Published 10/1/2012

Using Other People’s Money

One tax-advantaged investment strategy is to use other people’s money.

Irvine Blackman, Brian I. Whitlock

A group of wealthy business owners gathered for a symposium to find the perfect investment to leverage their liquid wealth. They came up with five criteria for the perfect investment: an investment size that can vary but could be large; a rate of return that must be earned each year and must compound; a significant profit potential; limited risk; and preferably tax-free earnings and ultimate profits.

Upon hearing these criteria, one man said (rather tongue-in cheek): “Really want to make it perfect? Use someone else’s money to fund the investment.”

Later that night, it hit me like a ton of bricks. Such an investment actually does exist: premium financing life insurance (PFLI). In a nutshell, PFLI is a wealth-transfer/estate-liquidity strategy that helps people meet their estate liquidity needs and transfers wealth to their children, tax-free. Why is it such a secret? Because a PFLI arrangement requires a high degree of sophisticated expertise and cooperation among a number of professionals.

An automobile is a good analogy. You know how to drive, use and enjoy your car, but most of us rely on others to build one. Likewise, it’s easy to understand the benefits of PFLI plan, but you must find the right team to build one for you. You need an accountant to discover the need, lawyers to complete complex documents, an insurance consultant to structure the transaction with the right insurance product, and a banker to provide the “other people’s” money.

Consider the following example: Joe and Mary are worth $40 million and need $20 million of second-to-die insurance. The premium cost is $225,000 per year. Joe and Mary can afford the premiums, but they would have to sell some assets to pay them and capital gains taxes would be incurred. Joe wants to avoid this and 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, and Joe and Mary’s children are the beneficiaries of the ILIT.

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

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

2. The premiums are paid using bank loans, which are borrowed by the ILIT, instead of cash.

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 collateral required must be supplied by Joe and Mary. They supply it with a stock and bond portfolio they already own.

6. Each year as the CSV grows, the amount of required additional collateral is reduced. Usually, the PFLI plan is designed for the CSV over time to cover 100 percent 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.

Note: 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: the gross death benefit, $24 million in this case, and the 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 and Mary created $20 million of (tax-free) wealth without any out-of-pocket cash.

The actual premium dollar outlay for Mary and Joe is zero because the premiums and loan interest are paid by loans. 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. 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.

It is important to understand that PFLI is not a type of insurance, but rather a way to pay for it. Here are the points to determine if you qualify for PFLI:

1. Have a legitimate need for life insurance.

2. Have a net worth of at least $15 million.

3. Have an annual premium to be financed of at least $100,000.

4. Own liquid assets that can be used as collateral for the loans.

5. Meet the insurance company’s underwriting requirements.

Most likely your PFLI plan will be structured to cover your potential estate tax liquidity needs or to ensure that your kids will benefit. But the concept is flexible and easily adaptable for business debt, key man insurance or buy-sell agreements.