8/14/2019 M Advisory Group - Dennis Branconier Article - October 2008

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F I N A N C I A L I N S I D E R

Mr. and Mrs. Successul Business Owners (well callthem Mr. and Mrs. Subo), now in their mid-60s, haverecognized that its time to make some critical deci-

sions that aect both business and amily. They have built asolid and growing manuacturing company over the past 28years and wish to keep the amily business thriving into thenext generation. O their three children, their daughter and oneson in their early 30s are active in the business and have shownboth competence and interest in continuing to grow the com-

pany. The other son has developed his career in education andis unlikely to participate in the amily business. Mom and Dadwant to treat all three equally as they address their estate plan-ning goals or the present and uture.About ve years ago, in a joint meeting with their estate plan-

ning attorney and CPA, it was clear that the Subos success wasresulting in the rapid growth o their assets, with ar more ex-pected. At that time, their net worth was about $5 million, com-prised almost entirely o their business. Their advisors recom-mended transerring a minority interest, as large as they werecomortable with, to an irrevocable trust or the three children.In that way, all uture growth o those assets would occur out-side o the Subos estate and thereore avoid estate taxes upondeath.Though this made sense economically, Mom and Dad elt

uncertain and awkward about giving up some control o thecompany. In addition, though the children were showing goodpromise in their young adulthood, the parents were concernedthat giving too much to them might be a curse rather than ablessing. They decided to ollow their advisors recommendationand git a portion o their company stock to a childrens trust,but kept it conservative by transerring 20% o their interest. Theappraised value o the company at the time was $4,000,000,but the 20% interest was worth less than $800,000 due to lacko marketability and lack o control. So the value reported onthe Subos git tax return was actually less than $600,000 ascalculated by a proessional appraiser (today that stock is worth

$2,200,000, which translates into an estate tax savings o about$1,000,000).Now that this strategy is old history or them and the chil-

dren are ve years older and more mature, the Subos wish theyhad done more at the time, but they are now ocused on howto make the most o the next steps o their succession plan. Thecompany is now worth $11,000,000 and counting (their 80%worth almost $9,000,000), with their net worth approaching$12,000,000. Though they are still in good health, they do notght the realization that the day will come when they will nolonger be here. I they were gone today, their estate tax liabilitywould be nearly $4,000,000. With even modest growth over

their lie expectancy o about 20 years, its not hard to imaginethe tax liability getting out o hand (5% growth would add an-other $5,000,000 to the tax bill in 15 years under the 2008 taxschedule).Space restrictions prevent the author rom discussing strategies

to reduce and/or reeze the size o the taxable estate. Thosetechniques can and should be applied as ully and reasonablyas possible with the help o qualied tax and legal advisors.Whatever is let is subject to estate taxes under two conditions:

The government accepts only cash.The government expects to receive cash within ninemonths o death (or a married couple, typically thismeans the second death).

This presents a particularly glaring problem i the estates as-sets are largely illiquid, as is the case or many business ownersand real estate investors.

Create Needed Liquidity Double Tax-FreeLie insurance is the only method authorized by the Internal

Revenue Code to create income tax ree dollars upon death.When structured properly, it can also avoid estate taxes. Thats

why it is such a popular tool or addressing the estate tax li-ability. However, when the premiums are substantial, severalconsiderations come into play:

The estate owner might not have the cash fow or liquidreserves to cover the entire premium.The estate owner might rather have use o the money orbusiness or other investment opportunities.Giting o the premium dollars to an insurance trust (orthe children outright) might exceed the annual git tax ex-emptions ($12,000 per donor per beneciary in 2008) andthereore incur a git tax liability or orce the use o a por-tion o the lietime git tax exemptions ($1,000,000 per per-

son). Though lie insurance can or many reasons warrantthe use o these exemptions, most planners want to try toavoid using them i other avenues exist.

Financing the Premiums Through Private SourcesFor high net worth individuals, the money needed or lie in-

surance premiums almost always exists; its just in a dierentplace than where it needs to be. There are three common sourc-es o private loans as well as several commercial lenders whoparticipate in premium nancing arrangements.

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Your Large Life Insurance Premium Need NotCome Out of Your Own Pocket

It is Possible to Get Tax Free Money to Pay Your Estate Taxes

Without Impacting Your Working Cash Flow!By Dennis J. Branconier, CLU

Continued on Other Side

RepRintedWith peRmission FRom Business insideR magazines thiRd issueoF 2008

http://www.businessinsider.us/http://www.businessinsider.us/

8/14/2019 M Advisory Group - Dennis Branconier Article - October 2008

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Typically a private loan to the childrenor their trust comes from:

The estate owners personal unds.The amily business.

Another amily member.

Private loans are oten attractive because the lender is moreopen and riendly to the cause, the interest rates are relativelyreasonable, and the insurance proceeds remain within controlo the amily system. Loans are arranged in legitimate, ully dis-closed terms with interest rates declared by the IRS or suchloans (the Applicable Federal Rate or AFR). Care must betaken so that nothing about the arrangement could cause inci-dents o ownership o the policy on the part o the estate owner,as that would bring the insurance proceeds into the individualstaxable estate. The attorney who is drating the estate planningdocuments can keep you out o trouble in this area.

Financing the Premiums Through CommercialThird Party Sources

For situations in which private loans are either not availableor not desirable, there are third party commercial lenders whospecialize in premium nance programs (this is not StrangerOriginated Lie Insurance that has been heavily promotedthrough seminars and direct marketing and relies heavily onthird party nancing). Loan underwriting will be necessary. In-terest rates are usually based on prime plus or LIBOR plusormulas and thus carry interest rate risk into the arrangement.Interest is generally not deductible.Regarding collateral requirements, commercial lenders not

surprisingly want the premium loan to be ully collateralized.The cash value o the policy will provide some portion. I theinsurance trust does not own assets that can be allocated or thispurpose, a personal guarantee may be required.In any case, whether nancing is private or commercial, care

must be taken when posting collateral to ensure that the clientis not deemed to have incidents o ownership in the insurancepolicy. Again, a qualied attorney will make sure this is handledproperly.

Interest Payments Are a Fraction of the PremiumOne o the great advantages o premium nancing is that

instead o paying the annual premium rom cash fow, an in-

dividual can pay only the interest on the borrowed premium.Not only are the annual payments a raction o the premium,but they are typically small enough to t within the annual gittax exemption limits ($12,000 per donor per beneciary). I aportion o the lietime git tax exemptions must be used in theamilys estate plan, the key is to use them wherever the greatestimpact can be made. Lie insurance very oten oers that op-portunity more than any other asset.It is also possible to accrue interest, though doing so is rare-

ly available with commercial loans. It is more common withprivate intra-amily loans, not only because the lender is notsubject to regulatory conditions, but also because ultimately

all the money remains within the amily system. For example,assume a $10,000,000 policy calls or an annual premium o$150,000. I the premium loan grows at 5% interest, it wouldaccrue to approximately $5,500,000 in 21 years (the actuariallie expectancy or two 65-year-olds). The trust would use deathproceeds to rst pay back the loan, leaving $4,500,000 or es-

tate liquidity. But the other $5,500,000 is still within the amilyseconomic control, whether it be in an investment account or abusiness. The bottom line result is that 4,500,000 new dollarsare introduced into the amilys control. This is particularly criti-cal or the type o situation the Subos have, in which liquidityis needed not only or estate taxes, but also may be needed toequalize the estate or the heirs who will remain in the busi-ness and those who will not.

Having an Exit StrategyIt is more prudent to pay annual interest in whole or in part (or

example, to put a ceiling on the accrual) so that the loan bal-ance does not grow to consume all the death proceeds. Indeed,

there are scenarios in which it could actually grow larger thanthe death benet. So proper planning must be done. Thoughmany premium nancing arrangements assume that death is theonly exit strategy, it is better to employ the premium nancingmethod when there is a denable exit strategy. Two commonscenarios will illustrate:

Fund the insurance suciently or the cash values to growover time, such that they can eventually be withdrawn topay back the loan without collapsing the insurance cover-age.Fund the trust with other assets that are anticipated to ap-

preciate over time and can be used to repay the loan. Fund-ing the trust can be done in a way that triggers little or nogit tax (when done in conjunction with special trusts thatare commonly and legitimately used in this circumstance).

The Proper Use of Life InsuranceA skilled lie insurance proessional will work with the amilys

other advisors to construct an eective estate plan. Again, eortswill rst ocus on reducing or even eliminating the estate tax.But the taxes that cannot be avoided need to be paid somehow.Insurance delivers a block o income tax ree dollars preciselyat the moment they are needed. The premium and the source opremium represent the solution, not the problem.