A D V A N C E D M A R K E T S Sales Strategy MONTHLY PUBLICATION DESCRIBING TIMELY AND USEFUL SALES IDEAS AND CONCEPTS EXIT STRATEGIES When putting a financing plan together, it is important to make sure that there is an exit strategy in place, if necessary. With today s low interest rates, planning techniques such as premium and private financing are popular ways to leverage assets to pay life insurance premiums. In these arrangements, the loan interest rate is usually based on the London Interbank Offered Rate (LIBOR) plus a spread, or the mid-term applicable federal rate (AFR), which over the past couple of years have experienced all time lows, making them very attractive. 1 However, eventually rates will go up and people will look not only for alternative planning ideas but also cost effective strategies to exit commercial and private financing arrangements. OVERVIEW OF COMMERCIAL AND PRIVATE FINANCING Commercial and private financing are planning techniques in which a loan is taken to pay the premium on a life insurance policy. With commercial financing, the policy cash value and other collateral are used to secure the loan. The insured pays the interest on the loan each year, which in most instances is lower than both the insurance premium and any investment returns on the assets being used as collateral. Depending on the age of the client, the loan is either paid off at death or after a term of years. The interest rate may be adjusted annually or may be fixed for a period of time but is usually not fixed for life. WHY DO WE NEED EXIT STRATEGIES? The challenges that clients face with a commercial or private financing arrangement often depend on variables such as the age of the insured, increases in interest rates, or a change in the tax law. The typical prospects for these types of arrangements are older individuals. However, when the plan is designed with an exit strategy in place, the insured has a neat and tax-effective way to leverage his or her assets and to terminate the arrangement. WHAT ARE EXIT STRATEGIES? Exit Strategies are estate planning techniques that help you terminate a premium or private financing arrangement when the financing is no longer needed or interest rates become too high. Popular exit strategies to consider are defective irrevocable grantor income trusts (DIGITs), grantor retained annuity trusts (GRATs) and charitable lead trusts (CLTs). 2 1 of 5
DEFECTIVE IRREVOCABLE GRANTOR INCOME TRUSTS (DIGITS) What is a DIGIT? A defective irrevocable grantor income trust (DIGIT) is an irrevocable trust where the grantor is the owner of the trust for income tax purposes, but the trust proceeds are still outside the taxable estate for estate tax purposes. 3 How does it work? The grantor/insured can either gift cash or assets such as stock or interest in a family limited partnership to the DIGIT or sell assets through an installment sales arrangement in which interest is based on the applicable federal rate (AFR). The grantor is responsible for paying any income taxes due on trust income. The Exit. By using a DIGIT as part of a premium or private financing arrangement, the income produced by the assets inside the trust can be used to pay off the loan and any interest due. Since a DIGIT is a grantor trust, the trust assets are not eroded by income taxes and are also available to pay any outstanding loan payments. To better understand, let s look at an example. 4 JULIA AND HENRY TALBOT The problem. Julia (70) and Henry (75), both non-smokers preferred, have an estate of $10,000,000, which is growing at 5% after-tax. They have two children and four grandchildren. The majority of their assets are tied up in a family limited partnership and real estate. They currently have insurance and have determined that they will need an additional $2 million in coverage. They are using the annual exclusions that they have available. They do not want to liquidate any assets to pay the premiums. The Solution. Julia and Henry s financial advisor recommends they enter into a private financing arrangement and use a Defective Irrevocable Grantor Income Trust (DIGIT) as the exit strategy. Here is how it will work. They will make a loan to the DIGIT to finance a life insurance policy. 5 They will also sell interest in one of their real estate holdings to the DIGIT. 6 The trustee will use the proceeds to purchase a $2 million Survivorship UL policy 7 and to pay the interest due on the premium loan. After the premiums have been paid, the DIGIT will use the trust income and remaining assets to pay off the entire loan. Here is what it will look like. Talbot Family DIGIT Life Insurance Policy Annual Premium $33,899 Why does this work? The assets build up inside the trust income tax-free. Once the side fund has reached a sufficient amount, it can be used to pay off the loan and terminate the financing arrangement. 2 of 5
GRANTOR RETAINED ANNUITY TRUSTS (GRAT) What is a GRAT? A grantor retained annuity trust is an irrevocable trust in which a person can transfer property to the trust and retain the right to receive an income stream for a fixed period of time. At the end of the GRAT term, the property transfers to the remainder beneficiaries named in the trust. How does it work? The grantor will make a gift to the GRAT of assets such as stock or real estate. The value of the gift to the GRAT is discounted, i.e., for gift tax purposes the value of the remainder interest is based upon a formula that factors in the Section 7520 rate, the length of the trust term and the amount of the annuity payout. The GRAT technique can be used to freeze the value of an asset after the initial valuation. Since the GRAT is only in existence for a term of years and not for life, life insurance is usually purchased to prevent the cost of an early death. If the grantor of a GRAT dies before the end of the trust term, all or a part of the trust assets will be included in the grantor s taxable estate. The Exit Strategy. A GRAT is a great exit strategy for a financing arrangement. The grantor will enter into an arrangement with the irrevocable life insurance trust (ILIT). The remainder interest from the GRAT will go into the ILIT and will be used to pay off the outstanding loan. A zeroed out Walton GRAT can also be considered for a lifetime exit strategy, to cut down on the amount of the gift to the GRAT. 8 To better understand, let s look at an example. HEIDI AND CRAIG NELSON The Facts. Heidi (56) and Craig (60) are both non-smoker preferred. They have an estate valued at $10,000,000 which is growing at 5%. As part of their estate they have $5,000,000 in stock. They are looking for a way to fund an additional life insurance policy of $3,000,000. The Solution. Private Financing with a GRAT exit strategy. Here is how it will work. Heidi and Craig will transfer stock to a GRAT. The GRAT will then make an annuity payment each year to the Nelsons. The Nelsons can use the annuity income (or other cash) to loan the life insurance premium to an ILIT each year. The ILIT will purchase a Survivorship UL life insurance policy on their lives. At the end of the GRAT term, the remaining GRAT assets will transfer to the ILIT, since the ILIT is the remainder beneficiary of the GRAT. The ILIT will pay back the loan to Heidi and Craig and will continue to make premium payments on the policy. 3 of 5
ANNUITY PAYMENTS STOCK GRAT GRAT REMAINDER Heidi and Craig LOANS TO FUND PREMIUMS INTEREST AND LOAN PRINCIPLE DUE ON PREMIUM LOAN PREMIUM ILIT DEATH BENEFIT Survivorship UL Policy Why does this work? In this arrangement, Heidi and Craig are able to leverage their stock, without liquidating it all at once. The GRAT will make an annuity payment back to Heidi and Craig, which they can use for the loan to the trust. Once the GRAT term has expired, the stock will transfer to the ILIT (as the beneficiary of the GRAT) and can be liquidated to pay back Heidi and Craig for the premium loan. This approach has allowed them to leverage their stock without having to pay capital gains taxes, reduced the size of their taxable estate, and enabled them to purchase the additional life insurance that they needed. CHARITABLE LEAD TRUSTS (CLTS) What is a CLT? A CLT is a split-interest trust that is the inverse of a charitable remainder trust (CRT). With a CLT, the charitable beneficiary receives an income stream for a period of time and the non-charitable beneficiaries receive the remaining trust assets at the end of the trust term. How does it work? The grantor will gift an asset to the CLT. The interest on the asset will grow at the applicable federal rate. The charity will receive a percentage payout for a period of time. At the end of the trust term, the asset will either revert back to the grantor or family beneficiaries or into a trust. The Exit Strategy. The CLT works similar to the GRAT as an exit strategy for the financing arrangement. With the CLT, at the end of the trust term all the assets will transfer to the ILIT (as the beneficiary of the CLT) and the ILIT will use the available assets and income to pay off the loan to the grantor. 4 of 5
SUMMARY It is always best to plan ahead, and it is even more important to plan carefully when it comes to sophisticated estate planning arrangements. Commercial and private financing are popular now because they allow people to leverage low interest rates, and are attractive to people who have little or no gift exemption available. However, over time interest rates will creep up and it is important to have an exit strategy in place such as a CLT, DIGIT, or GRAT. For more information on exit strategies or premium and private financing, please consult your John Hancock Representative or call the Advanced Markets department at (888) 266-7498, option 3. 1. The IRS publishes the AFR on a monthly basis. 2. Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including the generation-skipping tax). Failure to do so could result in adverse tax treatment of trust proceeds. 3. The defective trust takes advantage of the differences between the estate tax rules of IRC Sections 2036-2042 and the grantor trust income tax rules of IRC Sections 671-678. 4. In Revenue Ruling 2004-64, the IRS clearly stated a grantor can pay income tax on trust income and it will not be considered a gift to the trust. 5. Before the sale, the grantors should gift at least 10% of the value of the sale to the trust. See PLR 9515039. 6. In Revenue Ruling 85-13, the IRS ruled that a grantor trust is disregarded for income tax purposes and that transactions between a grantor and a grantor trust have no income tax consequences. 7. Survivorship UL is issued by John Hancock (U.S.A.) 8. The Walton Tax Court case from 2000, and the IRS proposed regulations on GRAT support this concept. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, MA and securities offered through John Hancock Distributors LLC through other broker/dealers appointed by John Hancock Distributors LLC, 197 Clarendon Street, Boston, MA 02116. John Hancock Life Insurance Company, John Hancock Variable Life Insurance Company, Boston, MA and securities offered through Signator Investors, Inc. 197 Clarendon Street, Boston, MA 02116. Sales Strategy is produced by John Hancock s Advanced Markets Group. We can be reached at 1-888-266-7498, option 3. This material is for informational purposes only. Although many of the topics presented may also involve tax, legal, accounting, or other issues, neither John Hancock Life Insurance Company (U.S.A.) nor any of its agents, employees, or registered representatives are in the business of offering such advice. Individuals interested in these topics should consult with their own professional advisors to examine tax, legal, accounting, or financial planning aspects of these topics. Produced 02/21/2005 Expires 02/21/2006 MLI0209055151 John Hancock Life Insurance Company (U.S.A.) Boston, MA 02117 2005. John Hancock Life Insurance Company (U.S.A.). All rights reserved. 5 of 5