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The Insurance Inheritance


Wealthy families have long used life insurance policies as a way to minimize the impact of estate taxes as they pass money from generation to generation. One drawback: On a multimillion-dollar policy, premiums can run well into six figures. For those who didn't have the cash flow, that used to mean liquidating investments or taking a loan, or for high-level executives, relying on employers. But now savvy lawyers have figured out ways for clients to finance multimillion-dollar policies without going to the bank.

Such family-funded insurance strategies are on the rise because employers can no longer finance such policies. The Sarbanes-Oxley Act prohibits personal loans from public companies to their executives. These deals generally rely on an irrevocable life insurance trust, or ILIT. The trust buys the policy and holds the proceeds for the beneficiaries. Why the trust? If you own a policy that insures your life, the proceeds become part of your estate and possibly subject to estate tax. Not so with the ILIT.

The major challenge is to figure out how to get money into the trust so it can pay the premiums. How you do this will depend on the number of beneficiaries, the annual cost, and how much you have to contribute. For example, a $10 million guaranteed universal life policy for a healthy 55-year-old man would cost about $150,000 a year, says Mark Armstrong, a vice-president at ValMark Securities, an insurance broker in Akron. That's a relatively new and popular type of insurance that offers a guaranteed premium and death benefit, and a small cash value.

The best way to pay the annual bill will depend on your situation. Here are some options.

You have plenty of money and many heirs to whom you want to give it.

Oddly enough, the more beneficiaries of your ilit, the easier it is to fund a policy. The goal is to contribute as much as you can to the trust without running up against gift tax. You can put in $12,000 a year for each trust beneficiary; it's called the "annual exclusion." Your spouse can add in another $12,000 for each beneficiary, too.

Those exclusions can give you a lot of bang for your buck. Take the case of a couple who used insurance to make gifts to their grandchildren go much further. They did this by setting up a trust that purchased a $10 million policy on their son, a 38-year-old father of eight. Together the couple put $192,000 a year—$24,000 for each childinto the ilit, says the couple's attorney, Jon Gallo, a lawyer with Greenberg Glusker Fields Claman & Machtinger in Los Angeles. The premium is $50,000 a year, so the trust can invest the rest of the money and build a nest egg. That way, the premiums will be paid by the trust when the grandparents are no longer around.

You don't have a lot of heirs, and paying that premium will trigger gift tax.

Don't give it, lend it. This loan to the trust must be documented, and you'll have to have an interest rate that's approved by the Internal Revenue Service. If you have the cash, you can lend it directly. If you don't, you can borrow from a bank and then lend that money to the ilit. The difference between the interest rate you pay the bank and the irs-approved rate you get from the trust amounts to a tax-free gift to the trust.

You don't have a lot of cash, but your privately held business is flush.

This is a common situation among entrepreneurs. Lawrence Brody, a lawyer with Bryan Cave in St. Louis, recently helped arrange a loan from a woman's import-export business to an ilit that bought $100 million of insurance for her, naming her two adult children as beneficiaries. The business loaned the trust $2 million to pay the premium. (The principal is due at her death.) To help the ilit finance the yearly $100,000 in interest payments, the owner, who's in her early 50s, will make annual gifts to the trust.

You don't have a lot of cash, but you own property that throws off income.

The easiest move is to give the property to the trust. But if that would trigger tax, sell the property to the trust in exchange for a promissory note with interest, says Stephan R. Leimberg, an insurance expert and president of Leimberg Information Services in Bryn Mawr, Pa.

You want to whittle down the sale price to make it easier for the trust to pay off the note. One way to lower the price is with a family limited partnership (FLP). (This popular estate-planning tool can serve a variety of functions, not just for ILITs.) Here's how it works: First you would put the property—assume it's publicly traded stock—into the FLP. Next, you would sell the ILIT a share of that partnership. Since few people outside the family would want an interest in such a partnership, you're allowed to discount the stock's value by about 30%. The ILIT will receive partnership distributions that it can use to pay premiums.

You have only enough cash to pay part of the premium.

Get someone in the family to share the cost in what's called a split-dollar deal. You give enough money to the ILIT to pay a portion of the premium. More precisely, it will be what a term life insurance policy would cost. Then a family member, known as the donor, pays the balance.

When you die, the trust and the donor typically share the proceeds. The donor, who gets paid first, must get back either what was paid out or the cash value of the policy, whichever is greater. Otherwise, the arrangement would be considered an interest-free loan subject to gift tax.

You are setting up other trusts anyway.

This is a terrific opportunity to use payouts from those trusts to fund the ilit, with the goal of making it self-sustaining. For instance, suppose you place appreciating assets, such as stocks, into an irrevocable trust and retain the right to receive an annual income for a period, usually five years or less. If you're alive at the end of the period, any property left in the trust (known as a grantor retained annuity trust, or grat) could pass to the insurance trust.

Before using a family deal to finance costly life insurance, ask about whether the arrangement can be undone if your circumstances change. Remember, too, that with any loan transaction, "at the end you have to repay the debt"—most likely out of the policy proceeds, warns Howard Zaritsky, a lawyer in Rapidan, Va. And that will leave less for those you intended to benefit. The upshot: Depending on financing technique, you may need to buy more insurance.

By Deborah L. Jacobs


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