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FINANCIAL INSIDER

Your Large Life Insurance Premium Need Not


Come Out of Your Own Pocket
It is Possible to Get Tax Free Money to Pay Your Estate Taxes
Without Impacting Your Working Cash Flow!
By Dennis J. Branconier, CLU

M
r. and Mrs. Successful Business Owners (we’ll call their life expectancy of about 20 years, it’s not hard to imagine
them Mr. and Mrs. Subo), now in their mid-60s, have the tax liability getting out of hand (5% growth would add an-
recognized that it’s time to make some critical deci- other $5,000,000 to the tax bill in 15 years under the 2008 tax
sions that affect both business and family. They have built a schedule).
solid and growing manufacturing company over the past 28 Space restrictions prevent the author from discussing strategies
years and wish to keep the family business thriving into the to reduce and/or freeze the size of the taxable estate. Those
next generation. Of their three children, their daughter and one techniques can and should be applied as fully and reasonably
son in their early 30s are active in the business and have shown as possible with the help of qualified tax and legal advisors.
both competence and interest in continuing to grow the com- Whatever is left is subject to estate taxes under two conditions:
pany. The other son has developed his career in education and
is unlikely to participate in the family business. Mom and Dad 1. The government accepts only cash.
want to treat all three equally as they address their estate plan- 2. The government expects to receive cash within nine
ning goals for the present and future. months of death (for a married couple, typically this
About five years ago, in a joint meeting with their estate plan- means the second death).
ning attorney and CPA, it was clear that the Subos’ success was
resulting in the rapid growth of their assets, with far more ex- This presents a particularly glaring problem if the estate’s as-
pected. At that time, their net worth was about $5 million, com- sets are largely illiquid, as is the case for many business owners
prised almost entirely of their business. Their advisors recom- and real estate investors.
mended transferring a minority interest, as large as they were
comfortable with, to an irrevocable trust for the three children. Create Needed Liquidity Double Tax-Free
In that way, all future growth of those assets would occur out- Life insurance is the only method authorized by the Internal
side of the Subos’ estate and therefore avoid estate taxes upon Revenue Code to create income tax free dollars upon death.
death. When structured properly, it can also avoid estate taxes. That’s
Though this made sense economically, Mom and Dad felt why it is such a popular tool for addressing the estate tax li-
uncertain and awkward about giving up some control of the ability. However, when the premiums are substantial, several
company. In addition, though the children were showing good considerations come into play:
promise in their young adulthood, the parents were concerned
that giving too much to them might be a curse rather than a • The estate owner might not have the cash flow or liquid
blessing. They decided to follow their advisor’s recommendation reserves to cover the entire premium.
and gift a portion of their company stock to a children’s trust, • The estate owner might rather have use of the money for
but kept it conservative by transferring 20% of their interest. The business or other investment opportunities.
appraised value of the company at the time was $4,000,000, • Gifting of the premium dollars to an insurance trust (or
but the 20% interest was worth less than $800,000 due to lack the children outright) might exceed the annual gift tax ex-
of marketability and lack of control. So the value reported on emptions ($12,000 per donor per beneficiary in 2008) and
the Subos’ gift tax return was actually less than $600,000 as therefore incur a gift tax liability or force the use of a por-
calculated by a professional appraiser (today that stock is worth tion of the lifetime gift tax exemptions ($1,000,000 per per-
$2,200,000, which translates into an estate tax savings of about son). Though life insurance can for many reasons warrant
$1,000,000). the use of these exemptions, most planners want to try to
Now that this strategy is “old history” for them and the chil- avoid using them if other avenues exist.
dren are five years older and more mature, the Subos wish they
had done more at the time, but they are now focused on how Financing the Premiums Through Private Sources
to make the most of the next steps of their succession plan. The For high net worth individuals, the money needed for life in-
company is now worth $11,000,000 and counting (their 80% surance premiums almost always exists; it’s just in a different
worth almost $9,000,000), with their net worth approaching place than where it needs to be. There are three common sourc-
$12,000,000. Though they are still in good health, they do not es of private loans as well as several commercial lenders who
fight the realization that the day will come when they will no participate in premium financing arrangements.
longer be here. If they were gone today, their estate tax liability
would be nearly $4,000,000. With even modest growth over Continued on Other Side

Reprinted With Permission From Business Insider Magazine’s Third Issue of 2008

M Advisory Group - Reprint Maste1 1 11/6/2008 10:58:57 AM


FINANCIAL INSIDER

Continued From Other Side


all the money remains within the family system. For example,
Typically a private loan to the children assume a $10,000,000 policy calls for an annual premium of
or their trust comes from: $150,000. If the premium loan grows at 5% interest, it would
accrue to approximately $5,500,000 in 21 years (the actuarial
• The estate owner’s personal funds. life expectancy for two 65-year-olds). The trust would use death
• The family business. proceeds to first pay back the loan, leaving $4,500,000 for es-
• Another family member. tate liquidity. But the other $5,500,000 is still within the family’s
economic control, whether it be in an investment account or a
Private loans are often attractive because the lender is more business. The bottom line result is that 4,500,000 new dollars
open and friendly to the cause, the interest rates are relatively
are introduced into the family’s control. This is particularly criti-
reasonable, and the insurance proceeds remain within control
cal for the type of situation the Subos have, in which liquidity
of the family system. Loans are arranged in legitimate, fully dis-
is needed not only for estate taxes, but also may be needed to
closed terms with interest rates declared by the IRS for such
loans (the “Applicable Federal Rate” or “AFR”). Care must be “equalize” the estate for the heirs who will remain in the busi-
taken so that nothing about the arrangement could cause inci- ness and those who will not.
dents of ownership of the policy on the part of the estate owner,
as that would bring the insurance proceeds into the individual’s Having an Exit Strategy
taxable estate. The attorney who is drafting the estate planning It is more prudent to pay annual interest in whole or in part (for
documents can keep you out of trouble in this area. example, to put a ceiling on the accrual) so that the loan bal-
ance does not grow to consume all the death proceeds. Indeed,
Financing the Premiums Through Commercial there are scenarios in which it could actually grow larger than
Third Party Sources the death benefit. So proper planning must be done. Though
many premium financing arrangements assume that death is the
For situations in which private loans are either not available only exit strategy, it is better to employ the premium financing
or not desirable, there are third party commercial lenders who method when there is a definable exit strategy. Two common
specialize in premium finance programs (this is not “Stranger scenarios will illustrate:
Originated Life Insurance” that has been heavily promoted
through seminars and direct marketing and relies heavily on 1. Fund the insurance sufficiently for the cash values to grow
third party financing). Loan underwriting will be necessary. In-
over time, such that they can eventually be withdrawn to
terest rates are usually based on “prime plus” or “LIBOR plus”
pay back the loan without collapsing the insurance cover-
formulas and thus carry interest rate risk into the arrangement.
age.
Interest is generally not deductible.
Regarding collateral requirements, commercial lenders not 2. Fund the trust with other assets that are anticipated to ap-
surprisingly want the premium loan to be fully collateralized. preciate over time and can be used to repay the loan. Fund-
The cash value of the policy will provide some portion. If the ing the trust can be done in a way that triggers little or no
insurance trust does not own assets that can be allocated for this gift tax (when done in conjunction with special trusts that
purpose, a personal guarantee may be required. are commonly and legitimately used in this circumstance).
In any case, whether financing is private or commercial, care
must be taken when posting collateral to ensure that the client The Proper Use of Life Insurance
is not deemed to have incidents of ownership in the insurance A skilled life insurance professional will work with the family’s
policy. Again, a qualified attorney will make sure this is handled other advisors to construct an effective estate plan. Again, efforts
properly. will first focus on reducing or even eliminating the estate tax.
But the taxes that cannot be avoided need to be paid somehow.
Interest Payments Are a Fraction of the Premium Insurance delivers a block of income tax free dollars precisely
One of the great advantages of premium financing is that at the moment they are needed. The premium and the source of
instead of paying the annual premium from cash flow, an in- premium represent the solution, not the problem.<
dividual can pay only the interest on the borrowed premium. Dennis J. Branconier, CLU, is Vice President of M Advisory Group in Torrance.
Not only are the annual payments a fraction of the premium, For affluent clients and entrepreneurial companies, the firm provides wealth
but they are typically small enough to fit within the annual gift preservation and executive benefit planning, insurance expertise and retire-
tax exemption limits ($12,000 per donor per beneficiary). If a ment plan consulting. He is past president of the South Bay Estate Planning
portion of the lifetime gift tax exemptions must be used in the Council and active in several local community organizations. Dennis can be
family’s estate plan, the key is to use them wherever the greatest reached at (310) 530-5525 or dennis@madvisory.com.
This material is not intended to present advice on legal or tax matters. Please
impact can be made. Life insurance very often offers that op-
consult with your attorney or tax advisor, as applicable.
portunity more than any other asset.
Securities and investment advisory services offered through M Holdings
It is also possible to accrue interest, though doing so is rare- Securities, Inc., a registered Broker/Dealer and Investment Advisor, Member
ly available with commercial loans. It is more common with FINRA/SIPC.
private intra-family loans, not only because the lender is not Services provided through Cal-Surance Benefit Plans, Inc. Both Cal-Surance
subject to regulatory conditions, but also because ultimately and M Advisory Group are independently owned and operated.

Reprinted With Permission From Business Insider Magazine’s Third Issue of 2008

M Advisory Group - Reprint Maste2 2 11/6/2008 10:58:58 AM

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