February 09, 2009
John Dedon
Enough about 2008: let’s start 2009 with a positive planning option for business owners still in need of planning. One strategy worthy of consideration is split dollar life insurance, allowing business owners to pass significant wealth to family members free of the estate tax with relatively minimal gift consequences.
The explanation is at the “30,000 feet level” due to space limitations. Notwithstanding, it is a worthy topic because of the substantial advantages split dollar life insurance can provide to a business owner. Although there are many variations of split dollar, this article discusses “private split dollar” — the parties being just family members and a Trust for family members — versus traditional split dollar where the business is also a party. According to Jorge Fuentes, vice president of Wachovia Insurance Services Inc. in McLean, this strategy has been used for several clients nationwide with a number of different insurance carriers.
Legal assumptions:
There is a current $3.5 million exemption that protects an individual from estate tax (with proper planning, $7 million for a married couple). However, in 2011, the exemption amount is only $1 million, $2 million for a married couple, and the estate tax rate is 55 percent.
Annual exclusion gifts are currently $13,000. Gifts in excess of these amounts erode the exemption amount available upon death.
Factual assumptions:
Mom and Dad, now in their mid 60s, ran a successful real estate company. Their 45-year-old child was not interested in the business, so they sold the company and netted $22 million after tax. Their total estate is $30 million.
Their child is financially secure. Therefore, Mom and Dad are not concerned about her, but they do want to provide for their four grandchildren and future generations.
Upon the second of their deaths, estate tax could be anywhere between $6 million to $14 million, even without asset appreciation.
Solution: Private split dollar
Mom and Dad (collectively Generation 1 or “G1”) pay the premium insuring the life of their child (“G2”). To remove the death benefit from the taxable estates of Mom, Dad and the child, the owner of the policy is an Irrevocable Trust. The Trust beneficiaries are Mom and Dad’s grandchildren (“G3”). (If there was more than one child, there could be more than one policy and more than one Trust.)
Applying numbers to the facts above, G1 makes a one-time premium payment of $2 million. Upon G2’s death, insurance proceeds ranging between $11 million and $23 million would be available to the grandchildren estate tax free. The death benefit depends on the age of G2, the type of policy, and the year of G2’s death. The Trust could be designed as a dynasty trust, meaning the proceeds are estate tax free in perpetuity.
And here is a major advantage of private split dollar: the gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy. According to Fuentes, this is because the IRS taxes G1 on the “economic benefit” of the premium payment, which is substantially less than the premium payment. “Current IRS rules and IRS tables indicate that private split dollar may be an effective way to preserve exemptions for other planning,” Fuentes commented.
In this example, absent the IRS rules, virtually all of Mom and Dad’s $2 million premium payment would reduce what they can otherwise protect from estate tax upon their deaths. Instead, because the gift tax value (economic benefit) is so low, the $2 million premium payment can be absorbed by annual exclusion gifts to the Trust. What have Mom and Dad accomplished? At a financial cost of $2 million, which after tax is worth roughly $1 million, they provided $11 million to $21 million of proceeds free from estate taxes for their grandchildren and future generations. These proceeds can also be protected from their grandchildren’s creditors and divorce. And they did so with minimal gift tax consequences.
As stated above, this is a dramatic simplification of how private split dollar works. There are also different variations of private split dollar.
February 09, 2009
In a previous column, I discussed the advantages of private split dollar for business owners to transfer wealth to future generations. This article discusses the exit strategy and the effect of the increasing “economic benefit” value.
In brief, Part 1 presented this example: Generation 1 (“G1”), which typically would be Mom or Dad, pays a life insurance premium insuring the life of their child (“G2”). The life insurance policy is owned by an Irrevocable Trust and would pass tax free to the grandchildren (“G3”) upon G2’s death. Assume G1 makes a one-time premium payment of $2 million. Upon G2’s death, insurance proceeds ranging between $11 million and $23 million would be available to the grandchildren estate tax free. Because G1 is taxed on the “economic benefit,” G1’s gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy. Thus, the $2 million premium is removed from G1’s estate; the gift tax is insignificant (at least in the early years); and substantial tax free death benefit is provided.
The advantages described above are derived from structuring the split-dollar arrangement as non-equity split dollar U.S. Treasury Regulations. There must be a contract between, in this example, G1 and the Irrevocable Trust, requiring that G1 is repaid the greater of the insurance premium ($2 million) or the cash value of the policy. The only “economic benefit” the Trust receives is the death benefit. Hence, the Trust does not have any “equity” in the policy.
Because the equity belongs to G1 in the form of the greater of the premium payment or cash value, there is a receivable due G1. The split dollar contract provides that the receivable is due upon G2’s death — the insured. And every year that the split dollar arrangement is in effect, the economic benefit increases. Thus, it is desirable to have an exit strategy in place to terminate the split dollar arrangement upon death or perhaps earlier when the premium has been fully paid. Here are various exit strategies:
1) If G2 dies first, G1 receives the greater of the policy cash value or the premium and a large amount of life insurance is inside the Irrevocable Trust tax free for G2’s family.
2) More likely, G1 dies first. Because the receivable is not due until G2’s death, which may be many years into the future, the receivable may be substantially discounted. G1’s estate includes the value of the receivable. The value may be absorbed by G1’s exemption. G2’s death terminates the split dollar agreement and the receivable.
3) A third alternative is that, prior to either G1’s or G2’s death, the receivable is sold for its fair market value, which again, may be subject to discount. The Irrevocable Trust or a new Trust purchases the receivable and the split dollar arrangement is terminated. The source of the payment has come from gifts by G1 or G2. Often times the source comes from gifting strategies such as GRATS or gift/sale techniques involving intentionally defective trusts.
The key is to plan for the termination prior to later years where the economic benefit begins to grow.
