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Enhance Your Legacy Using Private Split Dollar

Enhance Your Legacy Using Private Split Dollar

July 18, 2022

You are financially well off and have children – possibly even grandchildren – to whom you plan on passing a legacy. You understand that planning for the future is essential if you want to protect your legacy from erosion and taxation. Therefore, transferring your wealth to the next generation in an efficient manner is of utmost importance. Cash value life insurance owned by an irrevocable life insurance trust (“ILIT”) may be the solution.  Often the foundation of a solid wealth transfer strategy, ILIT-owned life insurance provides immediate, income-tax free liquidity upon the death of the insured.  A private split dollar arrangement is a creative strategy that can be used to efficiently fund the life insurance premiums in such a wealth transfer strategy.   

Cedar Point Financial Services LLC helps families protect their legacies via trust-owned life insurance that is funded by private split dollar arrangements. 

Understanding Private Split Dollar 

The first generation, grantor (“G1”), usually a parent or grandparent creates an ILIT for the benefit of children and/or grandchildren, and the ILIT applies for life insurance on the grantor or on the grantor and his or her spouse.  The trustee of the ILIT enters into a split dollar agreement with the grantor, whereby the grantor advances money annually to the ILIT to pay the premiums on the policy.  As security for the premium advances, a collateral assignment is placed on the life insurance policy, demanding payment of the greater of the policy’s cash value or premiums paid at death or rollout. 

The advancement of premiums can be treated as either an economic benefit or a loan. 

Economic Benefit Approach 

Under the ‘economic benefit’ approach, each year the grantor is considered to have made a gift to the ILIT equal to the economic benefit cost associated with the death benefit being supplied to the ILIT.  If the ILIT has the cash to do so, the ILIT can pay the economic benefit cost to the grantor to avoid a gift.   The economic benefit associated with the death benefit is the cost of term life insurance, which is calculated by using premium rates published by the IRS in Table 2001 or, if lower, the qualifying one-year term life insurance rates offered by the issuing life insurance company.   

Since the economic benefit cost is the annual renewable term cost on the life of the insured, this cost increases slightly each year as the insured gets older, unlike a fixed interest rate. 

Loan Approach 

Under the loan approach, a suitable interest rate, usually the Applicable Federal Rate (AFR) long-term interest rate, is charged to the ILIT for the premiums lent. As with an economic benefit approach, where the grantor typically gifts to the ILIT the amount needed to pay the ILIT’s portion of the premium, the grantor gifts the amount to the ILIT required to pay interest on the premium loan balance. 

The lower the AFR long-term rate, the more appealing it is to utilize the loan regime.  Given the recent increase in AFR rates, those considering private split dollar plans should evaluate the likely total interest cost and compare it to the illustrated economic benefit cost.  It may be that a loan regime is more attractive if a competitive rate can be locked in; though, as rates increase, this may not always be the case. 

Cedar Point Financial Services LLC can help determine if applying an economic benefit or a loan regime is the better way to treat premiums advanced under a private split dollar plan. 

Repayment Options 

There are several ways to repay the grantor the greater of the policy’s cash value or the premiums paid.  At the death of the insured grantor, this sum can be repaid by a portion of the policy’s death benefit.  The trustee can also use the death benefit paid to lend to the estate, or the trustee can use this money to purchase assets out of the estate, providing even greater liquidity if needed.   

Alternatively, during the insured grantor’s lifetime, the split dollar arrangement can be repaid through a number of wealth transfer strategies, including GRATs, CLTs, sales to defective trusts, or gifts. 

Benefits of Private Split Dollar 

Entering into a private split dollar arrangement has a number of benefits:1 

  • Minimizing Gift Taxes – If a client has no gifting capacity available, a direct gift of the premium would have negative tax implications.  A private split dollar arrangement limits the taxable amount to the annual economic benefit or loan interest. 
  • Lowering Costs – In many cases, the economic benefit cost is less than loan interest offered under private financing techniques, especially for second-to-die cases, making a private split dollar arrangement an attractive alternative to private financing. 
  • Retaining Control – Rather than making an outright gift to the trust, resulting in a loss of control of the gifted funds, clients who use a private split dollar arrangement retain some control of their premium outlay, since the premiums advanced can be ordered back at any time. 
  • Estate Freezing – If the policy chosen does not provide a cash value greater than premiums paid, the amount due back to the estate is exactly the premium amount paid without growth.  This “freezes” the amount of premium due back to the estate. 

Intergenerational Split Dollar 

Another form of a private split dollar arrangement, intergenerational split dollar relies upon funding by a senior generation (“G1”) to pay for life insurance on the next generation (“G2”) for the benefit of future generations (“G3”).  In principle, it is an economic benefit approach, and a split dollar arrangement with the family serving as the lender, thereby funding premiums to the life insurance policy owner, generally an ILIT.  G1 typically pays the portion of the premium equal to the economic benefit, and at the death of the G2 insured, the death benefit is paid to the ILIT for the benefit of G3. 

It is likely that the insured—usually a child or grandchild of G1—will live for many more years after the parties have entered into an intergenerational split dollar agreement.  Therefore, it is unlikely that G1’s estate will be paid back any time soon, and the value of the receivable repayment is subject to a substantial discount when calculating its value to the taxable estate of G1.  This ability to include the discounted value of the premium loans in G1’s estate rather than the full amount makes intergenerational split dollar attractive for efficient wealth transfer especially when G1 is uninsurable.  

Recent decisions handed down by the United States Tax Court have strengthened not only the intergenerational split dollar structure, but also have affirmed that the 2002 and 2003 Final Split Dollar Regulations continue to control the facts in similarly structured split dollar arrangements.2 

If protecting and passing wealth to several generations is your goal, Cedar Point Financial Services LLC can evaluate if an intergenerational split dollar arrangement is ideal. 

Enhance Your Legacy 

Private split dollar is a powerful planning technique that allows a client to pay annual premiums on a policy owned by an ILIT without having to make large gifts that would exceed the client’s lifetime estate tax exemption and incur gift taxes.  At Cedar Point Financial Services LLC, our team can evaluate how trust-owned life insurance can mitigate future estate taxes and protect wealth from erosion, and determine whether a private split dollar arrangement is a suitable funding strategy.