Advanced Designs. Pocket Guide. Private Split-Dollar Life Insurance Designs AD-OC-724B

Transcription

1 Advanced Designs Pocket Guide Private Split-Dollar Life Insurance Designs AD-OC-724B

2 This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its distributors and their respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Investment and Insurance Products: Not a Deposit Not FDIC Insured Not Insured by any Federal Government Agency No Bank Guarantee May Lose Value

3 Table of Contents I. Introduction 1 II. Overview 2 A. The Need for Private Split-Dollar and Intra-Family Loans 2 B. Reduction of Gift to Irrevocable Life Insurance Trust (ILIT) 3 C. Private Split-Dollar and Intra-Family Loans 3 III. Private Split-Dollar (Economic Benefit Regime) 5 A. Practical Considerations 5 B. Private Split-Dollar Designs 8 C. Pertinent Tax Issues Questions & Answers Regarding Private Split-Dollar Arrangements Under the Economic Benefit Regime Is the premium payor making a gift of the premiums to the trust beneficiaries? Is the Reportable Economic Benefit (REB) income taxable to the premium payor? How does divorce or separation affect the private split-dollar arrangement? What is included in the premium payor s estate? Can the premium payor access the policy s cash value? Must the ILIT pay the REB? Does the ILIT s payment of the REB offset the amount owed to the premium payor at rollout? What is cash value for split-dollar purposes? 20

4 9. How is the split-dollar arrangement documented? 21 D. Planning for Rollout of Private Split-Dollar Arrangements Under Economic Benefit Regime Necessity for Rollout Rollout Options 23 IV. Intra-Family Loans (Loan Regime) 27 A. Practical Considerations 27 B. Intra-Family Loan Designs Non-Insured Spouse as Lender 32 C. Disadvantages Intra-Family Loans by Non-Insured Spouse 34 D. Intra-Family Loan Designs Insured(s) as Lender 36 E. Pertinent Tax Issues Questions & Answers Relating to Intra-Family Loans What is the interest rate used for testing sufficient interest on a demand loan? What is the interest rate used for testing sufficient interest on a term loan? Can the lender(s) gift an amount equal to the loan interest to the trust to pay the loan interest to the lender(s)? What are the benefits of using a demand loan versus a term loan and vice versa? Are the loan interest payments income taxable to the lender? Could the loan transaction be re-characterized as a transfer with a retained interest? Can the loan interest be capitalized into the loan rather than paid yearly? What are the benefits of using a single lump sum loan over a series of loans and vice versa? What is included in the client s estate? 46

5 10. How is an intra-family loan payable at the death of the insured treated? How is the intra-family loan arrangement documented? Does the de minimus rule contained in IRC Sec apply? 48 V. Conclusion 49 VI. Appendix A 50

6 I. Introduction A private split-dollar arrangement is not a special type of life insurance policy, but rather, a premium sharing arrangement used by individuals who wish to purchase a life insurance policy for estate liquidity purposes but want to minimize the gift tax cost of funding the life insurance policy. Private split-dollar is an agreement between an owner of a life insurance policy and a nonowner under which one party pays all or part of the premiums and in return is entitled to recover all or any portion of those premiums from or secured by, the proceeds of the policy. 1 On September 11, 2003, the Internal Revenue Service issued the final regulations on split-dollar, which provide the rules governing split-dollar arrangements entered into or materially modified after September 17, This pocket guide discusses only new private split-dollar cases entered into after September 17, It is imperative that individuals interested in entering into a split-dollar design seek the advice of legal and tax counsel familiar with these regulations. This material is not intended as, nor may it be considered, legal or tax advice. This pocket guide begins with a brief overview of the need for private split-dollar arrangements and a brief analysis of the two types of private split-dollar arrangements as provided by final split-dollar regulations. The balance of the pocket guide is divided into sections, each discussing the benefits and mechanics of the two different types of private split-dollar designs: private splitdollar designs under the economic benefit regime and private splitdollar designs under the loan regime (Intra-Family Loans). Each section provides an overview of the different designs available under the two regimes and ends with a discussion of the pertinent tax issues in a question and answer format. For simplicity, the remainder of this pocket guide will refer to designs subject to the economic benefit regime as private split-dollar arrangements and designs falling under the loan regime as intra-family loans. 1 Treas. Reg. Sec (b)(1). Page 1 of 50

7 All references to income, gift or estate taxation shall refer only to federal tax implications as state taxation varies from state to state. Unless stated otherwise, all citations are to the Internal Revenue Code of 1986, as amended (the Code). For the sake of simplicity, the Internal Revenue Service will be referred to as the Service, and any reference to the masculine gender shall also include the feminine gender. II. Overview A. The Need for Private Split-Dollar and Intra-Family Loans Individuals enter into private split-dollar and intra-family loan arrangements when they want to buy a life insurance policy in an irrevocable life insurance trust (ILIT) at a reduced gift tax cost. Typically, wealthy individuals who want life insurance for estate liquidity purposes use ILITs to exclude the death benefit from their taxable estate. The insured gifts cash to the ILIT to provide the trustee with funds to pay the policy premiums. If the gift amounts are within the insured s available annual gift tax exclusions or lifetime exemption amounts, the gifts can be gift tax-free. However, the premiums for a policy with the requisite death benefit may greatly exceed those amounts. This situation typically arises where the insured seeks a policy with a large death benefit or the insured is already making gifts to the ILIT beneficiaries. In either situation, the insured might owe gift tax each time he or she transfers funds to the ILIT. This gifting limitation may cause the insured to settle for less death benefit than needed and leave the insured s estate without the necessary liquidity to pay estate taxes. 2 2 According to the American Taxpayer Relief Act of 2012, the federal estate, gift and generation skipping transfer (GST) tax exemption amounts are all $5,000,000 (indexed for inflation effective for tax years after 2011); the maximum estate, gift and GST tax rates are 40%. As of January 1, 2013, the annual gift tax exclusion is $14,000 per donee (indexed for inflation). Page 2 of 50

8 B. Reduction of Gift to ILIT Private split-dollar and intra-family loans can help significantly reduce gifts to the ILIT and thereby reduce or eliminate the payment of gift tax. In a private split-dollar and intra-family loan arrangement, the trustee of the ILIT and a donor (typically the insured or the insured's spouse) agree to share the policy premiums. 3 The donor agrees to pay the bulk of the premiums in exchange for an assignment of a portion of the cash value. If the arrangement is properly structured, the donor s payment of premiums should not be gifts to the trust because they are pursuant to the premium sharing arrangement. The insured would only need to gift a relatively small amount of funds to provide the ILIT trustee with the funds needed to pay its portion of premiums, which can be relatively small. Without private split-dollar or intrafamily loans, gifting concerns could limit the policy's death benefit. With private split-dollar or intra-family loans, an individual's needs can determine the appropriate death benefit. C. Private Split-Dollar and Intra-Family Loans Private split-dollar arrangements were originally designed around two private letter rulings issued by the Service which provided a road map to the use of private split-dollar planning: Private Letter Rulings and On September 11, 2003, the Service issued the final regulations on split-dollar that provide the rules for the tax treatment of private split-dollar arrangements entered into or materially modified after September 17, The final regulations provide that split-dollar arrangements fall under two mutually exclusive regimes: the economic benefit regime (private split-dollar) and the loan regime (intra-family loans). Private split-dollar arrangements split the costs and benefits of a life insurance policy and require the annual recognition of a 3 Someone other than the insured should serve as the trustee of the ILIT. If the insured serves as trustee, the policy proceeds would be includible in the insured s estate since the insured would be viewed as holding policy incidents of ownership. IRC Sec. 2024(2); Treas. Reg. Sec (c)(4). Page 3 of 50

9 reportable economic benefit amount (REB) for the cost of current life insurance protection provided by the premium payor. Alternatively, intra-family loans require sufficient loan interest be paid to the lender on the premiums paid rather than the aforementioned REB amounts. Generally, the determination of which regime applies is made by policy ownership. If the premium payor owns the policy, the economic benefit regime applies. If the non-premium payor owns 4 the policy, the loan regime applies. 5 In other words, traditional equity collateral assignment split-dollar arrangements are treated as loans under the final regulations while endorsement split-dollar arrangements are taxed as economic benefit split-dollar arrangements. A special exception to this general rule, however, applies the economic benefit split-dollar regime to nonequity collateral assignment split-dollar arrangements. This special rule treats the donor (premium payor) as the owner of the policy, even if the ILIT is the named policyowner under the policy if, at all times, the only economic benefits that will be provided to the ILIT is current life insurance protection. 6 Therefore, in the typical private split-dollar scenario, the ILIT is the named policyowner of the policy to avoid estate taxation of the death benefit 7 and is only entitled to the current life insurance protection. The balance (i.e., the entire cash value) is collaterally assigned to the donor (premium payor). The decision as to which design makes most sense for a particular client will depend on the specific facts of the case and will require a comparison of illustrations by the client's tax advisors. Generally, for younger insureds and for survivorship life insurance policy arrangements, a private split-dollar arrangement may 4 See footnote 3. 5 Treas. Reg. Secs (b)(3) and (a)(2). 6 Treas. Reg. Secs (c)(1)(ii) and (a)(2). 7 The final regulations provide that no matter who would be considered policy owner under the final regulations, the inclusion of the policy death benefit proceeds in a decedent s taxable estate will continue to be determined under normal estate tax rules of IRC Sec Page 4 of 50

10 provide lower cost to the client, especially in the early years of the arrangement. For older insureds, a loan arrangement may provide more desirable tax consequences, especially during periods of low interest rates, since interest rates may be lower than the cost of current life insurance protection. Please see the Private Split-dollar Decision Tree in Appendix A of this pocket guide. This pocket guide will discuss the advantages and tax issues to consider before choosing among the different types of private splitdollar designs. III. Private Split-Dollar (Economic Benefit Regime) A. Practical Considerations Private split-dollar is a premium sharing arrangement typically between an ILIT and an insured and/or spouse. In order to avoid estate taxation of the death benefit, the ILIT is the named policyowner. Private split-dollar, therefore, needs to be structured as a nonequity collateral assignment split-dollar arrangement under the special rules provided by the final regulations to be taxed as split-dollar rather than as a loan. As discussed previously, under the special rule, the premium payor pays all or most of the premiums and the ILIT must only be entitled to the current life insurance protection. 8 The balance, in other words the entire cash value, must be collaterally assigned to the donor as premium payor. 9 8 As discussed earlier, the donor (premium payor) must be assigned the entire cash value to qualify under the split-dollar economic benefit regime as defined in Treas. Reg. Sec (d)(1) pursuant to the special rule in Treas. Reg. Sec (c)(1)(ii)(A)(2). 9 Some commentators believe that a nonequity collateral assignment split-dollar arrangement should give to the premium payor the greater of premiums paid or cash value even though the final regulations provide that the special rules will apply so long as the only benefit provided to the ILIT is the current life insurance protection. The client s independent tax advisor should be consulted on this and all other issues. Page 5 of 50

11 Reportable Economic Benefit (REB) Because the ILIT s beneficiaries are being gifted current life insurance protection provided by reason of the payment of premiums by the premium payor, the ILIT must recognize this gift. Generally in private split-dollar, the ILIT will recognize this gift in the form of the cost of current life insurance protection as measured by the reportable economic benefit (REB). In the alternative, the ILIT can pay a portion of the policy premium equal to the REB using funds gifted by the insured. The REB amount is typically relatively small compared to the premium amounts, especially during the early years of the policy, and therefore should significantly reduce the gift amounts made by the insured. It is important to emphasize that if the ILIT does not pay a portion of the premium equal to the REB, the REB will be treated as a deemed gift to the ILIT by the premium payor that may not qualify for the annual gift tax exclusion. 10 The final regulations provide that the REB is measured by multiplying the amount of current life insurance protection provided to the ILIT multiplied by a life insurance premium factor that will be published by the IRS in the future. As of the date this pocket guide was written, these rates had not yet been published. The client s tax advisor should be consulted for any up to date information. Until this rate is published, Table 2001 rates, as provided by Notice , should generally be used as the measure of the REB. 11 Restricted Collateral Assignment In private split-dollar, the premium payor is typically the insured or the insured s spouse. While it is possible to have other premium payors (e.g., a relative or family business), additional tax 10 In order to qualify for the annual gift tax exclusion, the gift must be a present interest gift. IRC Sec. 2503(b). A deemed gift would not be a present interest. See note The use of any other rates, such as a life insurance company s lower published premium rates, should be carefully reviewed by a client s independent tax advisor to ensure that the rates satisfy the requirements set forth in Rev Rul and Notice Page 6 of 50

12 consequences must carefully be considered. This pocket guide will only discuss the most common type of private split-dollar arrangements where the premium payor is the insured or insured s spouse. If the insured is the premium payor, caution must be taken to avoid any incidents of ownership that may cause estate taxation of the death benefit. A collateral assignment that gives the insured as premium payor any rights over the policy s cash value would cause estate inclusion of the death benefit. Therefore, a restricted collateral assignment agreement and form should be used to restrict the insured s access to the cash value limiting the insured s right over the policy to a right of reimbursement upon termination of the arrangement only. Rollout A split-dollar arrangement can be terminated during the insured s lifetime or upon the insured s death. The termination of the arrangement during life is referred to as rollout because the trustee rolls the premium payor s interest out of the policy by reimbursing the premium payor an amount equal to the cash value. The REB amount increases as the insured gets older. From a gift tax perspective, therefore, the parties to the arrangement should consider terminating the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the ILIT to fund the policy with the split-dollar arrangement than without and would therefore defeat the purpose of the splitdollar arrangement. If the parties knew that the insured would die before the REB exceeded the actual premium, they might not need to plan for a rollout. However, prudence dictates planning for a possible rollout because failure to plan could force a rollout that could strip the policy of its cash value and result in little or no death benefit payable to the ILIT. This unfortunate result occurs because the ILIT is required to pay to the premium payor an amount equal to the entire cash value upon termination of the split-dollar Page 7 of 50

13 arrangement. 12 Section III.D of this pocket guide discusses various rollout strategies available. Cash Value Defined As discussed earlier, the premium payor must have an interest at least equal to the entire cash value in order for the arrangement to be treated as split-dollar. The final regulations provide that cash value for split-dollar purposes, is determined disregarding surrender charges or other similar charges or reductions. 13 Cash value for split-dollar purposes, therefore, is not the cash surrender value. Rather, the cash value must be at least as great as the accumulated value of the policy. Furthermore, the regulations provide that no artifice or device may be used to understate the cash value. 14 The client s independent tax advisor should be consulted to determine the appropriate cash value amount owed to the premium payor under the split-dollar arrangement. B. Private Split-Dollar Designs There are three common private split-dollar designs: (1) single life private split-dollar with a married insured, (2) single life private split-dollar with a single insured, and (3) second-to-die private split-dollar. The main difference between the three designs is that the second and third design must use a restricted collateral assignment agreement (i.e., limiting the premium payor s right in the cash value to a right of reimbursement at termination only) because the insured(s) is also a premium payor. Otherwise, the collateral assignment could give incidents of ownership that could cause the estate taxation of the death benefit. 12 Some commentators believe that a nonequity collateral assignment split-dollar arrangement should give to the premium payor the greater of premiums paid or cash value even though the final regulations provide that the special rules taxing nonequity collateral assignments split-dollar under the economic benefit regime will apply so long as the only benefit provided to the ILIT is the current life insurance protection. Treas. Reg. Sec (c)(1)(ii)(A)(2). The client s independent tax advisor should be consulted on this and all other issues. 13 Treas. Reg. Sec (d)(4)(i). 14 Treas. Reg. Sec (d)(5)(iii). Page 8 of 50

14 a. Benefits of Arrangement - Single Life Private Split-Dollar Married Insured Insured can minimize the gift to fund a trust-owned policy. The payment of premiums by the premium payor are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 15 Insured only needs to gift a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insured attains a certain age, that amount should be relatively small compared to the premium amount. Non-insured spouse can access the trust-owned policy's cash value. The collateral assignment can provide the non-insured spouse as premium payor with access to the policy's cash value. At retirement or in the event the family needs funds, the insured's spouse may take income tax-free withdrawals and loans from the policy's available cash value by exercising his or her rights set forth in the split-dollar and collateral assignment agreements. 16 While access to cash value may be an important benefit to this particular type of private split-dollar, it should not be the sole reason for establishing a private split-dollar arrangement. The primary reason for most private split-dollar arrangements is to reduce the gift amount that finances a policy owned outside of the 15 In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement,are not deemed gifts by the insureds to the ILIT. 16 Tax-free income assumes, among other things: (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) policy remains in force until death; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC Secs. 72, 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. Page 9 of 50

15 insured's estate. Indirect access to cash value may be obtained through other relatively simpler, drafting techniques. 17 The trust's portion of the policy's death benefit should pass to the trust beneficiaries free from estate tax. The trust's portion of the death benefit should pass to the trust beneficiaries free from estate tax. 18 This statement is true provided that the trust and agreements to effectuate the split-dollar arrangement are properly drafted so that the insured does not retain any prohibited power or benefit over the trust nor any incident of ownership over the policy that would cause the trust proceeds to be included in his or her estate. 19 Incomplete estate planning could, however, cause the trust's portion of the death benefit to be included in the insured's estate. The non-insured spouse s contractual rights under the split-dollar arrangement include rights that would cause the entire policy proceeds to be included in the insured's estate if held by the insured at or within three years of the insured s death. 20 Accordingly, the non-insured spouse s contractual interests must not pass to the insured at his or her death. The non-insured spouse should bequeath his or her interest to anyone other than the insured (e.g., his or her children or grandchildren) in his or her will or living trust. In addition, if the insured is the executor of the will or the trustee of the trust that distributes the non-insured spouse s contractual interest, the non-insured spouse's will or trust should designate a special executor or trustee to take all actions with respect to his or her contractual interest. Otherwise the insured will possess rights over the policy that could cause the entire policy proceeds to be included in his or her estate A competent estate planning attorney can draft an ILIT that should provide an insured's spouse with access to cash value during the insured's life without causing inclusion of the death benefit in either spouse's estate. 18 See footnote IRC Secs. 2036, 2038 and See Priv. Ltr. Rul IRC Secs and Id. Page 10 of 50

16 b. Disadvantages of Arrangement - Single Life Private Split-Dollar Married Insured Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 22 Rollout Issues The REB increases as the insured gets older. From a gift tax perspective, the insured should terminate the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. If the parties to the arrangement fail to plan in advance, gifting concerns may force a rollout that could strip the policy of its cash value and result in little or no insurance death benefit payable to the trust since the premium payor is entitled to the entire cash value of the policy. 23 ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value. 24 Pursuant to the final regulations, in order for the economic benefit regime to apply, the only economic benefit provided under the arrangement by the donor must be the current life insurance protection. 25 The arrangement, therefore, should provide the ILIT with no access to the cash value. 22 Treas. Reg. Sec (f)(2)(i). 23 The final split-dollar regulations provide that the term cash value shall mean the cash value of the policy, determined disregarding surrender charges or other similar charges or reductions, as defined in the insurer s policy form. Treas. Reg. Sec (d)(4)(i). 24 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). 25 Treas. Reg. Sec (c)(1)(ii)(2). Page 11 of 50

17 Cash value is includible in the premium payor s estate. Upon the death of the premium payor, the amount currently owed to him or her pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in his or her estate. 26 Payment of the REB may be income taxable to premium payor. Pursuant to the final regulations, the REB actually paid by the ILIT will be income taxable to the premium payor. 27 Establishing the ILIT as a defective grantor trust as to the premium payor spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 28 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private split-dollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. If the trust is drafted as a grantor trust to the premium payor spouse, the premium payor spouse should not be a beneficiary of the ILIT; otherwise, the trust proceeds, including the death benefit proceeds should the insured die prior to the spouse, may be includible in the premium payor spouse s estate under IRC Sec c. Benefits of Single Life Private Split-Dollar with a Single Insured Insured can minimize the gift to fund a trust-owned policy. The payment of premiums by the premium payor are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 29 The insured needs to gift only a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insured attains a 26 IRC Sec Treas. Reg. Sec (f)(2)(ii). 28 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. Page 12 of 50

18 certain age, that amount should be relatively small compared to the premium amount. The ILIT s portion of the policy's death benefit should pass to the ILIT beneficiaries free from estate tax. If structured properly, the trust's portion of the death benefit, as set forth in the private split-dollar arrangement, should pass to the trust estate tax-free 30 so long as the insured does not retain any prohibited power or benefit over the trust or any incident of ownership over the policy. 31 d. Disadvantages of Single Life Private Split-Dollar Single Insured Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 32 Rollout Issues The REB increases as the insured gets older. From a gift tax perspective, the insured should terminate the arrangement before the value REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value See footnote IRC Secs. 2036, 2038, Treas. Reg. Sec (f)(2)(i). 33 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The Page 13 of 50

19 Premium payor has no access to cash value. Because the insured is also the premium payor, the insured should not be given any access to the policy's available cash value; otherwise, he or she may be deemed to possess an incident of ownership over the policy that would cause the policy death benefit proceeds to be included in his or her estate. 34 To prevent the insured from having incidents of ownership, a restricted collateral assignment agreement and form should be used that limits the insured s right in the policy to a right of reimbursement upon termination only with no current access to cash value. Cash value is includible in premium payor s estate. Upon the death of the premium payor, the amount currently owed to him or her pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in his or her estate. 35 Payment of the REB may be income taxable to premium payor. Pursuant to the final regulations, the value of current life insurance protection actually paid by the ILIT will be income taxable to the premium payor. 36 Establishing the ILIT as a defective grantor trust as to the premium payor spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 37 It is unclear, however, whether the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private split-dollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). 34 See Rev. Rul , , C.B IRC Sec Treas. Reg. Sec (f)(2)(ii). 37 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 14 of 50

20 e. Benefits of Second-to-Die Private Split-Dollar Insureds can minimize the gifts to fund a trust-owned policy. The payment of premiums by the premium payors are not gifts to the ILIT because they are pursuant to the split-dollar arrangement. 38 The insureds only need to gift a relatively small amount of funds equal to the REB to the ILIT to allow the trustee to pay its portion of the premiums. Until the insureds attain a certain age, that amount should be relatively small compared to the total premium. The trust's portion of the policy's death benefit should pass to the trust beneficiaries free from estate tax. If the arrangement is structured properly, the trust's portion of the death benefit, as set forth in the private split-dollar arrangement, should pass to the trust estate tax-free. 39 Upon the first death of one of the insureds, only the value of the interest owed to the deceased spouse should be included in the deceased spouse's estate. 40 Upon the surviving spouse's death, only the value of the amount currently owed the surviving spouse pursuant to the private split-dollar agreement should be included in his or her estate In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. 39 See footnote The insureds may be able to delay the payment of estate tax due on the first death if their wills or trusts pass the first spouse to die's repayment right to the surviving spouse so that the interest may qualify for the marital deduction from estate tax. 41 IRC Sec Page 15 of 50

21 f. Disadvantages of Arrangement - Second-to-Die Nonequity Private Split-Dollar Payments of premiums by ILIT will not give tax basis in the policy. Pursuant to the final regulations, the ILIT will not receive any basis in the life insurance policy for the payment of the REB. 42 REB increases after the death of the first insured. The cost of the REB increases after the death of the first insured because the rates for a single life policy are higher than the rates for a second-to-die policy. Rollout Issues The REB increases as the insureds get older. The cost of current life insurance protection also increases at the first death of one of the spouses. From a gift tax perspective, the insured(s) should terminate the arrangement before the REB exceeds the actual premium cost. Otherwise, the insured(s) would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. ILIT has no access to cash value. The final regulations provide that the ILIT must not have any access to cash value. 43 Premium payors have no access to cash value. Since the insureds are also the premium payors in this type of design, the insureds should not be given any access to the policy's available cash value; otherwise, they may be deemed to possess an incident of ownership over the policy that would cause the policy 42 Treas. Reg. Sec (f)(2)(i). 43 Treas. Reg. Sec (d). The final regulations provide that the non-owner must take into account the full value of all economic benefits provided by the owner. The value of economic benefits include the amount of policy cash value to which the nonowner has current access. Treas. Reg. Sec (d)(2)(ii). Page 16 of 50

22 death benefit proceeds to be included in their estate. 44 This can be accomplished by using a properly drafted ILIT, a restricted collateral assignment agreement and restricted collateral assignment form. Cash value is includible in the insureds estate. Upon the death of the insureds, the amount owed to them pursuant to the split-dollar agreement (i.e., the entire cash value) will be included in their estate. 45 Payment of the REB may be income taxable to premium payors. Pursuant to the final regulations, any REB actually paid by the ILIT will be income taxable to the premium payors for any splitdollar arrangements entered into after September 17, Establishing the ILIT as a defective grantor trust as to the premium payors may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 47 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private splitdollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. C. Pertinent Tax Issues Questions & Answers Regarding Private Split-Dollar Arrangements Under the Economic Benefit Regime 1. Is the premium payor making a gift of the premiums to the trust beneficiaries? If the Service viewed the assignee's payment of premium pursuant to the split-dollar agreement as a gift to the trust beneficiaries, the 44 See Rev. Rul , , C.B IRC Sec Treas. Reg. Sec (f)(2)(ii). 47 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 17 of 50

23 split-dollar agreement would not serve its purpose of minimizing the gifts to the trust beneficiaries. Although the assignee is paying the majority of the premium under this arrangement, the premium payments should not be gifts to the trust beneficiaries they are pursuant to a private split-dollar arrangement Is the REB income taxable to the premium payor? Pursuant to the final regulations, the REB actually paid by the ILIT will be income taxable to the premium payor for any split-dollar arrangements entered into after September 17, Establishing the ILIT as a defective grantor trust as to the premium payor may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the REB. 50 However, it is unclear whether or not the use of a defective grantor trust will effectively avoid the income taxation of the REB in a private splitdollar arrangement given the language contained in the final regulations. Clients should consult their tax advisors on this issue. If the trust is drafted as a grantor trust to the premium payor, the premium payor should not be a beneficiary of the ILIT; otherwise, the death benefit proceeds may be includible in the premium payor spouse s estate under IRC Sec How does divorce or separation affect the private split-dollar arrangement? Divorce or separation does not diminish the premium payor s right to reimbursement. Furthermore, if the premium payor spouse has 48 The Service has privately ruled that the insured's spouse's premium payments were not gifts to the trust where he or she would receive the cash value (net of spouse's loans or debt secured by the policy) if the arrangement was terminated during the insured's life or the greater of the cash value immediately before death (net of spouse's loans or debt secured by the policy) or premium paid (net of spouse's loans or debt secured by the policy) if the arrangement is terminated by the death of the insured. Priv. Ltr. Rul In Priv Ltr. Rul , the Service privately ruled that premium payments made by a partnership (in which insureds were partners) pursuant to a private split-dollar arrangement are not deemed gifts by the insureds to the ILIT. 49 Treas. Reg. Sec (f)(2)(ii). 50 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 18 of 50

24 the ability to access cash value as premium payor and assignee on the policy, that ability would not be diminished by a divorce or separation. Accordingly, the premium payor may retain access to the policy's cash value after the couple divorces or separates. This issue should therefore be considered by the clients and their tax advisors before entering into a private split-dollar arrangement. 4. What is included in the premium payor s estate? Upon the death of the premium payor, only the amount currently owed to the premium payor pursuant to the split-dollar agreement (i.e., the entire cash value) should be included in his or her estate. 51 The portion of the death benefit ultimately payable to the trust should not be included in the insured(s)' estate Can the premium payor access the policy's cash value? The answer depends on whether the insured is also going to be the premium payor. If the insured is not the premium payor, the premium payor spouse would be able to access the cash value of the policy pursuant to his or her right under the split-dollar agreement and collateral assignment. On the other hand, where the insured is also the premium payor such as in a second-to-die private split-dollar arrangement the premium payor should not be given access to the policy s cash value. Since the insured is the premium payor, access to the policy's cash value would give the insured(s) incidents of ownership over the policy that would cause the death benefit to be included in his or her estate. 53 To prevent the insured from having incidents of ownership, the insured should not have any rights over 51 IRC Sec The final split-dollar regulations provide that the term cash value shall mean the cash value of the policy, determined disregarding surrender charges or other similar charges or reductions, as defined in the insurer s policy form. Treas. Reg. Sec (d)(4)(i). In addition, no artifice or device may be used to understate the cash value. Treas. Reg. Sec (d)(5)(iii). 52 Priv. Ltr. Rul See Rev. Rul , , C.B Page 19 of 50

25 the policy but only a right of reimbursement upon termination of the split-dollar arrangement. 6. Must the ILIT pay the REB? If the ILIT does not pay the REB, the premium payor is treated as making a deemed gift of the REB amount to the ILIT. The downside is that the deemed gift may not qualify for the annual gift tax exclusion because it is not a present interest. Thus, the premium payor would have to use his or her lifetime exemption amount and/or pay gift tax on that amount. 54 Since private splitdollar is intended to reduce the gift tax cost of funding a policy, the ILIT will typically pay the REB amount. The insured will gift cash in an amount equal to the REB to provide the ILIT trustee with the funds necessary to pay the REB. If the insured has sufficient annual exclusion gifts and/or lifetime exemptions available, the gift should be gift tax-free. 7. Does the ILIT s payment of the REB offset the amount owed to the premium payor at rollout? Any REB paid by the ILIT does not offset any amount owed to the premium payor at rollout. The REB paid by the ILIT is treated as being paid to the premium payor. 55 It, therefore, does not give the ILIT any basis in the policy and does not offset any amount owed to the premium payor. Rather, any REB contributed to the policy will be included in the basis of the premium payor What is cash value for split-dollar purposes? The final regulations provide that cash value for split-dollar purposes, is determined disregarding surrender charges or other similar charges or reductions and includes any amount attributable to paid-up additions. 57 Cash value for split-dollar purposes, therefore, is not the cash surrender value. Rather, the cash value 54 See footnote Treas. Reg. Sec (f)(2)(i). 56 Treas. Reg. Sec (f)(2)(ii). 57 Treas. Reg. Sec (d)(4)(i). Page 20 of 50

26 must be at least as great as the accumulated value of the policy. Furthermore, the regulations provide that no artifice or device may be used to understate the cash value. 58 The client s independent tax advisor should be consulted to determine the appropriate cash value amount owed to the premium payor under the split-dollar arrangement. 9. How is the split-dollar arrangement documented? To create a private split-dollar arrangement, the trustee of the ILIT and the premium payor spouse working with their attorney execute a private split-dollar agreement and submit a collateral assignment form to the life insurance company. In split-dollar cases where the insured is also the premium payor (such as in a second-to-die scenario or in a single life policy for a single person scenario), a restricted collateral assignment agreement and form should be used to avoid any incidents of ownership to limit the donor/assignee s rights to a right of reimbursement only with no access to the cash value. A written split-dollar agreement setting forth the rights and obligations of the trustee and premium payor spouse is necessary to prevent the Service from arguing that the premium payor spouse's payments of premium were gifts to the trust beneficiaries. 59 The split-dollar agreement should be carefully drafted not to give the ILIT any current access to the cash value of the policy. 60 Moreover, if the insured is also the premium payor, the agreement should be drafted as a restricted collateral assignment agreement to limit the insured s right to the policy s cash value to a right of reimbursement only with no access to the cash value in order to avoid any possible incidents of ownership. 58 Treas. Reg. Sec (d)(5)(iii). 59 If there is no proof that the spouse would be reimbursed for his or her premium advances, the Service could argue that the spouse made gifts to the trust. IRC Sec. 2512(b). 60 Treas. Reg. Sec (d). If the ILIT is given any access to the cash value, the regulations provide that the amount to which the non-owner has current access will be taxed as a gift to the ILIT. Page 21 of 50

27 In a single life private split-dollar agreement for a married insured where the non-insured spouse is the premium payor and is given access to the cash value, the non-insured spouse should use his or her separate property to pay for his or her portion of the premium to ensure that the death benefit payable to the trust is excluded from the insured s estate. Accordingly, depending upon the particular state law, the insured and spouse might also need to enter into an agreement transmuting community property funds to separate property funds prior to using such funds to pay their respective premium. 61 If the attorney is concerned that the release of a collateral assignment consequent to a split-dollar agreement is a potential transfer for value causing the life insurance proceeds to be income taxable, he or she might consider drafting the trust as a grantor trust to the insured. 62 If the trust is a grantor trust, arguably, the transfer at the time of the rollout would be considered to be made to a party exempt from the transfer for value rule; the insured In Private Letter Ruling , the taxpayers, who resided in a community property state, specifically indicated that the insured gifted separate property to the trust for the trust to pay its share of the premiums and the insured's spouse paid his or her portion of the premium using his or her separate property. While not specifically addressed in the ruling, each spouse's use of separate property is vital to excluding the portion of the death benefit payable to the trust from both spouses' estates. If the non-insured spouse uses community property funds to pay his or her portion of the premium, the insured might be a deemed assignee over the policy, giving him or her incidents of ownership over the policy, causing inclusion of the entire death benefit in his or her estate under Sec Furthermore, if the non-insured spouse is also a beneficiary of the ILIT, the insured spouse should gift separate property to fund his or her portion of the premiums in order to avoid inclusion of trust proceeds in the non-insured spouse s estate under Sec Some commentators argue that the transfer-for-value rule would not apply to collateral assignment split-dollar because, pursuant to Treas. Reg. Sec (b)(4), the "...assignment of a policy as collateral security is not a transfer for a valuable consideration..." It is posited that, given this regulation, the reverse should be true; i.e., the release of a collateral assignment should also not be a transfer for value. One must remember, however, that this regulation addressed assignments apparently for loans whereas, in the private split-dollar scenario, the assignee's interest in the policy is not a loan. 63 W. Clark Swanson, Jr., v. Comm'r., 518 F.2d 59 (8th Cir. 1975). Page 22 of 50

28 D. Planning for Rollout of Private Split-Dollar Arrangements Under Economic Benefit Regime 1. Necessity for Rollout A split-dollar arrangement may terminate during the insured's lifetime or upon the insured s death. The REB cost, however, increases as the insured gets older. From a gift tax perspective, the parties should terminate the split-dollar arrangement before the value of the REB exceeds the actual premium cost. Otherwise, the insured would be gifting more to the trust to fund the policy with the private split-dollar arrangement than he or she would without the arrangement. If the parties knew that the insured would die before the REB exceeded the actual premium, they might not need to plan for the rollout. However, prudence dictates planning for a possible private split-dollar rollout. If the parties to the arrangement fail to plan in advance, gifting concerns may force a rollout that could strip the policy of its cash value and result in little or no insurance death benefit payable to the trust. This unfortunate result occurs because only nonequity collateral assignment split-dollar arrangements where the ILIT is only entitled to the current life insurance protection qualify under the special rules provided by the final regulations for split-dollar treatment. This means that the entire cash value must be assigned to and paid to the premium payor upon rollout. 2. Rollout Options a. Pre-funding the Rollout One solution to the rollout dilemma is to "pre-fund" the rollout. If there is a spread between the value of current life insurance protection and the amount that the insured could gift to the trust beneficiaries gift tax-free using annual exclusion gifts and lifetime exemption amounts, the insured and/or spouse can gift the Page 23 of 50

29 maximum amount to the trust. 64 The trustee could, in turn, invest this spread in an investment, separate from the life insurance policy, over the term of the arrangement and use the funds to help roll out of the split-dollar arrangement without stripping the policy of its cash value. 65 For example, a married couple with four children could potentially make annual exclusion gifts to a trust totaling $112,000 (assuming gift-splitting gifts are made in 2013) yet the cost of current life insurance protection the trustee pays as its portion of the premium may only be $10,000. In that case, the couple can gift the entire $112,000 amount to the trust and the trustee could invest the additional $102,000 in another investment in an investment other than the life insurance policy to help create a side fund. b. Rollout with Promissory Note (i.e., convert to a private loan) If the insured is reluctant to pre-fund the rollout or unable to sufficiently pre-fund the trust for the rollout, the trustee of the trust may rollout of the arrangement by issuing the donor/assignee s spouse a note in an amount equal to the amount currently owed the donor/assignee spouse. The note could be structured as an interestonly note with a balloon payment payable upon the death of the insured. It is important to note, however, that the trust must pay the insured's spouse adequate interest or the insured's spouse will be making imputed gifts of the foregone interest to the trust beneficiaries. 66 If the parties take this approach to the rollout, they need to compare the REB cost to the interest that would be payable on the note. From a gifting standpoint, the trustee should only rollout of the arrangement with a note if the interest due on the note is less than the REB since the insured will either be gifting the interest payable on the note or the REB to the trust so that the trustee can meet his or her obligation to the assignee. If the note interest is 64 See footnote The income tax consequences associated with investing the spread in an investment separate from the life insurance should be discussed with the client s tax advisor. 66 The loan will be a below-market loan if the loan does not have a stated loan interest in excess of the appropriate applicable federal rate under IRC Page 24 of 50

30 higher, a promissory note would not make sense as a rollout option. c. Use in Tandem with a Grantor Retained Annuity Trust (GRAT) If the clients have assets that are income producing and highly appreciating, creating a GRAT may help them later roll out of the split-dollar arrangement by providing a future transfer of wealth to the trust at a reduced transfer cost. In addition to creating an ILIT, the client's attorney will establish a GRAT to which the client will transfer appreciating assets. The GRAT will provide the client with an annuity stream for a term of years with the GRAT s remainder interest passing to the ILIT in order to assist with the rollout. Depending on the term of the retained interest and the retained annuity stream, there may be little or no gift tax imposed on the initial transfer of property to the GRAT. 67 If the client survives the term of the GRAT, any amount remaining in the GRAT will pass to the ILIT without the imposition of any gift. The ILIT can use those assets to help repay the assignee all or some of the amount owed at rollout. One disadvantage of using a GRAT, however, is that a client cannot allocate generation-skipping transfer (GST) tax exemption to his or her initial transfer to the GRAT to leverage the GST tax exemption. 68 This means that a GST tax will be imposed at the end 67 The taxable gift, if any, is equal to the fair market value of the property reduced by the client's retained annuity interest. The client s gift to the GRAT may be valued at zero if the GRAT is structured as what is known as a zeroed-out GRAT. With a zeroed-out GRAT the client is not treated as making a gift to the trust because the value of the client s retained interest is equal to the value of the property the client transferred to the trust. Although zeroed-out GRATs were traditionally avoided because Example 5 of Treas. Reg. Sec (e) stated that it was impossible to create a non-taxable GRAT, the Tax Court in Walton invalidated Example 5, allowing the taxpayer to create a zeroed-out GRAT. Walton v. Comm r., 115 T.C. 589 (2000). In Walton, the Tax Court ruled that grantor's right to receive a fixed amount for a term of years, provided that such right is a qualified interest within the meaning of Code Sec. 2702(b), is valued for gift tax purposes without regard to the life expectancy of the transferor and thus concluded that Example 5 is an unreasonable interpretation and an invalid extension of Code Sec IRC Sec. 2642(f) prohibits the allocation of GST tax exemption during an estate tax inclusion period (ETIP). The selected term of a GRAT is an ETIP because the value of the GRAT property necessary to provide the retained annuity payments will be included in the client's gross estate if he or she dies during the selected term. Page 25 of 50

31 of the client s retained term if the GRAT s remainder interest benefits skip persons 69 such as grandchildren. For those clients who intend to benefit grandchildren and other skip persons, GST tax exemption is typically allocated to fully exempt the trust from GST. Unless a client has sufficient GST tax exemption to allocate to the transfer of assets from the GRAT to the ILIT at the end of the GRAT term, the ILIT may no longer be fully GST tax exempt and may cause GST tax at either termination of the trust or distribution to a skip person. GST tax consideration therefore should carefully be consulted. Moreover, individuals considering a private split-dollar arrangement should not solely rely on the GRAT as a rollout strategy. The GRAT is an estate freezing technique and may not be successful if the asset transferred to the trust fails to appreciate or produce income in excess of the IRS s assumed rate of return (equal to the Sec rate). From a transfer tax perspective, the use of a GRAT is a "win-tie" situation. If the transferred asset fails to produce sufficient growth or income, the grantor will be in no worse position than he or she would have been if the GRAT had never been established, except for the legal fees and costs associated with initially establishing the GRAT. If the GRAT is successful, on the other hand, the client may significantly reduce the size of his or her taxable estate at little or no gift tax consequence and may provide the ILIT with funds to help rollout of the private split-dollar arrangements. Other rollout alternatives should also be considered and may be used in conjunction with the GRAT as a rollout strategy. d. If the Policy is a Second-to-Die Policy, Purchase of Individual Annual Renewable Term Rider or Separate Term Policy An individual annual renewable term rider or separate term policy may be another solution to the rollout dilemma if the policy is a 69 A skip person can be either a natural person or a trust. A transfer to a skip person who is a natural person is a transfer that is made to an individual who, under federal law, is assigned to a generation that is two or more generations below that of the transferor. IRC Sec. 2613(a)(1). A trust is a skip person if all interests in the trust are held by skip persons. IRC Sec. 2613(a)(2)(A). Page 26 of 50

32 second-to-die policy. Assuming underwriting requirements are met, the trustee can either purchase a rider to the second-to-die policy insuring the life of the spouse that is more likely to die first or a single life term policy insuring the life of the spouse likely to die first. The proceeds payable on the death of the spouse who is insured with the annual renewable term rider or separate term policy may provide the trust with the requisite funds to partially or completely rollout of the split-dollar arrangement. If, however, both insureds live a long life, the REB may become prohibitively large, necessitating a rollout of the split-dollar arrangement before the death of the spouse on which the rider or single life policy was purchased. Other rollout strategies should therefore also be considered and may be used in conjunction with this alternative. IV. Intra-Family Loans (Loan Regime) A. Practical Considerations A split-dollar arrangement is treated as a loan arrangement if (i) the payment is made either directly or indirectly by the non-owner to the owner or insurance company, (ii) the payment is a loan under general principles of the federal tax law or, if not, a reasonable person would expect the payment to be repaid in full to the non-owner (with or without interest), and the repayment is to be made from, or is secured by, the policy death benefit proceeds, cash surrender, or both. 70 They are structured to avoid the below market loan treatments under IRC Sec IRC Sec Sec of the Code prescribes the treatment of below market rate loans. Below market is generally a loan that bears an interest rate below the appropriate applicable federal rate (AFR) for the type and duration of the loan. Pursuant to the final regulations on split-dollar, new regulations have been added to Sec. 7872, codifying the treatment of private split-dollar loans ( intra-family loans ) used to pay life insurance premiums. An intra-family loan 70 Treas. Reg. Sec (a)(2). Page 27 of 50

33 should be structured with an interest at least equal to the appropriate AFR in order to avoid being treated as a below market loan under IRC Sec Otherwise, the loan will be recharacterized as a loan with interest at the AFR, coupled with a taxable imputed transfer by the lender to the borrower. Demand versus Term Loan An intra-family loan can be structured as either a demand loan or a term loan. A demand loan is a loan that is payable in full at any time on the demand of the lender. The loan interest prescribed for a demand loan must be no lower than the blended annual rate for the year. 71 A term loan is any intra-family loan other than a demand loan. The loan interest prescribed for a term loan must be no lower than the AFR appropriate for the loan's term. 72 Demand loans should not be used where the insured is also the lender because the lender s right to demand repayment may be deemed an incident of ownership of the policy; rather, a term loan should be used. Imputing Loan Interest If a demand loan is used, the loan interest can be imputed rather than paid. If the interest is imputed, the lender is treated as making a deemed gift of the interest amount to the ILIT. If a term loan is used, imputing the interest can have undesirable tax consequences due to the complicated original issue discount (OID) rules under Code Secs The difference between the loan amount and the present value of the loan amount at the loan's AFR is deemed transferred to the ILIT when the loan is first executed Treas. Reg. Sec (e)(3)(ii). The blended annual rates are published in the Internal Revenue Bulletin in July of each year. The annual blended rate can be found on the IRS website at 72 Treas. Reg. Sec (e)(4)(ii). The short-term AFR applies to terms of 3 years or less; the mid-term AFR applies to terms in excess of 3 years but less than 9 years; the long-term AFR applies to term in excess of 9 years.irc Sec. 1274(d)(1). 73 OID are income tax rules and may, therefore, be avoided by using a defective grantor trust as to the premium payor since transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 28 of 50

34 Another disadvantage of imputing the interest is that the deemed gift does not qualify for the annual gift tax exclusion because it is not a present interest. Thus, the premium payor has to use his or her lifetime exemption amount and/or pay gift tax on that amount. 74 Since intra-family loans are intended to reduce the gift tax cost of funding a policy, the ILIT will typically pay the loan interest, rather than impute it. Capitalizing Loan Interest The loan interest on an intra-family loan can be paid yearly or capitalized into the loan and paid at maturity. The benefits of capitalizing the loan interest is that the ILIT does not need to pay yearly interest. The insured, therefore, does not need to gift any funds to the ILIT. The disadvantage of capitalizing the loan interest, however, is that the yearly loan interest will be based on the entire loan principal, which will include the loan interest from the previous year. This amount will continue to increase every year. The loan interest may get so high and may leave little death benefit for the benefit of the ILIT. The client s tax advisor should be consulted on whether this type of loan is appropriate for a client. Loans Conditioned on Future Performance, Non-Recourse Loans and Contingent Payments Loan arrangements that are non-recourse or contain alternative repayment options based upon certain contingencies or future performance receive particular treatment pursuant to the Final Regulations. Such arrangements will be assessed using the contingent split-dollar method. 75 This method requires that the lowest possible value or yield of the contingent payments be considered when determining whether the loan is below market as discussed in prior sections. This value will be used when determining whether the loan will be considered below market and whether there will be income imputed to the parties. 74 See footnote Treas. Reg. Sec (d)(2)(ii). Page 29 of 50

35 The parties may keep a non-recourse loan from being treated as a loan with contingent payments by making a written representation to the IRS that a reasonable person would expect that all payments under the loan will be made. This can be done by signing a written representation before the last day of the taxable year (including extensions) for the taxable year in which the lender makes the first split-dollar loan under the arrangement. The representation must include the names, addresses and taxpayer identification numbers of the borrower, lender and any indirect participants. Each party is also required to attach a copy of the representation to its federal income tax return for each year that the representation applies. 76 Series of Loans versus Lump Sum Loan An intra-family dollar loan can be structured as (1) series of loans where each yearly premium is a separate loan or (2) lump sum loan where the ILIT borrows one large lump sum of money in the first year. The client s tax advisor should determine which type of loan is more appropriate in a particular situation. Both types offer several advantages. A single large lump sum loan structured as a term loan can provide more certainty because the loan interest can be locked in for the duration of the loan. With a series of loans, each premium payment would be a new loan with a new interest rate. A lump sum loan can also be less cumbersome because unlike a series of loans, there is only one loan made. The ILIT trustee can use part of the single lump sum loan to pay the life insurance premiums, the loan interest to the lender, and can invest the balance in an investment separate from the life insurance. The main disadvantage of using a lump sum loan, however, is that it is only available to those clients who have a very large sum of cash available and who are willing to part with that cash in one year. The loan must be in cash, not property. Seeding the ILIT With regards to sales to intentionally defective irrevocable trusts (IDIT sales), there has been concerns that the trust s promise to 76 Treas. Reg. Sec (d)(2)(ii). Page 30 of 50

36 pay the installment note may be deemed illusory and that the transaction would be deemed a transfer to a trust with a retained interest if the trust was under funded. Accordingly, most commentators recommend that the clients gift cash prior to the sale to seed the trust in an IDIT sale. It is unclear whether this also applies to intra-family loans made to a newly created ILIT that only owns a life insurance policy. One viewpoint is that the payment of the Sec applicable federal interest rate is a safe harbor and therefore there is no gift unless there is foregone interest. Another viewpoint is that Sec is simply silent on this issue and the Service could raise the argument. One approach in order to offset this argument would be to follow the approach used in IDIT sales and to seed the ILIT with gifts of cash prior to the lending of the funds. 77 Using the Life Insurance Policy as Collateral for the Loan The final regulations do not provide that the policy must be used as security for the loan. It may, however, be preferable to secure the loan with the life insurance policy and/or other ILIT assets in order to offset any potential argument that the loan is not a bona fide loan. A loan that is merely secured by the life insurance policy, however, is a non-recourse loan. For documentation requirements of a non-recourse loan, please see question How is the intra-family loan arrangement documented? Caveat when using a variable life insurance policy: Some lenders, such as broker-dealers and financial institutions, must satisfy additional lending requirements such as, but not limited to, per 12 C.F.R. 220 (Reg. T) and per 12 C.F.R. 221 (Reg. U) when loans are to be used to purchase a variable life insurance policy. Certain non-bank lenders who, in the ordinary course of business, extend credit secured by a variable life insurance policy may also be subject to the requirements of 12 C.F.R. 221 (Reg. U). Such lenders should seek the advice of their tax and legal advisors before making such loans. 77 Some commentators suggest that 10 to 15 percent of the total value of the property that will be sold to the IDIT is sufficient to seed the trust in an IDIT sale. Page 31 of 50

37 B. Intra-Family Loan Designs Non-Insured Spouse as Lender In situations where a married couple wants to purchase a single life policy in an ILIT, the non-insured spouse can serve as the lender of the policy premiums. If the non-insured spouse is the lender, the loan can be structured either as a term loan or a demand loan. The non-insured spouse can lend yearly premiums to the ILIT or can make one lump sum loan to the ILIT up front. Insured can minimize the gift to finance a trust-owned policy. If structured properly, intra-family loans can reduce gifts made to an ILIT to fund a life insurance policy because the premiums paid by the insured s spouse are a loan to the ILIT, not gifts. The non-insured spouse can retain some access to the trust-owned policy s cash value. If a demand loan is used, the non-insured spouse can demand repayment of the loan at any time. The ILIT trustee can then use the policy s cash surrender value and/or other assets in the ILIT to repay the non-insured spouse as lender. While access to cash value may be an important benefit to this particular type of intra-family loan design, it should not be the sole reason for establishing an intra-family loan arrangement. The primary reason for most private split-dollar arrangements is to reduce the gift amount to fund a policy owned outside of the insured s estate. Indirect access to cash value may be obtained through other, relatively simpler, drafting techniques A competent estate planning attorney can draft an ILIT that should provide an insured's spouse with access to trust assets during the insured's life without causing inclusion of the death benefit in either spouse's estate. Page 32 of 50

38 The trust s portion of the policy s death benefit should pass to the trust beneficiaries free from estate tax. 79 The trust s portion of the death benefit should pass to the trust beneficiaries free from estate tax. This statement is true provided that the trust and agreements to effectuate the intra-family loan arrangement are properly drafted so that the insured does not retain any prohibited power or benefit over the trust nor any incident of ownership over the policy that would cause the trust proceeds to be included in his or her estate. 80 Incomplete estate planning could, however, cause the trust s portion of the death benefit to be included in the insured s estate. The non-insured spouse s contractual rights under the intra-family loan arrangement may include rights that could cause the entire policy proceeds to be included in the insured s estate if held by the insured at or within three years of his or her death. 81 Accordingly, such contractual interests should not pass to the insured. The noninsured spouse should bequeath his or her interest to anyone other than the insured (e.g., his or her children or grandchildren) in his or her will or living trust. In addition, if the insured is the executor of the will or the trustee of the trust that distributes the non-insured spouse s contractual interest, the non-insured spouse s will or trust should designate a special executor or trustee to take all actions with respect to his or her contractual interest. Otherwise the insured will possess rights over the policy that could cause the entire policy proceeds to be included in his or her estate See footnote IRC Secs. 2036, 2038 and In Priv. Ltr. Rul , the Service privately ruled that the lending of premiums by the insured to a trust that he or she created did not create incidents of ownership in the policy. 81 IRC Sec Id. Page 33 of 50

39 C. Disadvantages Intra-Family Loans by Non-Insured Spouse ILIT may not have sufficient funds to repay loan. If the lender spouse demands repayment of loan or if the term of the loan expires when the policy s cash surrender value is less than the loan balance, the policy may be surrendered in order to satisfy part of the loan repayment and the ILIT may not have sufficient assets to satisfy the difference. Depending on the terms of the agreement, the insured spouse may need to gift additional funds to the ILIT to satisfy the difference. Consequently, the ILIT may be left without the adequate death benefit needed for estate liquidity purposes. Loan interest may be disregarded. IRC Sec governs below-market loans. Those loans bearing sufficient loan interest, on the other hand, are taxed under general rules for debt instruments. 83 The split-dollar final regulations provide that interest provisions will be disregarded if an intrafamily loan provides for the payment of interest and all or a portion of the interest is to be paid directly or indirectly by the lender (or a person related to the lender). 84 As an example, the regulations provide that if an employer and employee set up a deferred compensation plan as part of the intra-family loan arrangement that provides for the lender to pay an amount equal to the loan interest to the employee, that loan interest will be disregarded. It is unclear whether this provision prohibits a donor lender from gifting to the ILIT an amount equal to the loan interest each year because the lender would be indirectly paying the loan interest. The final regulations provide that all of the facts and circumstances determine whether a payment to be made by the lender (or a person related to the lender) is sufficiently independent from the intrafamily loan for the payment to not be an indirect payment of the interest (or a portion thereof) by the lender (or a person related to 83 Treas. Reg. Sec (a)(1). 84 Treas. Reg. Sec (a)(4). Page 34 of 50

40 the lender). 85 In order to avoid the argument that the gift of money or assets to the ILIT by the lender is an indirect payment of the loan interest by the lender, the gifting should be structured independently from the ILIT s requirement to pay the loan interest. Value of loan balance included in lender spouse s estate. Upon the death of the lender spouse, the amount currently owed to the lender spouse pursuant to the loan agreement will be included in his or her estate. 86 Loan interest may be income taxable to lender. Loan interests are income and therefore income taxable to the lender. Establishing the ILIT as a defective grantor trust as to the lender spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the loan interest. 87 If the trust is drafted as a grantor trust to the lender, the lender should not be a beneficiary of the ILIT; otherwise, the death benefit proceeds may be includible in the lender s estate under IRC Sec Interest rates may fluctuate. With a demand loan, the loan is tested for sufficient interest based on the annual blended rate on a yearly basis. 88 The interest rate with a demand loan, therefore, may change every year and therefore exposes the parties to unpredictable spikes in interest rates. With a term loan, the loan is tested for sufficient interest based on the AFR appropriate for the loan s term. 89 Even though the interest rate is locked in for the term of a specific loaned amount, each premium payment is treated as a new loan; therefore, 85 Treas. Reg. Sec (a)(4). 86 IRC Sec Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Treas. Reg. Sec (e)(3)(ii). 89 Treas. Reg. Sec (e)(4)(ii). Page 35 of 50

41 unless a single lump sum loan is used, each premium payment borrowed may bear a new interest rate therefore exposing the parties to some interest rate fluctuations. D. Intra-Family Loan Designs Insured(s) as Lender In some instances, an insured will serve as the lender of the life insurance premiums. Situations include when a couple is purchasing a second-to-die policy or when a single person is purchasing a policy on his or her life. When an insured is also the lender, caution should be taken to avoid any incidents of ownership in the life insurance policy that could cause estate inclusion of the death benefit. A demand loan, therefore, should not be used when the insured is also the lender because the lender s right to demand repayment may be deemed an incident of ownership of the policy; rather, a term loan should be used when an insured is also the lender. In addition, if the life insurance policy is used to secure the loan, a restricted collateral assignment should be used to avoid any incidents of ownership. The restricted collateral assignment would restrict the insured s access to the cash value and limit his or her right in the policy to a right of reimbursement only upon termination. Benefits Intra-Family Loans by Insured(s) as Lender(s) Insureds can minimize the gift to finance a trust-owned policy. If structured properly, intra-family loans can reduce gifts made to an ILIT to fund a life insurance policy because the premiums paid by the insureds as lenders are a loan to the ILIT, not gifts. The ILIT s portion of the policy s death benefit should pass to the ILIT beneficiaries free from estate tax. The trust s portion of the death benefit, as set forth in the intrafamily loan arrangement, should pass to the trust beneficiaries free Page 36 of 50

42 from estate tax. 90 This statement is true provided that the insureds do not retain any prohibited power or benefit over the trust nor any incident of ownership over the policy. 91 The insureds should not retain any incidents of ownership over the policy even though they are a party to the intra-family loan agreement provided that their rights over the policy were restricted to the right to reimbursement on termination of the split-dollar arrangement. 92 A properly drafted ILIT, intra-family loan agreement and the use of a restricted collateral assignment form should ensure this result. Disadvantages Intra-Family Loans by Insured(s) as Lender(s) ILIT may not have sufficient funds to repay loan. If the term of the loan expires when the policy s cash surrender value is less than the loan balance and the trust does not have other assets, the ILIT may not have sufficient assets to satisfy the difference. Depending on the terms of the agreement, the insured(s) may need to gift additional funds to the ILIT to satisfy the difference. If the policy is surrendered to satisfy repayment of the loan, the ILIT may be left without the adequate death benefit needed for estate liquidity purposes. Some alternatives to avoid this problem include establishing a loan payable upon the death of the individual or renewing the loan when the term expires. 90 In Priv. Ltr. Rul , the Service privately ruled that the lending of premiums by the insured to a trust that he or she created did not create incidents of ownership in the policy. 91 IRC Secs.2036, 2038, 2042.IRC Sec. 2512(b). 92 In Private Letter Ruling (Aug. 8, 1997), the Service concluded that the policy proceeds payable to the trust were excludable from both insureds' estates because the insureds did not have any incidents of ownership over the policy nor any prohibited powers over the trust. While the policy subject to the private split-dollar arrangement in that ruling was a second-to-die policy, the Service's reasoning should apply even if the policy subject to the arrangement is a single life policy. Accordingly, a single insured should also be able to exclude policy proceeds payable to the trust from his or her estate provided that he or she does not retain any incidents of ownership over the policy nor any prohibited powers over the trust. Page 37 of 50

43 Loan interest may be disregarded. IRC Sec governs below-market loans. Those loans bearing sufficient loan interest, on the other hand, are taxed under general rules for debt instruments. 93 The split-dollar final regulations provide that interest provisions will be disregarded "if an intrafamily loan provides for the payment of interest and all or a portion of the interest is to be paid directly or indirectly by the lender (or a person related to the lender)." 94 It is unclear whether this provision prohibits a donor lender from gifting to the ILIT an amount equal to the loan interest each year because the lender would be "indirectly" paying the loan interest. The final regulations provide that "all of the facts and circumstances determine whether a payment to be made by the lender (or a person related to the lender) is sufficiently independent from the intra-family loan for the payment to not be an indirect payment of the interest (or a portion thereof) by the lender (or a person related to the lender)." 95 In order to avoid the argument that the gift of money or assets to the ILIT by the lender is an indirect payment of the loan interest by the lender, the gifting should be structured independently from the ILIT's requirement to pay the loan interest. Value of loan balance included in insured(s) estate. Upon the death of the lender(s), the amount currently owed to the lender(s) pursuant to the loan agreement will be included in his or her estate. 96 Loan interest may be income taxable to lender(s). Loan interests are income and therefore income taxable to the lender. Establishing the ILIT as a defective grantor trust as to the lender(s) may be considered by the client s legal and tax advisors 93 Treas. Reg. Sec (a)(1). 94 Treas. Reg. Sec (a)(1). 95 Id. 96 IRC Sec Page 38 of 50

44 to possibly avoid the income taxation of the loan interest. 97 If the trust is drafted as a grantor trust to the lender, the lender should not be a beneficiary of the ILIT; otherwise, the death benefit proceeds may be includible in the lender's estate under IRC Sec Interest rates may fluctuate. A term loan is tested for sufficient interest based on the AFR appropriate for the loan s term. 98 With intra-family loans, even though the interest rate is locked in for the term of a specific loaned amount, each premium payment is treated as a new loan and therefore may bear a new interest rate therefore exposing the parties to some interest rate fluctuations. If a single lump sum loan is used, the interest rate will be set for the entire duration of the predetermined term of the loan. Original Issue Discount (OID) Issues If the loan interests on a term loan are imputed, undesirable tax consequences would result due to the complicated OID rules established in IRC Secs The difference between the loan amount and the present value of the loan amount at the loan's AFR is deemed a taxable transfer to the ILIT when the loan is first executed. 99 Another disadvantage of imputing the interest is that the deemed gift may not qualify for the annual gift tax exclusion because it is not a present interest gift. Thus, the premium payor has to use his or her lifetime exemption amount and/or pay gift tax on that amount. Since intra-family loans are intended to reduce the gift tax cost of funding a policy, the ILIT will typically pay the loan interest, rather than impute it. 97 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Treas. Reg. Sec (e)(4)(ii). 99 OID rules are income tax rules and may, therefore, be avoided by using a defective grantor trust as to the insured since transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 39 of 50

45 E. Pertinent Tax Issues Questions & Answers Relating to Intra-Family Loans Structuring loan transactions under IRC Sec and OID rules can be complex. This pocket guide is not intended as a complete discussion of those issues. It is important that individuals considering entering into an intra-family loan arrangement consult their tax and legal advisors on all issues. Some lenders, such as broker-dealers and financial institutions, must satisfy additional lending requirements such as, but not limited to, per 12 C.F.R. 220 (Reg. T) and per 12 C.F.R. 221 (Reg. U) when loans are to be used to purchase a variable life insurance policy. Certain non-bank lenders who, in the ordinary course of business, extend credit secured by a variable life insurance policy may also be subject to the requirements of 12 C.F.R. 221 (Reg. U). Such lenders should seek the advice of their tax and legal advisors before making such loans. 1. What is the interest rate used for testing sufficient interest on a demand loan? The loan interest prescribed for a demand loan must be no lower than the blended annual rate for the year. 100 The blended annual rates are published in the Internal Revenue Bulletin in July of each year. 101 If the loan interest is lower than the blended annual rate, the loan will be a below-market loan and the foregone interest will be treated as gifted by the lender to the ILIT and as retransferred as interest by the ILIT to the lender on the last day of the calendar year. The foregone interest is the excess of the amount of interest that would have been payable on the loan for the calendar year if interest accrued at the blended annual rate minus any interest that accrued on the loan during the year Treas. Reg. Sec (e)(3)(ii). 101 The annual blended rate can be found on the IRS website at Id. Page 40 of 50

46 Further, as a demand loan, there is the option not to have the ILIT pay the loan interest but rather have it deemed an imputed gift to the ILIT. This imputed gift, however, will not qualify for the annual gift tax exclusion and may reduce the applicable exemption amount available at the insured's death or trigger gift taxes. The ILIT, therefore, should pay the loan interest in order to unnecessarily use the lender's exemption amount or trigger gift taxes. 2. What is the interest rate used for testing sufficient interest on a term loan? The loan interest prescribed for a term loan must be no lower than the applicable federal rate (AFR) appropriate for the loan's term. 103 The short term AFR applies to terms of 3 years or less; the midterm AFR applies to terms in excess of 3 years but less than or equal to 9 years; the long term AFR applies to term in excess of 9 years. 104 If the loan interest is lower than the appropriate AFR, the loan will be a below-market loan and the foregone interest will be treated as gifted by the lender to the ILIT and as retransferred as interest by the ILIT to the lender on the last day of the calendar year. The foregone interest is the excess of the amount of interest that would have been payable on the loan for the calendar year if interest accrued at the blended annual rate minus any interest that accrued on the loan during the year. 105 Unlike with a demand loan, the loan interest on a term loan should be paid at least annually and should not be imputed. If the loan interests on a term loan are imputed, undesirable tax consequences would result due to the complicated original issue discount (OID) rules established in IRC Secs The difference between the loan amount and the present value of the loan amount at the 103 Treas. Reg. Sec (e)(4)(ii). 104 IRC Sec. 1274(d)(1). 105 Treas. Reg. Sec (e)(3)(ii). Page 41 of 50

47 loan's AFR is deemed a taxable transfer to the ILIT when the loan is first executed. 106 Another disadvantage of imputing the interest is that the deemed gift does not qualify for the annual gift tax exclusion because it is not a present interest. Thus, the premium payor has to use his or her lifetime exemption amount and/or pay gift tax on that amount. Since intra-family loans are intended to reduce the gift tax cost of funding a policy, the ILIT will typically pay the loan interest, rather than impute it. 3. Can the lender(s) gift an amount equal to the loan interest to the trust to pay the loan interest to the lender(s)? IRC Sec governs below-market loans. Those loans bearing sufficient loan interest, on the other hand, are taxed under general rules for debt instruments. 107 The split-dollar final regulations, however, provide that interest provisions will be disregarded "if an intra-family loan provides for the payment of interest and all or a portion of the interest is to be paid directly or indirectly by the lender (or a person related to the lender)." 108 As an example, the regulations provide that if an employer and employee set up a deferred compensation plan as part of the intra-family loan arrangement that provides for the lender to pay an amount equal to the loan interest to the employee, that loan interest will be disregarded. It is unclear whether this provision prohibits a donor lender from gifting to the ILIT an amount equal to the loan interest each year because the lender would be "indirectly" paying the loan interest. The final regulations provide that "all of the facts and circumstances determine whether a payment to be made by the lender (or a person related to the lender) is sufficiently independent from the intra-family loan for the payment to not be an indirect 106 OID rules are income tax rules and may, therefore, be avoided by using a defective grantor trust as to the insured since transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Treas. Reg. Sec (a)(1). 108 Treas. Reg. Sec (a)(4). Page 42 of 50

48 payment of the interest (or a portion thereof) by the lender (or a person related to the lender)." 109 As a contrasting example, the final regulations provide that where an employee and employer enter into a deferred compensation arrangement that will provide a payment equal to the employee s salary in the three years preceding the retirement of the employee and also enter into an intra-family loan arrangement, the facts and circumstances indicate that the payment of the non-qualified compensation is independent from the employee's requirement to pay interest under the intra-family loan. The regulations provide that this is because the terms and conditions of the employee's deferred compensation plan do not change in a way that indicates that the payment of the non-qualified deferred compensation is related to his or her requirement to pay interest on the intra-family loan. In order to avoid the argument that the gift of money or assets to the ILIT by the lender is an indirect payment of the loan interest by the lender, the gifting should be structured independently from the ILIT's requirement to pay the loan interest. For example, if the annual gifting to the ILIT constitutes an amount equal to the loan interest due rather than gifting the same amount to the ILIT each year irrespective of the loan interest, the facts and circumstances may indicate that the gifting and the payment of loan interest are not independent of each other and therefore disregarded. A less formal arrangement where a donor makes gifts to the ILIT in an amount irrespective of the loan interest amount may be more desirable. The client's tax advisors should be consulted on this issue before implementing such a gifting program to avoid having the loan interest provisions disregarded. 4. What are the benefits of using a demand loan versus a term loan and vice versa? The benefit of using a demand loan is that a demand loan can allow for the use of a lower interest rate. While term loans are 109 Treas. Reg. Sec (a)(4). Page 43 of 50

49 based on the appropriate AFR (depending on the duration of the note), a demand loan is based on the annual blended rate which is often times lower than the AFR used with a term loan. However, using a demand loan can have its disadvantages. For example, the interest rate with a demand loan changes every year and therefore exposes the parties to unpredictable spikes in interest rates while the interest on a term loan would be locked in for the duration of the term. Moreover, demand loans are not appropriate in all situations. As mentioned previously, demand loans should not be used where the lender is also the insured because the lender's right to demand the loan may be deemed incidents of ownership in the policy causing inclusion in the insured's estate. Rather, where the lender is also the insured, a term loan should be used. 5. Are the loan interest payments income taxable to the lender? Loan interests are income to the lender. Therefore, the interest would generally be income taxable to the lender. Establishing the ILIT as a defective grantor trust as to the lender spouse may be considered by the client s legal and tax advisors to possibly avoid the income taxation of the loan interest. 110 If the trust is drafted as a grantor trust to the lender, the lender should not be a beneficiary of the ILIT and should not hold any prohibited powers that may cause estate inclusion. 6. Could the loan transaction be re-characterized as a transfer with a retained interest? With regards to sales to intentionally defective irrevocable trusts (IDIT sales), there has been concerns that the IDIT s promise to pay the installment note may be deemed illusory and that the transaction would be deemed a transfer to a trust with a retained interest if the trust was under funded. Accordingly, in an IDIT sale, most commentators recommend that the clients gift cash prior 110 Revenue Ruling is often cited for the proposition that transactions between a grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B Page 44 of 50

50 to the sale to seed the trust in an IDIT sale. It is unclear whether this also applies to Sec loans made to a newly created ILIT that only owns a life insurance policy. One viewpoint is that the payment of the Sec applicable federal interest rate is a safe harbor and therefore there is no gift unless there is foregone interest. Another viewpoint is that Sec is simply silent on this issue and the Service could raise the argument. One approach would be to follow the approach used in IDIT sales and to seed the ILIT with gifts of cash prior to the lending of the funds Can the loan interest be capitalized into the loan rather than paid yearly? The loan interest on an intra-family loan can be capitalized into the loan and paid at maturity. The benefits of capitalizing the loan interest is that the ILIT does not need to pay yearly interest. The insured, therefore, does not need to make yearly gifts to the ILIT. The disadvantage of capitalizing the loan interest, however, is that the yearly loan interest will be based on the entire loan principal, which will include the loan interest from the previous year. This amount will continue to increase every year. The loan interest may get so high and may leave little death benefit for the benefit of the ILIT. The client s tax advisor should be consulted on whether this type of loan is appropriate for a client. 8. What are the benefits of using a single lump sum loan over a series of loans and vice versa? A single large lump sum loan structured as a term loan can provide more certainty because the loan interest can be locked in for the duration of the loan. With a series of loans, each premium payment would be a new loan with a new interest rate. A lump sum loan can also be less cumbersome because unlike a series of loans, there is only one loan made. The ILIT trustee can use part of the single lump sum loan to pay the life insurance premiums, the loan interest to the lender, and can invest the balance in an investment separate 111 Some commentators suggest that 10 to 15 percent of the total value of the property that will be sold to the IDIT is sufficient to seed the trust in an IDIT sale. Page 45 of 50

51 from the life insurance. If the side investment generates sufficient funds, the insured may not need to make additional gifts to the ILIT because the trustee can use the side investments to make future premium payments and/or interest payments. Furthermore, the trustee can use the side investments to help repay the lender at the end of the predetermined term of the loan. The main disadvantage of using a lump sum loan, however, is that it is only available to those clients who have a very large sum of cash available and who are willing to part with that cash in one year. The loan must be in cash, not property. In addition, there is a possibility that the side investment will not generate sufficient income to pay future premiums and/or interest. Furthermore, the yearly loan interest would be very large because it would be on a much larger initial loan principal. 9. What is included in the clients estate? Upon the death of the lender spouse, only the amount currently owed to the lender spouse pursuant to the loan agreement should be included in his or her estate. 112 The portion of the life insurance death benefit ultimately payable to the ILIT should pass to the trust and to the trust beneficiaries free from estate tax. This statement is true provided that the insureds do not retain any prohibited power or benefit over the trust or any incident of ownership over the policy How is an intra-family loan payable at the death of the insured treated? Intra-family loans payable at the death of an individual are treated as term loans in determining whether there is sufficient interest under IRC Sec (see previous question 2). 114 The term of the loan is the life expectancy of the insured as determined under the 112 IRC Sec IRC Secs. 2036, 2038, 2042.IRC Sec. 2512(b). In PLR , the IRS ruled that the lending of premium payments by the insured to a trust he or she created did not create incidents of ownership in the policy. 114 Treas. Reg. Sec (e)(5)(i). Page 46 of 50

52 appropriate table in Treas. Reg. Sec on the date the loan is made. 115 If the loan fails to have sufficient loan interest and is a below market loan, any foregone interest would be treated, for federal gift tax purposes, as a one-time imputed transfer at the date the loan is contracted that would not qualify for the annual gift tax exclusion. 116 If the insured outlives his or her life expectancy, the intra-family loan would be treated as retired and reissued as a splitdollar demand loan at such time for the loan s adjusted issue price on that date. The loan, however, would not be retested for sufficiency of interest at that time. Rather, for purposes of determining forgone interest, the appropriate AFR for the reissued loan is the AFR determined on the day the loan was originally contracted How is the intra-family loan arrangement documented? To create an intra-family loan arrangement, the trustee of the ILIT and the lender spouse execute an intra-family loan agreement (demand or term) and generally submit a collateral assignment form to the life insurance company. The written loan agreement should set forth the rights and obligations of the trustee and the lender to prevent the Service from arguing that the lender s payment of premiums were gifts to the trust beneficiaries. In intrafamily loan cases where the insured is also the lender (such as in a second-to-die scenario or in a single life policy for a single person scenario), a term loan arrangement is recommended over a demand loan arrangement to avoid any incidents of ownership. Furthermore, a restricted collateral assignment form should be used when the insured is also the lender in the arrangement to avoid inclusion of the death benefit proceeds in the insured lender s estate. 115 Treas. Reg. Sec (e)(5)(ii)(C). 116 Treas. Reg. Sec (e)(5)(iv). This transfer would not qualify for the annual gift tax exclusion because it is not a present interest gift. 117 Treas. Reg. Sec (e)(5)(iii)(D). Page 47 of 50

53 If the loan arrangement is established as non-recourse 118 to the borrower, an additional written representation may be needed since the regulations treat a non-recourse loan as a loan that provides for contingent payments thereby complicating the calculation of the tax consequences and testing for adequacy of interest. 119 The regulations provide that contingent payments will not apply to a non-recourse loan if the parties to the arrangement represent in writing that a reasonable person would expect that all payments under the loan would be made. 120 The regulations provide that the Commissioner may prescribe the time and manner for providing the written representation. Until the Commissioner prescribes otherwise, in order to avoid the treatment of the loan as one that provides for contingent payments, both the borrower and lender must sign such a representation not later than the last day for filing the federal income tax return of the borrower or lender (whichever is earlier) for the year in which the lender makes the first loan under the arrangement. The representation must include the names, addresses and taxpayer identification numbers of the borrower and lender. A copy of the representation should be attached to each party s federal tax return for such year Does the de minimis rule contained in IRC Sec apply? Under normal applications of IRC Sec. 7872, its rules generally do not apply to gift loans, compensation-related loans, or corporate-shareholder loans on any day on which the aggregate amount of indebtedness outstanding does not exceed $10, However, under the final split-dollar regulations, Sec rules 118 The term non-recourse is not defined in the regulations. It is unclear whether a recourse loan to an ILIT with no assets other than the life insurance policy would be treated as non-recourse for this purpose. One alternative to avoid that treatment when using a recourse loan with a newly created ILIT may be to fund (or seed ) the trust with additional funds that can be used as collateral in addition to the life insurance policy s cash value. 119 Treas. Reg. Sec (d) and (j). 120 Treas. Reg. Sec (d)(2)(i). 121 Treas. Reg. Sec (d)(2)(ii). 122 IRC Sec. 7872(c)(2)-(3). Page 48 of 50

54 are applied to an intra-family loan without regard to the de minimis exceptions contained in IRC Sec V. Conclusion The use of a private split-dollar arrangement may allow a wealthy individual to purchase the appropriate amount of life insurance death benefit needed for estate liquidity purposes while minimizing gift tax cost. In order to benefit from these arrangements, it is important that the private split-dollar arrangement is set up properly. The client s independent legal counsel and tax advisors should be consulted on all issues. If structured properly, private split-dollar can be an effective technique. 123 Treas. Reg. Sec (a)(3). Page 49 of 50

55 VI. Appendix A Which private split-dollar design is appropriate for new cases? For younger insured or for secondto-die policies Compare cost of current life insurance protection For older insured or in low interest rate environment For single life policy on a married individual where noninsured is donor/assignee Consider: Single Life Private Split- Dollar For single life policy on single insured or for second-to-die policy Consider: Single Life Private Split-Dollar Single Insured or Second-to-Die Private Split- Dollar For single life policy on a married insured where noninsured is lender Consider: ILIT-Owned Policy Purchased with Intra-Family Loans (Demand or Term) or Single Lump Sum Intra- Family Loan by Non- Insured For single life policy on single insured or for second-to-die policy Consider: ILIT-Owned Policy Purchased with Intra-Family Term Loans or Single Lump Sum Intra-Family Loan by Insured Checklist: Checklist: Checklist: Checklist: ILIT ILIT ILIT ILIT Split-Dollar Agreement Collateral Assignment Implement Exit Strategy Restricted Split-Dollar Agreement Restricted Collateral Assignment Implement Exit Strategy Demand or Term Loan Agreement Collateral Assignment Implement Exit Strategy Term Loan Agreement Restricted Collateral Assignment Implement Exit Strategy Page 50 of 50

56 Pacific Life Insurance Company Newport Beach, CA (800) Pacific Life & Annuity Company Newport Beach, CA (888) Pacific Life refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company. Insurance products are issued by Pacific Life Insurance Company in all states except New York and in New York by Pacific Life & Annuity Company. Product availability and features may vary by state. Each insurance company is solely responsible for the financial obligations accruing under the products it issues. Insurance products and their guarantees, including optional benefits and any fixed subaccount crediting rates, are backed by the financial strength and claims-paying ability of the issuing insurance company, but they do not protect the value of the variable investment options. Look to the strength of the life insurance company with regard to such guarantees as these guarantees are not backed by the broker-dealer, insurance agency or their affiliates from which products are purchased. Neither these entities nor their representatives make any representation or assurance regarding the claims-paying ability of the life insurance company. Variable insurance products are distributed by Pacific Select Distributors, Inc., (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company, and an affiliate of Pacific Life & Annuity Company, and are available through licensed third-party broker-dealers.. Please Note: This brochure is designed to provide introductory information in regard to the subject matter covered. Neither Pacific Life nor its representatives offer legal or tax advice.. Consult your attorney or tax advisor for complete up-to-date information concerning federal and state tax laws in this area. Life Insurance Producer's Name.. Insurance Professional s Name State Insurance License Number (or affix your business card) State Insurance License Number (or affix your business card) AD-OC-724B /13