Premium Financed Life Insurance:
Bridge Financing Case Study
While reviewing his estate plan, John and his advisors determine that John needs a large amount of life insurance coverage (several million dollars) to protect his family and to pay estate taxes. This policy will require the payment of an annual premium of $150,000. While John has ample assets and income to pay the policy premium, he realizes that the cash needed for premiums will be diverted from investments that are presently producing a very high return.
► Irrevocable Life Insurance Trust (ILIT) Protects Policy Proceeds From Estate Tax
John has been advised that the new life insurance should be held in an irrevocable life insurance trust (ILIT), for the benefit of his family, to avoid losing approximately half of the policy proceeds to estate taxes.
► Insurance Policy Premiums Exceed Exclusions and Remaining Exemption
The large premium payments would exceed his annual gift tax exclusions and his remaining gift tax exemption, which would result in his paying gift tax on gifts to the Trust.
Estate Plan Solution
After exploring his options, John decides to implement a special "bridge financing" arrangement for the policy premiums with a commercial lender.
► Policy Funded for 9 Years in 1st Year
The lender will lend cash to the Trustee in the 1st policy year to fund a large premium that is sufficient to carry the policy for 9 policy years without additional premium outlays.
► Trustee Repays Loan and Funds Permanent Guaranteed Death Benefit
At the end of the 9th policy year, the Trustee will repay the premium loan, along with accumulated interest. The Trustee will also pay a "catch-up" premium out-of-pocket at the beginning of the 10th policy year, which will fund a permanent guaranteed death benefit, with no additional premiums required.
► Options to Repay Loan, and Avoid Estate and Gift Taxes
To provide the Trustee with funds to repay the lender and pay the "catch-up" premium, while avoiding gift tax and estate tax, John is considering other asset transfer techniques, including the Grantor Retained Annuity Trust (GRAT) and a Grantor Domestically Owned Trust.
Premium Financed Life Insurance – Bridge Financing Process
Premium Financed Life Insurance Bridge Financing Process Explained
- John creates an Irrevocable Trust for the benefit of his children.
- The Trustee of the Trust is applicant, owner and beneficiary of a life insurance policy insuring John's life.
- The Trustee and a Commercial Lender enter into an agreement under which the Lender will finance the payment of a large premium in the 1st policy year that will be sufficient to carry the policy for 9 years without additional premium outlays. To secure the repayment of the loan, the Trustee collaterally assigns the life insurance policy to the Lender, and the Lender may require that John provide his own personal guarantee and additional collateral.
- The Lender advances funds to the Trustee for payment of the 1st year's premium. The Trustee in turn pays the premium to the insurer. Interest on the loan accumulates until the Lender is repaid at the end of policy year 9.
- The Trustee repays the Lender at the end of policy year 9 from assets held by the Trustee.
- The Trustee pays a "catch-up" premium at the beginning of policy year 10, which is sufficient to support a permanent guaranteed death benefit with no additional premiums required. At John's death, the Trustee receives policy proceeds free of income tax and estate tax, to be held with other assets for the benefit of John's children.
- Permanent Life Insurance Acquired: Needed permanent life insurance protection is acquired by the insured's Irrevocable Trust.
- Asset Growth: Invested assets can remain deployed in high-yield / high-growth investments.
- Policy Proceeds Tax-Free: Policy death proceeds are received free of income tax and estate tax.
- Beneficial for Tax Purposes: Techniques offers significant leverage that can be beneficial for gift tax and estate tax purposes.
- Enhances Other Savings: Life insurance benefit can enhance other estate tax saving techniques, e.g., a GRAT or a Sale to a Grantor Domestically Owned Trust.
- Future Premiums Funded: Repayment of financed premiums and payment of future premiums can be funded through assets already held by the Irrevocable Trust, or through other estate tax saving wealth transfer techniques, e.g., a GRAT or a Sale to a Grantor Domestically Owned Trust.
Generally, Premium Financed Life Insurance is an arrangement in which premiums for a life insurance policy are paid by means of borrowing from a third party lender, such as a bank. To secure the repayment of the premium loans, the policy is collaterally assigned by the policy owner to the lender, and additional collateral may be needed. When the loan is repaid, the lender releases its interest in the policy (and other collateral, if any), leaving the unencumbered policy (or net death proceeds) for the policy owner. An irrevocable trust, created by the insured individual for the benefit of his or her family, serves as the policy owner and designated beneficiary. This arrangement is typically required by the lender, but also results in positioning the life insurance policy to avoid estate taxes, as well as income taxes, at the insured's death.
► Buys Time to Reposition Assets for Eventual Tax-Free Transfer
This is a special type of Premium Financed Life Insurance that we call "Bridge Financing," in which premium financing is used for only a limited period of time. Bridge Financing could be useful, for example, where assets are presently illiquid and unavailable to pay premiums, but are expected to be available for premiums for the longer term. Another example would be where premiums will exceed the insured individual's available annual gift tax exclusions and his or her remaining gift tax exemption is insufficient to shelter the insured's cash gifts to the irrevocable trust from gift tax. In such case, Bridge Financing can be used to "buy time" (usually several years are needed) for the insured to reposition a sufficiently large amount of non-insurance assets in the irrevocable trust, providing the trustee the means to fully fund the life insurance program and allowing the policy proceeds and remaining non-insurance assets to be transferred to the insured's family free of gift tax and estate tax.
► Premium Payment Schedule and Amounts are Key to Technique Success
This scenario illustrates the typical premium structure used in Bridge Financing, although the technique is flexible enough to accommodate the policy owner's particular needs. The premium paid in the first policy year is sufficiently large to carry the policy through 9 policy years without additional premium outlays. At the beginning of policy year 10, the trustee pays a large "catch-up" premium, which will provide guaranteed permanent life insurance coverage without any additional premium outlays.
Key to the success of the technique is arranging for the trustee's repayment of the loan at the end of policy year 9 and payment of the "catch-up" premium at the beginning of policy year 10, without generating gift tax or estate tax. Techniques that could be employed to accomplish these goals would include:
- Use existing assets of the trust;
- Grantor Retained Annuity Trust (GRAT), coordinated with the irrevocable trust — a special wealth transfer technique that allows high-growth assets to be transferred free of gift tax and estate tax.
- Sale to Grantor Domestically Owned Trust — another special wealth transfer technique that allows high-growth assets to be transferred free of gift and estate tax.
Tax Reduction Formulas To Protect Your Future
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