Life Insurance: Your blueprint for Wealth Transfer Planning. Private Financing Producer Guide. For agent use only. Not for public distribution.

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1 Life Insurance: Your blueprint for Wealth Transfer Planning Private Financing Producer Guide

2 Private Financing Most people don t object to owning life insurance, they just object to paying the premiums. One way to pay for life insurance is to borrow the premium dollars from someone else. Older family members who have discretionary capital are often willing to make loans so their children and grandchildren can receive life insurance death benefits. These loan arrangements are often referred to as private financing. This Guide is a general discussion of the concepts and mechanics of private financing. It contains hypothetical scenarios and is not intended to apply to any specific individual situation. The Voya Life Companies do not give tax or legal advice. Customers should consult their own professional advisors. Private Financing fundamentals What is Private Financing? Private financing is an agreement between two parties in which one party (the lender) lends the other party (the borrower) the funds needed to pay the premiums on a life insurance policy. Private financing arrangements do not involve compensation and are outside the scope of employment. A discussion of employment-related loans to pay life insurance premiums can be found in the Endorsement Split Dollar Producer Guide (order #153620). Private financing arrangements are usually between two family members of different generations or between a family member and a trust he/she created for the benefit of his/her children and/or grandchildren. The arrangement can also be between individuals who have a personal relationship but are not related by blood or marriage. Unless otherwise indicated, this guide will assume the private financing arrangement is between a parent as the lender and an Irrevocable Life Insurance Trust (ILIT) the parent has created to benefit his/her children as the borrower. The split dollar regulations finalized in 2003 permit the parties to structure an arrangement so that it will be subject to either the economic benefit regime or the loan regime. Private financing arrangements use the loan regime. They are also sometimes referred to as private loan arrangements or split dollar loans. In them the borrower purchases the life insurance policy and pays premiums with loans received from the lender. The borrower is responsible for paying the annual interest on the loan balance and eventually must repay the loans. The policy may be assigned back to the lender as security for repayment. Some advantages of Private Financing Using private financing to pay life insurance premiums has a number of potential advantages both to the parent and to the children, some of which include: To the parent: Loans can be leveraged into income tax free life insurance death benefits Ability to have some control of the policy without actually owning it Part of the death benefits may be estate tax free Loans aren t considered gifts and therefore aren t subject to limits of the gift tax lifetime exemption or annual exclusion Retain ability to recover amounts loaned to pay premiums To children (as beneficiaries of the ILIT): Get the benefits of life insurance on parent without having to pay premiums Children s portion of death benefits are generally income and estate tax free Some disadvantages of Private Financing The advantages of private financing come with some tradeoffs. There are some potential disadvantages to private financing, including: To parent/lender: Loan balance is part of taxable estate at death Gifts may be needed to provide the borrower the funds to pay the interest Income taxes may be due on interest received and deemed interest Administration is required to keep track of the loans and the interest To child/ilit/borrower: Interest must be paid or accounted for annually No certainty of receiving benefits because the parent may end the arrangement Possibility of personal liability if loans must be repaid and policy cash values are less than loan balance. (Especially in the early years, policy value is not likely to be sufficient to cover the loan balance. Any projections of future values are hypothetical and not guaranteed.) Risk of increasing interest costs if interest rates rise

3 How it works Private financing can be similar to loan transactions that individuals may already be using (home mortgage, car loan, home equity loan or a credit card balance). Here are the steps in a private financing arrangement: Life Insurance Company 1. Policy 4. Premium 7. Death Benefits Irrevocable Life Insurance Trust (ILIT) for Children 2. Loan 3. Note & Assignment 5. Interest 6. Loan Repayment Parent 1. ILIT applies for a life insurance policy on parent s life 2. Parent agrees to lend the ILIT trustee cash to pay premiums 3. ILIT trustee signs a note and assigns the policy to the parent 4. ILIT trustee uses loan proceeds to pay the policy premium 5. ILIT trustee pays loan interest annually under the note 6. At the insured s death a portion of the death benefits are used to repay the outstanding loan balance 7. The ILIT receives the remaining death benefits. Who are the best prospects? Private financing arrangements make sense for people who want to use life insurance to increase their ability to transfer wealth to younger family members. It may be particularly attractive to clients who: Want the flexibility to recover the dollars they ve supplied to pay premiums Are concerned that federal or state tax laws may change Have used up or don t want to use either their lifetime gift tax exemption and/or their gift tax annual exclusions. Two types of loans demand loans and term loans Loans are either payable at a specific time or upon the parent s (lender s) demand. If a repayment date is specified in the note, the loan will be treated as a term loan (provided the parent does not have the right to demand repayment before the term ends). Term loans fall into three categories: short term (lasting not more than three years), medium term (lasting more than three years but not more than nine years) and long term (lasting more than nine years). If a loan does not have a specific repayment date, but by its terms does not have to be repaid until the insured s death, it is treated as a term loan. Its duration is determined by the insured s life expectancy on the date the note is executed. All other loans that do not have a specific repayment date are treated as demand loans. Documenting Private Financing arrangements Every private financing loan transaction should be in writing and a copy kept in each participant s legal and financial records. A client s attorney may be called upon to draft as many as three documents to put the arrangement in place, including: 1. The agreement for a loan is a document called a note. A note is the contract between the lender and the borrower promising to lend a specific sum of money at a specified interest rate for a stated period of time. A new note is needed each time there is a new premium loan. 2. If the life insurance policy is to serve as security for repayment of the loan, a collateral assignment from the borrower to the lender should be drafted and filed with the insurer. 3. It is not unusual for the lender to want to control how the life insurance policy is managed without subjecting the death benefits to estate taxes. When this is the case, the lender may create an ILIT to own the policy. The trustee manages the policy under the directions in the trust and pays out benefits as it directs. 2

4 Private Financing arrangements are usually a series of loans The premiums for most life insurance policies are paid in a series of annual installments rather than in a lump sum. In private financing, each premium payment will generally constitute a new loan. Thus, each time a new premium is due, the parties will have to determine if the new loan should be a demand loan or a term loan. While each demand loan is distinct structurally, a new demand loan can be added to previous demand loans to make a single demand loan pool for accounting purposes. In other words, all demand loans can be added together and accounted for as a single sum. They may even be renegotiated into term loans at any time. Term loans, however, generally should not be pooled for administrative purposes. Each term loan usually stands on its own and must be separately handled until its term ends. This example is shown for illustrative purposes only. Jane Jones wants to create an ILIT for her children. She wants to fund the ILIT with loans rather than gifts. Jane will make annual $20,000 loans to the ILIT over a ten-year period. At the end of ten years the ILIT will owe Jane $200,000. Because the type and interest rate of each loan is determined in the year in which it is made, some of the loans will be demand loans and others will be term loans. The demand loans are pooled together. At the end of the tenth year, there are five loans outstanding: one $20,000 long-term loan at 5 percent interest (year #1), three $20,000 mid-term loans at 4 percent, 4 percent and 5 percent (years 4, 5, & 6) and a $120,000 demand loan with a current interest rate determined by the IRS Short-Term blended interest rate. Loan #1 Term 5% Loan #2 Demand Loan #4 Term 4% Loan #5 Term 4% Loan #6 Term 5% Demand Loan Pool $120,000 Loan #3 Demand Loan #7 Demand Loan #8 Demand Loan #9 Demand Loan #10 Demand Paying the interest on the loan balance As long as interest is due on some or all of the notes in a private financing transaction, the parties will have to plan for how that interest will be paid. There are several options. They include: 3 The ILIT (borrower) pays the interest from other assets The parent makes gifts to the ILIT so it has the ability to pay the interest The ILIT can withdraw or borrow policy cash values to pay the interest By mutual agreement, the interest can be accrued (added to the loan principal). Repaying the loans A key part of the loan arrangement is retiring the loan balance. There may be a number of alternatives for retiring the loan balance. They include: Death benefits The loan arrangement can stay in place until the insured s death; part of the death benefit can be used to pay back the outstanding loan balance. Interest continues to be due until the loan is retired. Other ILIT resources The ILIT may repay the loan balance from assets other than the life insurance policy. Of course, this assumes the ILIT has other assets available to repay part or all of the loan balance. Policy cash values If policy cash values exceed the loan balance, the ILIT trustee has the option of withdrawing and/or borrowing policy cash values to pay back the loan balance. This approach may threaten the policy s long term ability to remain in force. Removing cash values will reduce death benefits and weaken its financial foundation and may eventually cause the policy to lapse. (Especially in the early years, policy value is not likely to be sufficient to cover the loan balance. Any projections of future values are hypothetical and not guaranteed.) A gift from the parent There may come a time when the parent decides he/she will be financially secure without the assets represented by the loan balance. If so, he/she may forgive all or part of the ILIT s repayment obligation. This is a taxable gift that may reduce the parent s lifetime gift tax exemption. From the ILIT s standpoint, this is the most attractive option. A combination The ILIT and parent may agree to combine any of these alternatives into a plan customized to meet their respective needs.

5 The taxation of Private Financing arrangements Notice and the final split dollar regulations require premium payments on split dollar arrangements implemented after January 28, 2002 to be taxed under either the economic benefit regime or under the loan regime. This applies both to arrangements that are based on family relationships and those that are based on employment relationships. The gift tax consequences of Private Financing arrangements Because private financing transactions are not related to employment and do not involve compensation, they generally do not have income tax consequences to the borrower. However, they can have both income tax and gift tax consequences to the parent as the lender. Income tax consequences to the parent may be avoided if the borrower is a grantor trust. The income and gift tax consequences may vary depending on how the loans are structured. The gift tax consequences of a private financing arrangement can generally be determined from the answers to three questions: When will the loan be repaid? Is the loan s interest rate lower than the market interest rate? How much interest will be paid each year? Question #1 When will the loan be repaid? Loans are either payable on a specific date or upon the parent s demand. If a repayment date is specified in the note, the loan will be treated as a term loan (provided the parent does not have the right to demand repayment before the term ends). Term loans fall into three categories: short term (lasting not more than three years), medium term (lasting more than three years but not more than nine years) and long term (lasting more than nine years). If a loan does not have a specific repayment date, but by its terms does not have to be repaid until the insured s death, it is treated as a term loan. Its duration is determined by the insured s life expectancy on the date the note is executed. Loans that do not have a specific repayment date are treated as demand loans. The answer to this question will determine the appropriate market interest rate. Question #2 Is the actual loan interest rate lower than the market interest rate for loans of similar length? Congress has given the IRS the power to determine what constitutes a fair market interest rate for different types of loans. When the interest rate on a loan is less than the fair market rate, then income and gift tax consequences may be triggered under IRC Section The IRS sets the fair market rate monthly. This published rate is known as the applicable federal interest rate (AFR). Whether the interest rate for a term loan is at or below market is determined by comparing the interest rate in the note with that month s AFR rate for loans of similar duration. Short-term, mid-term and long-term loans have different AFR rates. If the interest rate on the note is less than the AFR rate, then the loan is below market and tax consequences under Section 7872 are triggered. Demand loans are different. The short-term AFR rate may generally be used as the fair market rate. However, because that rate can change monthly, the calculation of interest would result in a month-by-month calculation, with monthly compounding of accrued interest. To simplify calculations of interest for demand loans, IRC Section 7872 allows the use of a blended annual rate for demand loans with a fixed principal amount outstanding for an entire calendar year. Under Revenue Ruling (1 CB 377), the blended annual rate is the product of (a) one half of the January semiannual short-term AFR rate times (b) one half of the July semiannual short-term AFR rate. The IRS publishes this blended annual rate every July based on the relevant rates for January and July of that year. Whether a demand loan is at or below market is determined by comparing the interest rate in the note with this rate. Because the blended market interest rate for a demand loan changes yearly, a demand loan with a fixed-interest rate may be at or above market in some years and below market in other years. Question #3 How much interest was paid during the tax year? Once you ve established the type of loan to be used, and the appropriate market interest rate for that loan, consider how loan interest is actually paid to determine the tax consequences. The annual tax consequences of a loan transaction (either a term or demand loan) also depend on how much interest was actually paid during the year. All the interest actually paid to the parent may be taxed to the parent as ordinary income. The actual interest payment is compared with the amount of interest that should have been paid under the terms of the note. If the interest payment was less than that required by the note, then the parent will be treated as making a taxable gift in the amount of this difference. In a term loan it may be possible to prevent this difference from being treated as a taxable gift if the unpaid interest is added to the principal of the loan. This is called accruing the unpaid interest. Accruing interest isn t possible in a demand loan arrangement. 4

6 Example Mr. Smith has made a $100,000 term loan to his son. The note requires the son to make a 5 percent annual interest payment to Mr. Smith. The fair market interest payment was $5,000 but the son paid only $2,000. Thus, the son has received a taxable gift of $3,000 (the difference between the interest the son should have paid and the interest he actually did pay). This taxable gift could be negated if the son and Mr. Smith agree to add the $3,000 in unpaid interest to the $100,000 loan balance. If this happens, the loan principal will grow to $103,000. There may also be income tax consequences; they will be addressed later. Structuring Private Financing arrangements The parent has the option of making the loans to his/her children or to an ILIT established for their benefit. There may be several advantages to making the loans to an ILIT instead of to the family members themselves. Some of them are: The parent retains a greater degree of control because he/she drafts the terms of the trust and is able to name the trustee The private financing strategy is easier to implement since only one set of transactions with the trustee is needed instead of multiple sets of transactions with each of several children The ILIT trustee may be a better manager of the life insurance policy than the children The ILIT may protect the policy from claims made by the children s creditors After the parent s death, the trustee will distribute the trust s share of the death benefits according to the directions the parent put into the trust when it was first drafted If the ILIT qualifies as a grantor trust, the transactions between the parent and the trust may be income tax free to the parent under the grantor trust income tax rules. To fully explain the tax consequences of private financing, unless otherwise indicated, the balance of this discussion on private financing taxation assumes the private financing arrangement is entered into between parent and an ILIT he/she establishes for the children with the parent as the lender and the ILIT as the borrower. Using a grantor trust may eliminate taxable income to the parent It may be possible to avoid the interest payments (either actual payments or deemed payments) from being treated as taxable income to the parent. The status of taxable income may be eliminated if the parent creates a grantor trust and makes the loan(s) to it the rather than to the child. When a grantor trust takes the place of the child as the borrower, the parent is treated as the owner of the trust for income tax purposes. The parent has no taxable income because the parent is treated as entering into a transaction with him/herself under the grantor trust rules of Code Sections The grantor trust rules clearly provide that a person can t enter into a taxable transaction with him/herself. The parent s ability to avoid income taxes on actual or deemed interest can be one of several good reasons to create a grantor trust and make the loans to it. A properly drafted ILIT can qualify as a grantor trust. 5

7 The parent may assist the ILIT with interest payments The parent may help the ILIT with the interest costs of the loan arrangement. This can be done in one of three ways: 1. Structure the loans as interest-free loans. The notes can be drafted so that the ILIT is required to pay a below market interest rate. The interest rate can even be reduced to zero. This is known as an interest-free loan. Interest-free loans may work well with demand loans, but can be problematic in term loans because of original issue discount (OID). 2. Make a separate gift of the interest costs. The parent may make a cash gift to the ILIT to provide the funds needed to make the annual interest payment. When the ILIT is actually going to make interest payments, this may be an attractive option. That s because the gifted funds will be paid right back to the parent in the form of the interest payment. For example, suppose the ILIT has an interest payment due of $11,000. The parent makes an $11,000 gift that qualifies for the gift tax annual exclusion. After the Crummey withdrawal period has expired, the ILIT trustee is able to pay the $11,000 back to the parent as an interest payment. If the ILIT is a grantor trust, the parent pays no income tax on the $11,000 payment. 3. Add all or part of the annual interest to the loan principal. This is also known as accruing the interest. It is a simple alternative to paying the annual interest without creating a taxable gift. For example, suppose the parent and ILIT are in the fifth year of a private loan arrangement and the total outstanding loan is $100,000. The ILIT is responsible for paying $5,000 of interest this year. If the parent and trustee agree to accrue the interest, the loan balance will increase to $105,000. Accruing the interest costs has several potential negative consequences, including: The interest due in future years will increase because of the increase in the loan balance; the ILIT will be required to pay interest on interest The amount ultimately transferred to the ILIT will decrease because the accrued interest will increase the amount that must be repaid to the parent When finally paid to the parent, the accrued interest will be taxable income The accrued interest will also be part of the parent s taxable estate. Estate taxation Private financing arrangements may have estate tax consequences. Any notes outstanding on the date of the parent s death are included in the parent s gross estate. In addition to the principal of these notes, any interest that was due but unpaid on these notes on the date of the parent s death is also part of the gross estate. The private financing transaction should be carefully documented to prevent the life insurance death benefits from also being included in the parent s gross estate. In the transaction, the ILIT owns the life insurance policy. If the policy is collaterally assigned back to the parent as security for repayment of the loans, there is a possibility that ALL the policy death benefits may be included in the parent s estate. This can happen if the collateral assignment is drafted in a way that gives the parent an incident of ownership in the policy under IRC section A collateral assignment that is not carefully drafted could easily be interpreted to give the parent an incident of ownership in the policy. An incident of ownership includes a number of rights, including the right to: Name the beneficiary Pledge the policy as security for a loan Surrender or cancel the policy Borrow against the policy Assign the policy or revoke an assignment. 6

8 Conclusion Private financing arrangements can potentially be very effective in meeting a family s retirement and estate planning goals. Parents may use them to create additional inheritances for their children and grandchildren while retaining the ability to recover some of their money if their objectives or finances change. A demand loan structure can take advantage of lower interest rates for a period of time. However, the parents will need to be comfortable with potential volatility in interest rates and recognize that that they may rise substantially over time. Parents who want their arrangements to have more predictable costs and results may choose a term loan structure that has stability but potentially higher interest costs. Below market private financing arrangements may have both gift and income tax consequences. The income tax consequences may be minimized if the parent establishes a grantor trust to own the policy and receive the loans. Both demand and term private financing arrangements have the potential to help parents transfer wealth to their children through life insurance without weakening their own financial security. Split dollar arrangements, including private financing arrangements, are subject to IRS Notice and regulations that apply for purposes of federal income, employment and gift taxes. Individuals should consult with their tax and legal advisors before purchasing a life insurance policy that will be used in a private financing arrangement. For more information contact your Voya Life Companies representative or call ( ), option #4. These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The Voya Life Companies and their agents and representatives do not give tax or legal advice. The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation. Life insurance products are issued by ReliaStar Life Insurance Company (Minneapolis, MN), ReliaStar Life Insurance Company of New York (Woodbury, NY) and Security Life of Denver Insurance Company (Denver, CO). Variable universal life insurance products are distributed by Voya America Equities, Inc. Within the State of New York, only ReliaStar Life Insurance Company of New York is admitted and its products issued. All are members of the Voya family of companies Voya Services Company. All rights reserved. CN /01/2015 Voya.com