Inter-Generational Split Dollar – A substitute GRAT

Overview

What are you waiting for? The tax time bomb is due to explode. On January 1, 2013, the top estate tax bracket increases from 35% to 55%. The exemption equivalent drops from $5.25 million-$1 million per taxpayer. Tax payers in the New York and New Jersey will see their combined marginal tax bracket exceed fifty percent. Ouch!!!

As a follow up to the prior blog post on inter-generational split dollar, we wanted to outline a few sales examples to “get the wheels” turning for you. The sand passing through the sandglass in the days of our lives!

Strategy Review

The basic solution proposes the use of a private restricted collateral assignment non-equity split dollar arrangement between the patriarch and matriarch of the family (Assignee), i.e. the family members that are looking to transfer wealth, and an irrevocable life insurance trust (ILIT #1). The underlying life policy that will be utilized will be a traditional single life or second-to-die policy issued by a life insurance. The split dollar agreement will be a restricted collateral assignment split dollar arrangement.

Restricted collateral assignment is the classical form of split dollar arrangement utilized by the majority shareholder of a closely held business. Under restricted collateral assignment split dollar, a restriction is added to the split dollar agreement which “restricts” the premium payor’s access in the policy under the split dollar arrangement (greater of cash value or premium). The “restriction” limits the premium payor’s access until the earlier of the death of the insured, termination of the split dollar agreement, or surrender of the policy.

The trustee of an ILIT is the applicant, owner and beneficiary of the policy.

The Split dollar restriction is contractually in effect until the earlier of the death of the insured or termination of the split dollar arrangement. The Patriarch at their discretion may decide to transfer by sale their interest in the split dollar arrangement, aka the split dollar receivable.

Strategy Examples

Example 1 – Patriarch, age 80, has existing investment assets of $40 million and a net worth of $75 million. ILIT #1 is the applicant, owner and beneficiary of a policy issued by Acme Life, a New York -based life insurer. The policy will insure Patriarch’s son and daughter-in-law who are both age 50. The policy funding strategy calls for single premium of $35 million. The policy has an initial death benefit of $55 million.

The Patriarch and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 2, the Patriarch approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement.

The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the CFC into the policy – $35 million. The discounted value of the Patriarch’s interest is $3.5 million ($20 million minus 90 percent discount).  The Patriarch creates a second ILIT, ILIT #2 to purchase the split dollar receivable.  ILIT #2 utilizes trust corpus to purchase the Patriarch’s split dollar receivable for $3.5 million.

Example 2- GRAT Substitute – Same facts as Example 1. ILIT #1 is the applicant, owner and beneficiary of a policy issued by Acme Life, a New York -based life insurer. The trustee will use premium financing for the policy to finance a $20 million single premium.  The Patriarch provides a personal guarantee for the loan as well as additional collateral.

In the beginning of Year 3, the trustee cancels the policy and receives the cash surrender. The Patriarch is personally obligated to repay the Bank and borrows $20 million from the trustee on an arms-length basis and repays the Bank. The Patriarch transfers $20 million of real estate limited partnership interests to the repayment as repayment for the loan.

Example # 3 Corporate Restricted Collateral Assignment Split Dollar – Same facts as Example 1. Client owns a C corporation that has $20 million of retained earnings that he would like to transfer out of the corporation and out of his estate. Patriarch uses the restricted collateral assignment technique to transfer the retained earnings.

The policy insures his son, age 50, who is the CEO of the company. The premiums are $4 million per year targeted for five years. The death benefit is $50 million.

The Company and the trustee of ILIT #1 enter into a restricted collateral assignment split dollar arrangement. In the beginning of Year 6, the Company approaches the trustee of ILIT#1 with the idea of selling its interest in the split dollar arrangement.

The valuation study reflects a 90 percent discount from the amount of cumulative premiums paid by the Company into the policy – $20 million. The discounted value of the Company’s interest is $2 million ($20 million minus 90 percent discount).  The CEO creates a second ILIT, ILIT #2 to purchase the split dollar receivable.  ILIT #2 utilizes trust corpus to purchase the Company’s split dollar receivable for $2 million.  The two trusts (ILIT #1 and ILIT #2) merge following the transfer.

Summary

The combination of the restricted collateral assignment and permanent life insurance provides significant   tax and wealth accumulation benefits to your client.

1. Split Dollar Taxation – The client is not taxed on the amount of proposed premium payments. Instead the client is taxed on the economic benefit (term insurance cost) of coverage provided under the arrangement for income and gift tax purposes.

2. Tax-Advantaged Wealth Accumulation – Permanent life insurance provides the vehicle for shifting an investment portfolio that is currently taxable within the Patriarch into a structure which enjoys all the tax advantages of life insurance – (a) Tax-free accumulation of the policy cash value (b) Income tax-free death benefit (c) Investment flexibility  (d) Ability to access the cash value on a tax-free basis through policy loans.

3. Asset Protection – The policy’s assets are not subject to the claims of the life insurer’s creditors or the policyholder’s creditors.

About gerrynowotny

I am a tax and estate planning attorney with a JD and LL.M in estate planning from the Univesity of Miami School of Law. I have worked in the life insurance industry for twenty three years and the last eleven in private placement life insurance.
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2 Responses to Inter-Generational Split Dollar – A substitute GRAT

  1. Steve Bertino says:

    How do we rationalize the 90% discount in your example?
    RE Example #2, are we assuming a no load life policy that will have a zero surrender charge?

    • gerrynowotny says:

      The valuation is supported by an independent third party valuation firm. the valuation firm looks to comparables as uses the life settlement market partially as a basis for some of their methodology as well as the time value of money. A number of valuation firms do this particular technique and have ended up with similar discounts. Private Placement. This aspect is not critical to the result. Same result using retail life insurance.

      Gerry

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