payments in kind would exhaust the GRAT, and there would be the additional expense of getting new appraisals every year. There were health issues. By shopping around for insurance to numerous top-rated companies, we were able to get standard on one and preferred best on the other. Based on the cash surrender value of the existing life insurance policies available after paying income taxes on the gain, the onetime payment into a second-to-die policy would produce a guaranteed $18 million death benefit for ten years, reducing to $10 million for an additional three years. No premium payments were shown. An ILIT was being implemented to be the owner and beneficiary of the life insurance. To fund the ILIT without making a taxable gift, the insured-grantors entered into a loan DECEMBER 2009
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split-dollar arrangement that was restricted so that the insurance would not be included in the grantors’ estates. The trustee could pay or accrue interest at the trustee’s discretion. The trust was made into a grantor trust using additional provisions apart from the ability to pay life insurance premiums from trust income or assets. The first year lumpsum payment was to be loaned by the grantors. The proper notices were going to be filed by the lenders and the trust according to Reg. 1.787215(d)(5), assuring loan status. A sale to an IDGT of some LLC interests (at a discount) made the most sense for reducing the value of the estate. The issues were seeding the trust and making interest payments. It was decided that the LLC interests were going to be sold to the ILIT at the long-term AFR. The beneficiary of the ILIT was going to guarantee the loan. However, there was insufficient trust income to meet the interest payments, and the grantors needed those payments to maintain their life style because they were giving up the rental income on the properties. What the split-dollar loan to the ILIT with a sale to the ILIT accomplished that a sale to an IDGT for a note could not. While it is possible that the trust beneficiary’s guarantee of the loan might be sufficient to legitimatize the note transaction, using the representations to the IRS according to Reg. 1.787215 gives more substance to this being a real loan. The face amount of the life insurance was substantially more than the value of the LLC interests sold. Additionally, because interest can be paid or accrued on a split-dollar loan, the trustee can make partial interest payments equal to the rental income received and accrue the rest. In that way, the grantors still had the same cash flow as before. Their
Practice Notes A split-dollar loan transaction with a GILIT appears to offer decided advantages compared to a GRAT or IDGT. This is especially true if an ILIT and one of the other strategies are going to be implemented at the same time.
estate received the immediate benefit of having only the value of the note in the estate (based on the discounted value of the LLC interests sold). Because of currently distressed real estate prices, the values are likely to increase. The appreciation will also be out of the grantors’ estates. If one of the properties in the LLC is sold, there will be cash for future premium payments to keep the life insurance in force and potentially pay off the note plus any accrued interest.
Conclusion The split-dollar Regulations provide new tools and offer new possibilities for estate planning. As can be seen above, the loan or sale of an asset, after the cash loan has been made to a GILIT and collateralized by life insurance will enable it to comply with the split-dollar Regulations. If a GRAT transaction is considered with the confidence that the asset will outperform the Section 7520 rate, or the note in a sale to an IDGT is not going to be a SCIN, the split-dollar loan transaction with a GILIT appears to offer decided advantages compared to the other strategies. This is especially true if an ILIT and one of the other strategies are going to be implemented at the same time. Regardless of which strategy is used, careful financial modeling should be done, especially of the loan to the GILIT, because of the number of moving parts. What in concept appears to make sense may look different when creating a real example with the numbers. I S P L I T- D O L L A R I N S U R A N C E
