Paying for Large Insurance Premiums Daniel Capobianco, J.D. and Ron Ware, J.D. June 17,

Planning for the high net worth client often requires the use of life insurance as an important component of the plan Today’s Topic © Law Offices of Daniel B. Capobianco 2

Issues to be Addressed What if annual premiums exceed available Crummey Exclusions What if insured (grantor) has used up $1,000,000 lifetime exclusion How to “roll out” of a premium finance plan (or private split dollar plan) What if the insured “can’t afford” the annual premium –Usually this means “I don’t see the value of buying insurance” © Law Offices of Daniel B. Capobianco 3

Universal Life No Lapse Guarantee Whole Life Variable Universal Life Guaranteed VUL Product Design of Life Insurance © Law Offices of Daniel B. Capobianco 4

Policy Considerations Rating of Carrier (insolvency risk) Use of Multiple Carriers to spread risk Use of Multiple Policies © Law Offices of Daniel B. Capobianco 5

Methods of Premium Payment Insured (grantor) gives money to ILIT and the ILIT makes premium payments –Crummey Gifts Insured’s company pays premium directly to the insurance company –Split Dollar Third party loans funds to ILIT and the ILIT makes premium payments –Premium Financing © Law Offices of Daniel B. Capobianco 6

Split Dollar Rules Rules were substantially changed, but the basics remain the same. There are two regimes – The “Economic Benefit” and the “Loan” They are mutually exclusive © Law Offices of Daniel B. Capobianco 7

Split Dollar Rules ECONOMIC BENEFIT -- the life insurance policy is actually owned by the grantor-insured –Policy equity belongs to the insured (and therefore is in his or her estate) –Tax is imposed on the annual term cost (formerly known as “PS 58 cost”) as dictated by the IRS (Table Rate) or the insurer’s alternative term rates. In the case of second-to-die, these amounts must be extrapolated –The Regulations permit the policy to be owned by an irrevocable life insurance trust (“ILIT”) and collaterally assign a security interest in the policy to the grantor- insured, as long as the ILIT does not retain any equity in the policy © Law Offices of Daniel B. Capobianco 8

Split Dollar Rules LOAN REGIME-- the life insurance policy is owned by the ILIT –Policy equity belongs to the ILIT –Tax is imposed on the interest on the premium loans –The interest is measured by the AFR rather than the Table Rate –Loan can be demand, short, mid- or long-term © Law Offices of Daniel B. Capobianco 9

“Private Split Dollar” When Premiums are likely to exceed gift tax exclusion Premiums are Grantor loans Carry IRS interest Can be given to spouse (marital deduction) Can be funded by company © Law Offices of Daniel B. Capobianco 10

Premium Financing An arrangement in which the Irrevocable Trust borrows money from a third-party lender to pay premiums The policy is collaterally assigned to the lender Interest due on the cumulative premium loan can either be paid currently or funded from the policy (i.e., accrued) © Law Offices of Daniel B. Capobianco 11

Premium Financing (Exit Strategy) The loan is repaid and the collateral assignment is released Loan can be repaid on death of the insured out of the death benefits payable Loan can be repaid during life from the CSV of the policy Loan can be repaid from collateralized assets (may be serious gift tax implications) Combination of the above © Law Offices of Daniel B. Capobianco 12

Components of the Solution Large cases will not fit neatly into any one strategy and accordingly two or more strategies are often integrated together to achieve the overall goal As the prospective client goes through the planning process, the value of life insurance becomes obvious and the “cost” of such insurance is viewed as an investment in the family legacy © Law Offices of Daniel B. Capobianco 13

Dynasty Trust © Law Offices of Daniel B. Capobianco It is an irrevocable trust – e.g., an ILIT It is designed to span more than one generation –Does not terminate until the maximum period allowed under the law (e.g., 90 years or more in Massachusetts) –Value of trust assets not included in the estates of children or grandchildren Takes maximum advantage of the $3,500,000 GSTT exemption 14

Dynasty Trust © Law Offices of Daniel B. Capobianco Appreciation of assets will be estate tax free Provides a layer of asset protection from the beneficiaries’ creditors Assets appreciate outside of the transfer tax system Can be the remainder beneficiary of a GRAT 15

Limited Partnership with family members as limited partners and senior members are the general partners Securities and real estate are typical assets of the FLP Donor makes gifts of limited partnership interests to next generation Annual exclusion gifts Lifetime exemption ($1,000,000) Gift FLP interests to trusts rather than to children outright Family Limited Partnership (FLP) © Law Offices of Daniel B. Capobianco 16

–Valuation discounts are often taken: Lack of marketability Lack of management control (minority interest) –Retention of general partnership interest allows senior generation to retain control while transferring future appreciation out of taxable estate. FLP Basics © Law Offices of Daniel B. Capobianco 17

It is an irrevocable trust – e.g., an ILIT Contains specific language intended to “violate” income tax rules, yet NOT violate the estate tax rules –Grantor is taxed on the income of the trust –Value of trust assets is not included in grantor’s estate This is both a “freezing” technique And an “asset burn” technique Intentionally Defective Grantor Trust © Law Offices of Daniel B. Capobianco 18

Grantor cannot be a beneficiary or trustee Spouse & children are beneficiaries Requires careful drafting Intentionally Defective Grantor Trust © Law Offices of Daniel B. Capobianco 19

Sale to trust –Business owner receives cash and installment note for balance of the selling price –No capital gain on sale Interest received on note is not taxable Installment obligation is paid through income received by trust Installment Note –Self-amortizing –Demand note –Interest-only balloon note Intentionally Defective Grantor Trust © Law Offices of Daniel B. Capobianco 20

Grantor Retained Annuity Trust A GRAT is a split interest trust in which a grantor retains the lead annuity interest, while transferring the remainder interest to non-charitable beneficiaries (e.g., children) A GRAT is used to transfer substantial assets out of the estate at zero gift tax cost and without using any applicable exclusion amount © Law Offices of Daniel B. Capobianco 21

Grantor Retained Annuity Trust Whenever the total return on the trust assets exceeds the applicable IRC §7520 rate, property will pass tax free to the remainder beneficiaries AFR as of June 2009 is 2.8% An effective way to GSTT-proof a dynasty trust without incurring additional gift tax ($3,500,000 GST exemption, but only a $1,000,000 lifetime gift exemption) GST allocation made at GRAT termination © Law Offices of Daniel B. Capobianco 22

GRAT Basics The amount of the taxable gift is the value of the property transferred to the trust minus the present value of the retained annuity interest. By setting the present value of the annuity stream equal to the full value of the property initially transferred to the GRAT, the amount of the taxable gift is reduced to zero (a “zeroed-out” GRAT) © Law Offices of Daniel B. Capobianco 23

GRAT Basics At the end of the GRAT term, any property remaining in the trust will pass to the remainder beneficiaries with no further tax consequences If the total return the trust assets actually produce is equal to or less than the rate assumed by the IRS (IRC §7520 rate) there will be nothing left in the trust to pass to the remainder beneficiaries at the end of the GRAT term If the actual total return substantially exceeds the IRC §7520 rate, however, very large amounts of property will be in the trust to pass to the remainder beneficiaries tax free © Law Offices of Daniel B. Capobianco 24

GRAT Basics Calculation of the annuity & gift –Term of the GRAT –AFR for the month of GRAT formation –FMV of asset transferred into the GRAT Where the FMV of the asset can be legitimately discounted (e.g., FLP interest or closely held stock) the tax efficiency of the GRAT is substantially magnified © Law Offices of Daniel B. Capobianco 25

GRAT Basics The grantor is responsible for the income tax on the GRAT’s taxable income The grantor may be reimbursed by the GRAT for any income tax paid on income in excess of the annuity amount If the grantor is not reimbursed by the GRAT, then the taxes paid by the grantor are in effect an additional non-taxable “gift” to the remainder beneficiaries © Law Offices of Daniel B. Capobianco 26

GRAT Basics In the event earnings of the GRAT are not enough to satisfy the required annuity amount, the GRAT could also distribute GRAT property back to the grantor with no income tax effect Although earnings are more desirable, the distribution of GRAT assets continues to freeze growth at the IRC §7520 rate for the property remaining within the GRAT. If GRAT property is paid out in-kind, the grantor could “Re-GRAT” the in-kind distribution to a new GRAT © Law Offices of Daniel B. Capobianco 27

GRAT Example $3,000,000 FMV asset transferred to GRAT. AFR is 2.8%. Term = 10 years. Annual annuity = $348,112 © Law Offices of Daniel B. Capobianco 28

GRAT Example What if rate of return were 6% © Law Offices of Daniel B. Capobianco 29

GRAT Example If the asset could be discounted 33% -- even if there were little or no rate of return © Law Offices of Daniel B. Capobianco 30

GRAT Example What if rate of return were 6% © Law Offices of Daniel B. Capobianco 31

ILIT Premiums are financed –Traditional split dollar (paid by company) –Private (paid by the insured) –Third Party Financing (financial institution) –both split dollar & §7872 regulations apply Create a GRAT GRAT rolls out into ILIT at termination Proceeds from GRAT used to pay off split dollar loan GRAT – Split Dollar Combo © Law Offices of Daniel B. Capobianco 32

Example Age $2,000,000 whole life; premium $100,000 for 10 years. Estate is taxable. Insured has used up his $1 million gift tax exemption. How do we pay the premium? Insured contributes $100,000 per year to ILIT Annual contribution treated as split dollar loan Insured Forms FLP with $3 million of assets. Discounted value is $2 million 33

Example No growth expected - but 3% earned each year Contribute FLP to a 10 year “Zero-GRAT” GRAT calculations are based on the discounted value After 10 year term, $1.3 million is transferred to ILIT (allocate $1.3 million GST exemption at this time) –Free of gift taxes Money is then used to repay the split dollar loan plus interest (almost $1.23 million) 34

Family Trust $2,500,000 ($3,500,000 less $1,000,000 gifted to ILIT) Family Trust $2,500,000 ($3,500,000 less $1,000,000 gifted to ILIT) QTIP Trust (for Cynthia) Minimum amount required to reduce estate to $0 QTIP Trust (for Cynthia) Minimum amount required to reduce estate to $0 Life Insurance Trust Insert additional special provisions for IDGT to permit ownership of additional assets (initially funded with $1,000,000) Life Insurance Trust Insert additional special provisions for IDGT to permit ownership of additional assets (initially funded with $1,000,000) Sam Smith Revocable Trust Sam Smith Revocable Trust Family Dynasty Trust Mary, Mike and Lisa & their children/descendants Trust will be divided into 3 unique trusts for each child Each child can be a Co-Trustee Family Dynasty Trust Mary, Mike and Lisa & their children/descendants Trust will be divided into 3 unique trusts for each child Each child can be a Co-Trustee © Law Offices of Daniel B. Capobianco Integrated Estate Plan with Multiple Tax Strategies Sam Smith GRAT (on termination flows to ILIT if Sam alive / to RLT if Sam dies) Sam Smith GRAT (on termination flows to ILIT if Sam alive / to RLT if Sam dies) Sam Smith FLP Holds stock, real estate, etc. Sam Smith FLP Holds stock, real estate, etc. BY SALE AND/OR GIFT directly to the ILIT or re-route through GRAT SCIN and /or interest- only Promissory Note 35

Gift stock to GRAT for specified term of years (5, 10, 15). Beneficiary is an Irrevocable Trust f/b/o Wife, children & descendants At termination of GRAT, cash, stock and/or FLP interest is distributed to Trust with no further gift tax costs Sam Smith FLP and/or S Corporation Sam Smith makes gift of FLP interests and/or S Corp. stock (at a discount) ILIT – IDGT – Dynasty for benefit of Wife, children & descendants of Sam Smith ILIT – IDGT – Dynasty for benefit of Wife, children & descendants of Sam Smith Any “excess” tax incurred by Sam Smith can be reimbursed by GRAT Cash distributions based on ownership transferred GRAT pays annuity to Sam Smith based upon existing IRS interest rate. Cash to make payment is received from Sam Smith Companies GRAT pays annuity to Sam Smith based upon existing IRS interest rate. Cash to make payment is received from Sam Smith Companies GRAT to Transfer S Corp. and/or FLP © Law Offices of Daniel B. Capobianco Cash received from GRAT is used to “loan” money to ILIT pay insurance premiums 36

Gift of $100,000 to Irrevocable Trust for children/grandchildren. File gift tax return to allocate GST Sale of Doe Sales Co common stock for 20-year term promissory note. Interest payable at AFR of 3.88% Sam Smith Companies Sam Smith gift/sale of common stock Sam Smith gift/sale of common stock Sam Smith Family “Defective” Dynasty Trust for benefit of children & descendants of Sam Smith Sam Smith Family “Defective” Dynasty Trust for benefit of children & descendants of Sam Smith Interest paid annually to cover tax payments Principal payable on demand (as needed) Distributions of cash Based on the value of the stock sold ($2,000,000), and the monthly AFR (3.88% in June 2009), the annual interest payment will be $77,600, which will be sufficient to pay income taxes on DSC earnings. This interest is not taxable to Sam Smith and not deductible by the trust since the trust is a “grantor trust.” Alternatives are a private annuity for life ($115,652 per year) or a SCIN over 20 years ($146,805 per year) or an interest-only SCIN ($86,991 per year). Sam Smith’s income tax liability is the same before and after the transaction. Trust can pay down promissory note “on demand” for additional cash flow to Sam Smith. Sale to Defective Grantor Trust 37