The coincidence of historically low-interest rates and the increased gift tax exemption under the 2017 Tax Cuts and Jobs Act has temporarily created an opportunity for high net worth families to tax-efficiently transfer wealth from generation to generation. Of course, families can use their exclusion by giving outright to their children and grandchildren, but most do not want to provide the funds with no guidance. One potential avenue to explore is the use of a trust, to which assets can be gifted and/or loaned, effectively maintaining control of the assets while housing them outside of the taxable estate.  

We’re going to show how a family could take advantage of the increased gift tax exemptions as well as low-interest rates to fund a life insurance policy.  Trust me, even if your first thought is to cut and run at the words “life insurance,” stick with me — we will try and make it worth your while.

The goal of this process is to move the assets out of a taxable estate early, and allow the returns to accumulate in the tax free or deferred tax haven.

Why do this now? 

Under the Tax Cuts and Jobs Act, there was a change to the basic exclusion amount (BEA), which is the tax exclusion applied against a person’s lifetime of cumulative taxable gifts. This exclusion, previously $5.49 million in 2017, has been more than doubled for the years 2018 to 2025. The BEA for 2020 is $11.58 million(1). The increased exclusion will apply to any gifts made between these years. After expiration in 2025, if there is no further legislation to extend the increase, the BEA will return to its pre-2018 level of $5 million as adjusted for inflation. However, assets that were gifted during the 2018-2025 period will be grandfathered under the increased exclusion. Because of the uncertainty associated with the BEA in the future, it may be advantageous to utilize the increased exclusion while it still exists. 

So in the example above a family that chooses to maximize its gifting ability between 2018 and 2025 would realize a net tax savings of $2.4 million dollars. (2)

The second component of timing is the historically low-interest-rate environment. The graph below illustrates the steep drop in the Applicable Federal Rate (AFR) over the last 15 years. These rates are used to determine the interest rate that must be applied to any loans made to the trust. The mid-term rate is applicable to loans between three and nine years, and the long-term rates are applicable to loans that mature in more than nine years. 

Many corporations have taken advantage of low-interest rates and have increased their allocation to debt financing.  The concept of using loans as a conduit for wealth transfer can be challenging for many families. However, in this scenario, we are discussing private financing. A traditional bank/lender is not involved. The grantor is loaning money to the trust. The grantors are acting as the bank receiving interest on the loan, while the trust invests the loan. In the case of structuring the transfer of assets to a trust, debt may in fact be a low-cost way to provide funding.   

For most clients, this is a head-scratching moment.  Wondering how or why lending to the trust at a low-interest rate is helping.  The answer is that we are trying to take advantage of the difference between the expected return the assets can generate in the trust and this low-interest rate.  For example: If the family lends to a trust at the Mid Term rate of 0.5% while the trust assets have an expected return of 6%, the trust is left with a net 5.5% return after paying the interest expense.  Increasing that interest rate while maintaining the same expected return clearly leaves less in the trust.

How should the trust be funded? 

We’ve outlined two reasons why this might be a good time to fund a trust.  Depending on the unique circumstances of each family they may wish to utilize the higher BEA and gift the funds, take advantage of the low-interest rates and loan the funds to the trust, or utilize some combination of the two. Unlike the aforementioned corporate finance decision, other factors will contribute to a family’s decision. Do they have gifting availability?  How important is flexibility or control? How comfortable are they with leverage? What type of return rate can they expect on your assets/investment portfolio? Furthermore, it is important to consider that a loan can be refinanced or even forgiven and reclassified as a gift, but a completed gift cannot become a loan.

The timing issues associated with the BEA should also be considered here. If the loan would need to be forgiven(3) later when the increased BEA is no longer in effect, the reclassification as a gift would be against the significantly lowered $5 million exclusion. If gifting has been part of the estate plan and the full exclusion has already been used, the grantor would be responsible for the gift tax. Taking advantage of the current BEA levels may be a limited-time opportunity to shift assets outside of the taxable estate. 

How should the trust assets be invested? 

The most straightforward consideration is a traditionally invested portfolio that generates more than the loan interest rate.  To maximize the benefits of using the trust and moving assets outside the taxable estate, the investment must be one that provides leverage while minimizing the probability of failure due to asset volatility.  

One asset that can offer these features is life insurance. Life insurance is often a misunderstood and underutilized financial tool, but it offers many attractive features when housed within a trust. First, it provides leverage in the form of a death benefit without the uncertainty of downside volatility. The cash flows used to pay the premium can be structured such that they are regular and predictable. Second, life insurance can provide much-needed liquidity for the estate. Many wealthy families have significant positions in illiquid assets such as a business interest(4), land, properties, etc. These assets are included in the estate for tax purposes, but the heirs might not want to sell these assets, and it is also possible that the sale would be highly sensitive to timing considerations. Rather than liquidating these assets under inopportune conditions, the death benefit provided by the life insurance in the trust can be used to purchase the assets from the estate, thereby generating the liquidity needed to fund the estate tax at the exact moment when it is most necessary. 

Introducing life insurance into the trust can also create additional optionality. The choice of product as well as the amount of cash value can influence the amount of leverage that is available. In addition, if the insurance has a higher cash value, that cash value can also be used to support loan payments if necessary.

How should the trust be funded around life insurance? 

For illustration purposes, let us assume a 65-year-old couple wishes to move $40 million outside of their taxable estate as a planning strategy to address the federal estate tax on a $100 million gross estate. The estate tax amount(5) is used as the death benefit of the life insurance. 

A base case implementation would be to plan the amount and duration of the loan around the premium payments required for the life insurance. For simplicity, in our example, the gift is excluded. The duration of both premium payments and the loan is kept to 9 years in order to take advantage of the mid-term loan rate.

Highlights from the Table

  • Trust borrows $16 million from Grantor for 9 years.
  • The Trust will pay Grantor $68,800 in annual loan interest every year for 9 years.
  • At the end of the 9-year period, the Trust repays the Grantor the principal payment of $16 million.
  • Trust pays $800,000 in insurance premiums ($7.2 Million total over 9 years)
  • Trust owns a $40 million paid-up insurance policy at the end of 9 years.

In this illustration, we can see that the low-interest rate netted the trust a relatively small annual outflow of $68,800, leaving the trust with ample returns to fund the insurance premiums. In our example the trust is overfunded(6) if judged purely by the values within the financial model above. However, the additional cushion provides a contingency plan in case of an adverse market event. It not only enables the trust to be better positioned to meet loan and premium payments but also serves as a source of cash should the life insurance need to be replenished, much like rebalancing a traditional portfolio. This cushion is still invested within the trust and continues to grow, just as if it was held outside of the trust. There is a twofold benefit to this approach – there are liquid assets available to the trust should the policy require it, and the gift assets and the growth on both loan and gift assets all exist outside of the taxable estate.  

There is additional optionality built into this situation. If interest rates continue to fall to still lower levels, the loan can be refinanced at the new, lower rate. If the loan is long-term and the grantor is in need of the assets, assuming the trust is funded enough to support any ongoing premium payments, the trust can pay off the loan early.  

In Summary

By combining the heightened BEA with historically low AFRs, there is a planning opportunity using loans and/or gifts to shift assets and the growth of those assets outside of the taxable estate. The use of life insurance within the trust can create leverage and offer flexibility while also providing a level of certainty. The funding source decision, as well as the life insurance design, should be based upon your gifting availability, willingness to gift, understanding and comfort with leverage, capital market assumptions, and current versus future opportunities for optionality.(7)(8)

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About the Author: Brian Bobeck

Brian Bobeck
Brian Bobeck is a Principal and Senior Consultant at Cornerstone Institutional Investors, LLC, and has been in the financial services industry for over 20 years. His focus is on the niche area of providing customized life insurance solutions to affluent clients in the areas of wealth transfer, business succession, and estate/tax planning. In coordination with his client’s entire advisory team (accountant, attorney and investment advisor) he provides the necessary due diligence and transparency on planning options to be considered. Typical plans include wealth transfer strategies that utilize sophisticated techniques such as Irrevocable Life Insurance Trusts (ILITs), split dollar arrangements, Intentionally Defective Grantor Trust (IDGTs), installment sales and discounted assets. Brian also advises corporate clients on employee benefit plans including Non-Qualified Deferred Compensation (NQDC) plans, Supplemental Executive Retirement Plans (SERPs), and executive bonus plans. Brian received a Bachelor of Science Degree in Computers and Information Systems from Kings College and an MBA with a concentration in Marketing from Lehigh University. Brian holds his FINRA Series 7 and 66 licenses, Chartered Financial Consultant (ChFC) designation and the Chartered Life Underwriter (CLU) designation from the American College. He is a member of the Association of Advanced Life Underwriters, a member of the Lehigh Valley and Philadelphia Estate Planning Councils, and a member of the Union League of Philadelphia. He is a registered representative of M Holdings Securities, Inc. Through webinars, podcasts, continuing education seminars and speaking engagements Brian covers the topics of life insurance, executive benefits, and wealth transfer strategies to better educate his audience.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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