The Case For Private Split-Dollar Loans

To determine the loan amount, we need to assume a gross rate of return that the trust will conservatively earn during the years the split-dollar loan is in place. The other piece we need is the loan's assumed termination year, unless the loan stays in place until the second death, which could be very expensive.

Because we're using a non-grantor CLUT as the "exit" strategy, we will assume that the term of the CLUT is 10 years to coincide with the last premium payment. (We use a non-grantor CLUT because the GST exemption may be applied at the time of the transfer rather than at the termination of the term of years in a grantor retained annuity trust (GRAT), or a CLAT.)

Now that we have our assumed trust rate of return and we have a time frame, we can "solve" for the initial loan amount. By establishing a single term loan for the entire 10-year premium period, rather than a new loan each year, April's long-term applicable federal rate (AFR), which is currently 4.79%, may be locked in without additional interest rate risk.

So long as the ILIT is drafted as a grantor trust, the Smiths will not have to pay income tax on the annual interest income they receive. Also, to the extent the non-insurance trust assets generate a return (let's assume 7% gross), the total return of the trust will be enhanced because the Smiths, as the grantors, will be responsible for paying the tax. This essentially equates to an "extra" gift to the trust (see Rev. Rul. 2004-64).

The loan termination relies on the CLUT to perform as anticipated. A CLUT allows taxpayers to transfer income-producing or appreciating assets to an irrevocable trust, pay an income interest to a charity and eventually pass the remainder to the beneficiary, in this case via the ILIT.

The remainder interest will hopefully be sufficient to repay the Smiths at the beginning of the 11th year and thereby terminate the split-dollar loan. The best assets to use in the CLUT are rapidly appreciating assets that generate income and may be eligible for valuation discounts (i.e., lack of marketability and lack of control as determined by a qualified appraisal).

In conclusion, the above planning scenario provided the clients with a method of acquiring the insurance death benefit to give the estate access to liquidity to pay the estate taxes. Additionally, using the ILIT as the remainder beneficiary of the CLUT completed the necessary funding to repay the loan in a gift tax efficient manner because of the discount available for the charity's interest. Moreover, the interest cost of the arrangement is controlled because using only one term loan limits the interest cost to the applicable federal rate at that time. And because of the grantor trust status, the interest is not recognized.

Of course, the circumstances of each client must be considered carefully to ensure that proper planning is implemented. The private split-dollar loan is not for every client. In fact, for those clients who feel strongly about using outside sources of money whenever possible, another loan with a third-party lender (i.e., premium finance) may be more appealing. However, if your client appreciates simplicity and privacy with less interest rate risk, then a private loan may be the right strategy.