LIFE INSURANCE PREMIUM FINANCING PANEL DISCUSSION

Transcription

1 LIFE INSURANCE PREMIUM FINANCING PANEL DISCUSSION Dennis H. Roberts, CLU American General Matt Davis Oakmont Group Scott Schepps, J.D., CPA Fizer Beck HOUSTON BUSINESS AND ESTATE PLANNING FORUM April 23, 2009 I. Premium Financing Purposes a. Premium Financing involves the borrowing of funds by the owner of a life insurance policy to enable such owner to make the required premium payments due on such policy. b. The owner or insured may lack the necessary cash flow to satisfy premium requirements. c. The owner or insured may desire not to sell investments to create liquidity d. Gift tax implications may make it tax inefficient for the insured to gift the necessary funds to an ILIT. II. Structured/Promoted Premium Financing Transactions a. Historically, in addition to securing a premium financing loan with the policy cash value and death benefits, the Policyowner was typically required to guarantee the debt and put up additional assets as collateral or purchase a letter of credit. Some structured/promoted transactions were created that involved nonrecourse loans. b. LILAC Transaction for Charitable Desires i. Life Insurance Life Annuity Combination i iv. Pools of Insureds Grouped Together Annuity Company life expectancies were shorter than Life Insurance life expectancies Differences created arbitrage that allowed SPIA distributions to cover premiums and provide investors an annual return v. Insureds simply donated insurability vi. v Insureds allowed to choose charity to receive 5% of death benefit; balance went to pay principal back to investors Excise tax of 35% was proposed in a bill that never passed; regardless, this forced all structured transactions to prohibit the use of charity (some

2 flexibility with respect to charitable beneficiaries has seemingly made its way back into the structured transactions within the last year) c. Focus Switched from Charitable Beneficiaries to Individuals i. 3 General Structures i 1. Non-recourse loan with option at end of term to sell policy, give policy to lender as full satisfaction of debt, refinance the loan or retain policy by paying off lender (some plans used to include upfront money to insured or beneficiary) 2. Percentage of face value upfront with no sharing in death benefit 3. Some percentage of death benefit, varying based on year of death 2 year non-recourse loan transactions (now often 5-10 year loans) 1. Policy typically owned by irrevocable trust (trust agreement usually provided by lender) of which a bank is the trustee 2. Initially, the loans were structured completely as non-recourse loans with respect to the policyowner with recourse only against the policy. Now, the transactions require a personal guarantee by the insured, a letter of credit or posting of some collateral. 3. Loan proceeds were used to cover origination fee, trustee fee and premiums for 2 years. 4. Trust protector would typically be the one to provide direction to trustee as to desired course of action at end of 2 years. 5. If policy is sold on secondary market, any gain should be taxed as capital gain (ordinary income to extent cash surrender value exceeds basis). Lender paid principal balance plus interest. Interest rates can be high (12% - 14%). Interest is non-deductible. Basis in policy should be equal to premiums paid plus costs in purchasing policy. However, the IRS has ruled in a private ruling (PLR ) that basis is reduced for premiums allocable to pure insurance protection when a policy is sold to a viatical company. 6. No further interest in policy is held by the insured or his or her beneficiaries after it is sold. Upfront money 1. Typically, insured received 3% of the policy face value by allowing the investor group to own a policy on his life 2. Due to favorable insurance interest laws in Texas (see TX Insurance Code ), the transaction is permitted in our state. However, the insurance industry in general and specifically the insurance companies were opposed to policies be used in these 2

3 iv. types of transactions. Most insurance companies developed supplements to their applications to avoid their policies from being used in such transactions. 3. Ordinary income tax on funds received by the insured. 4. No further interest in policy is held by the insured or his or her beneficiaries after it is sold. Share of Death Benefit 1. Policy typically owned by irrevocable trust (trust agreement provided by promoter) of which a bank is the trustee 2. Non-recourse loan from lender to owner 3. Loan proceeds used to cover origination fee, trustee fee and premiums for lifetime of insured 4. Agreement provides for beneficiaries of trust to receive some percentage of the death benefit a. Percentage decreases as insured lives longer (more premiums paid) b. Usually no lower than 5% of death benefit III. IV. Ideal Insured for Structured Transactions (as initially designed) a. Between ages 70 and 90 b. Good health (standard or higher rating by insurance companies) c. High net worth relative to existing insurance d. The insured should have a desire for additional insurance, but was not always the case. Concerns with Transactions from the Viewpoint of the Insurance Industry a. Risk to 101 tax-free nature of death benefits b. Risk to 72 tax deferred build up inside policy c. Increased death claims i. Not factored into pricing of policies by the insurance companies. i Assumption that a significant percentage of policies will lapse or be cashed in was built into the pricing. Investors in policies presumably will hold policies until maturity and not allow a lapse. 3

4 iv. Re-insurance companies ultimate reaction no more V. Concerns with Structured Transactions from Insured s Viewpoint a. Insurance Capacity used up b. Mafia Factor - Third Party to Benefit from Insured s death (not true in all cases) c. Debt Forgiveness (2 year and Shared Death Benefit Deals) i. If no market for the policy at the end of 2 years and policy transferred to lender, loan is deemed paid off 1. Is this debt forgiveness income to Owner? 2. General rules on non-recourse financing provide that if collateral transferred in satisfaction of debt, treated as if the collateral was sold for the principal amount of the debt (see Commissioner v. Tufts, 83-1 USTC 9328). 3. Thus, gain should only be recognized if principal amount of debt exceeds basis in policy (should be close to equal without accrued interest component). However, principal may include interest accrued over the loan term that is rolled into principal. 4. To avoid income tax risk to the insured, the trust/policyowner should be structured as a non-grantor trust. In a Shared Death Benefit Transaction, if insured lives a long time, accrued interest plus principal could exceed lender s share of the policy death benefits. 1. If general non-recourse rules apply, then should be no concern, subject to accrued interest being rolled into principal over the loan term. 2. Trust/policyowner should be structured as a non-grantor trust to avoid risk of income being taxed to the grantor/insured. d. Capital Gain Amount on Sale for Profit i. Basis in policy should be equal to premiums paid plus costs incurred in purchasing policy (see IRC 72(e)(6)). i iv. However, as noted above, the IRS has ruled privately (PLR ) that the basis must be reduced to the extent that the premiums are allocable to the cost of insurance protection when a policy is sold to a viatical company. Interest payments do not increase income tax basis. No authority confirming that profit realized on sale is capital gain. 4

5 e. Documents are prepared and approved by the counsel for lenders, investors and promoters. Most cases, no changes can be made to documents (other than identification of the trust beneficiary(ies), which can often be another trust (may be necessary for estate tax reasons). Representations and warranties must be read carefully to confirm no liability risk to insured or insured s family members. Oftentimes, the lender (who may also be a potential buyer of the policy on the life settlement side) has some control over the life settlement process. The life insurance companies have also become parties to the structures because the insurance companies only want their policies used in pre-approved transactions that are legitimate life insurance transactions. VI. Non-Structured/Customized Premium Financing Arrangements a. Generally, in the personal estate planning context, premium financing arrangements are used to reduce/avoid the gift tax consequences of making large gifts to an ILIT. i. Annual exclusion amounts ($13,000 per donee per donor for year 2009) are either being utilized with other transfers by the insured or the anticipated premiums are substantially greater than the available annual exclusions. Lifetime gift tax exemption (fixed at $1,000,000 under current law) will be used and gift tax will become due if funds are not transferred to the ILIT in a manner other than gifting. b. In the premium financing context, the ILIT receives funds via loans from the insured or some other party. c. To avoid any implied gifts, interest charged must meet the minimum required rates under section 7872 (which refers to section 1274) of the Internal Revenue Code. d. To avoid any risk of application of the original issue discount ( OID ) rules under section 163 of the Internal Revenue Code, interest should be payable on an annual basis. e. Split-dollar rules (see Reg and/or Reg ) will most likely apply to a premium financing arrangement. Loan regime will most likely be applicable. However, the loan can be structured to use the economic benefit regime (generally, under the split-dollar agreement, the lender would have to own the greater of cash value or premiums paid). f. Exit strategies should be planned/discussed i. Over time, the interest payments could give rise to gift tax consequences if funded with gifts. Alternatively, if the interest payments are funded with additional loans, the amount due to the lender (often the insured) can 5

6 i iv. approach an amount equal to the face value of the policy, thus defeating the purpose of the ILIT. One option forgive debt at some point in future and suffer gift tax consequences. Second option consider life settlement of policy. Third option create structure for sufficient funds to pass into ILIT to enable the ILIT to pay off the loan balance. VII. VIII. Life Settlements Historically a. Viatical settlements were created in mid 1980s as the incidence of AIDS cases increased in the U.S. b. Viatical settlements allowed AIDS patients to cover expenses of medication and treatment by selling insurance policies prior to death and realizing a percentage of the policy face value. c. Investors who purchased policies through viatical settlements initially made significant returns on their investments until the AIDS treatments began to extend the patients life expectancies (investors effectively overpaid for the policies) d. Mid 1990s, some innovative people determined that a large number of insurance policies were either lapsing or being surrendered to insurance companies for the cash surrender value due to lapsing of the need for the insurance or an inability to continue to make premium payments (these innovators realized that the true value of these policies exceeded the CSV similar to the viatical situation). e. Institutional investors were made aware of the opportunity to purchase life insurance policies and the secondary market for policies was born. f. There is now at least one U.S. public company (Life Partners, Inc.) that is a life settlement company. Design a Plan to Provide Funding to ILIT to Payoff Loan a. Contrary to Structured/Promoted Plans, a grantor trust typically provides the best result in the private split-dollar context. i. Transactions between the insured/grantor and ILIT (e.g. interest payments) can be carried out without income tax consequences. Grantor pays income tax on income generated inside the ILIT. b. Transfer to ILIT via gift or sale discounted assets to create cash flow for the ILIT. i. Allows ILIT to have its own source of cash to make a portion or all of the required premium payments. 6

7 i Insured/grantor continues to pay income tax on the income generated by such assets. If ILIT is a grantor trust, then assets can be sold by grantor/insured to the ILIT without income tax consequences. c. Create one or more GRATs that designate the ILIT as the remainder beneficiary. i. ILIT can use funds/assets from GRAT to pay off loan from the lender and pay future premiums on the policy. i ILIT could use funds/assets from GRAT to purchase discounted assets from the insured/grantor. Caution regarding GST issues. 1. GST exemption cannot be allocated to the GRAT until the end of the term. 2. Consider formula allocation of GRAT remainder between GST Exempt ILIT and GST Non-Exempt ILIT (may require division of ILIT subsequent to GRAT term). d. Structure the policy in a manner that enhances the success rate of the plan. e. Consider using multiple policies instead of one large policy. One policy could be sold via a life settlement to provide funds to pay off debt and pay premiums on other policies. 7