The secret behind a tax-advantaged investment

Oct. 10, 2012
A group of successful, wealthy business owners, including their closest advisors, gathered for a symposium. What’s the subject? To find the perfect investment for these wealthy business owners to leverage their liquid wealth (cash, stocks, bonds, etc.) that they have accumulated.

A group of successful, wealthy business owners, including their closest advisors, gathered for a symposium. What’s the subject? To find the perfect investment for these wealthy business owners to leverage their liquid wealth (cash, stocks, bonds, etc.) that they have accumulated. They were trying to solve the age-old problem: Successful business owners know how to make money in their business, but are lost when it comes to investing the after-tax dollars taken out of their business.

After two days of discussion, the group came up with the size of the investment can vary but could be large; the rate of return must be earned year after year and must compound; the profit potential of the investment must be significant; risk would be almost eliminated (everyone agreed there must be some risk); and although not necessary, but preferred, the earnings and ultimate profits would be tax-free (income tax and estate tax).

After the symposium, I quoted the above five items to a well-to-do client. His response (somewhat tongue-in-cheek) was, “Really want to make it perfect, then use someone else’s money to fund the investment.”

Later that night, while not even thinking about the perfect investment, it hit me like a ton of bricks: such an investment actually does exist. Just what is this perfect investment? The answer is premium financing life insurance (PFLI). In a nutshell PFLI is a wealth transfer/estate liquidity strategy that helps wealthy people meet their estate liquidity needs and transfer huge amounts of wealth to their children and grandchildren tax-free.

Maybe a must follow-up question is why is PFLI such a secret? The answer: Because a PFLI arrangement requires a high degree of sophisticated expertise and cooperation among a number of professionals. Typically an accountant, like your author, to discover the need; lawyers to do the complex documents; a knowledgeable insurance consultant who knows how to structure the transaction with the right insurance product; and finally, a banker to provide other people’s money. Four professionals, who normally do not work together as a team, must chip in to get a PFLI plan done right. In practice, almost the impossible dream.

An automobile is a good analogy. You know how to drive, use and enjoy your car. But can you build one? No, you must rely on others. In a like fashion, it’s easy to understand the benefits of a PFLI plan, but you must first find the right team to build one for you.

Cradle to grave

By now you must have a number of questions. An easy way to answer the most common questions is via an example from the cradle (the issuance of the policy and approval of the loan) to the grave (the death of the single insured or insureds if a second-to-die policy).

Joe and Mary, both 63, are worth $40 million and need $20 million of second-to-die insurance. (PFLI would work the same for an individual policy on Joe’s life.) The premium cost is $225,000 per year. Sure, Joe and Mary can afford the premiums, but they would have to sell some assets to pay the premiums. Capital gains taxes would be incurred. Joe says, “No” to that idea. Nor does he look kindly at the large gift tax that would be incurred as the premium costs are gifted to an irrevocable life insurance trust (ILIT) each year. The ILIT is the owner and beneficiary of the policy. Joe and Mary’s children are the beneficiaries of the ILIT.

Joe and Mary decide to use PFLI to pay the premiums. Following is a summary of the PFLI plan process:

1.     The ILIT buys the policy and will pay the premiums.

2.     Instead of paying the premiums with cash, the premiums are paid using bank loans, which are borrowed by the ILIT.

3.     The interest due on the loans is typically deferred and paid at death out of policy proceeds, but the interest, as due, could be paid in cash.

4.     The lender requires collateral to secure its loans. The policy itself is pledged as the primary collateral: the cash surrender value (CSV) during life and ultimately the death benefit if the loan is still due at the insured’s death.

5.     Any additional collateralrequired (almost always required in the early years after the policy is issued) must be supplied by Joe and Mary. They supply the additional collateral with a stock and bond portfolio they already own. In many cases, Joe and Mary would go to their local bank and use their collateral to back up a letter of credit from the bank. Then, the letter of credit would be used as the additional collateral.

6.     Each year as the CSV grows (tax-free), the amount of required additional collateral is reduced. Usually, the PFLI plan is designed for the CSV over time to cover 100% of the loan, plus interest. Simply put, you never have to write a premium check.

7.     When the CSV has grown large enough to adequately secure the loan, Joe and Mary can take back their additional collateral.

8.     When the second of Joe and Mary dies, the policy proceeds are paid to the ILIT, subject to any unpaid loan balance or interest due.

Please note that since Joe and Mary need $20 million of insurance coverage, the amount of the policy must be greater than $20 million (say $24 million). PFLI requires two death benefit amounts: (1) gross death benefit, $24 million in this case and (2) net death benefit, $20 million. The difference, $4 million, will be used to pay off the loans, plus interest. The $20 million net death benefit will be paid to the ILIT, which will use the funds for the benefit of its beneficiaries (Joe’s and Mary’s children and grandchildren).

Because 100% of the premiums, as well as loan interest, is paid by loans, the actual premium dollar outlay for Mary and Joe is zero. Of course, they can substitute collateral of equal or greater value from time to time.

Any gain or loss in the securities (used as collateral) in Joe’s and Mary’s portfolio belongs to them. The same is true of income items: interest and dividends. Joe and Mary would report gains and losses, as well as income items on their tax return, just as if the collateral assignment did not exist.

Now stop for a moment. Think about the power of PFLI to leverage (explode) your current wealth. Joe and Mary created $20 million of (tax-free) wealth without any out-of-pocket cash. As my grandkids would say, “Awesome!”

It is important to understand that PFLI is not a type of insurance, but rather a way to pay for it. The next question is should you consider PFLI? Okay, to determine your need and if you qualify ask yourself if you have a legitimate need for life insurance; have a net worth of at least $15 million; and the amount of annual premium to be financed is at least $100,000. (The death benefit can be as high as your net worth, but generally not to exceed about $225 million.) Also ask yourself if you own liquid assets that can be used as collateral for the loans and meet the insurance company’s underwriting requirements.

Most likely your PFLI plan will be structured to cover your potential estate tax liquidity needs, to ensure that your kids and grandkids benefit from the fruits of your labor, or both. But the concept is flexible and easily adaptable for business debt, key man insurance or buy-sell agreements. If you already have a private foundation (or are thinking of creating one), a PFLI is indeed the perfect investment to fund your foundation.

Sure, you have questions. You and or your professional advisor are invited to contact me (Irv) via phone at 847-674-5295 or e-mail at [email protected].

Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at: WWW.TAXSECRETSOFTHEWEALTHY.COM.

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