Using Commercial Lending to “Juice” the Funding of Loan Method Split Dollar Arrangements
In past articles I have vigorously defended the notion that I know "Squat." Most readers would view such a claim as sheer lunacy and maybe in certain circles it would be a great insult. However, as a lifetime lover of the Iron Game (weightlifting), the "squat" is a critical part of the weightlifting DNA. My passion started early. Even as I get “longer in the tooth," I can still trace the steps of my weightlifting passion.
It started at around age six in the weightroom of Balboa High School in the Panama Canal Zone when I lifted a 50 lb. dumbbell. About eight years later, I suffered a serious knee injury playing football and the coach at the junior college (Canal Zone College, Morris Finkelstein (of blessed memory), personally took it upon himself to help rehabilitate me with Mr. Johnson, the Jamaican trainer. After recovering, I became a member of the Balboa YMCA which has the only complete weight room in the Canal Zone.
The Y became my Mecca where I spent hundreds of hours perfecting the squat. My neighbor and childhood friend Mark Givens had the best collection of lifting magazines from York Barbell - Strength and Health, and Muscle Development. He gravitated towards bodybuilding while I gravitated towards powerlifting. In high school I had an opportunity to visit York Barbell which was the weightlifting equivalent of a pilgrimage to Mecca for weightlifting enthusiasts.
Arnold Schwarzenegger became the face of bodybuilding and went on to a substantial career in business, acting and politics. His Terminator series made him a Hollywood icon. Personally, my favorite was Conan The Barbarian probably because I enjoyed Hercules movies featuring Reg Park (a former Mr. Universe).
This article focuses on how a business can use a commercial loan to finance a Loan Regime Split Dollar™ Arrangement and deduct the interest payments for its tax purposes without running afoul of the limitations of IRC Sec. 264. The use of commercial lending provides a source of funding and leverage on an after-tax basis to provide funding for the loan by a business to the policyholder in a Loan Regime Split Dollar Arrangement.
Loan Regime Method of Split Dollar Review
I have been going on and on for weeks about the magic of the Loan Regime Method of Split Dollar life insurance in the current loan interest rate environment. The current long term AFR in August 2020 is 1.12 percent. In the loan regime, the policyholder may be a business owner or key executive or alternatively, an irrevocable trust for the benefit of the business owner. The Trust removes the policy from the reach of personal and business creditors while allowing the business owner as a discretionary income beneficiary for tax-free loans and withdrawals. The policy proceeds are received income and estate tax-free. The Trust may also be multi-generational.
The business makes a one-time loan locking in the long-term AFR. The policyholder funds the policy using the loan proceeds to fund the policy on a non-MEC basis. The business receives a collateral assignment in the policy cash value and death benefit equal to the loan plus any accrued interest.
What if the business has a better use of its existing capital which would allow it to receive a higher rate of return on business operations? A business may obtain a commercial loan from a bank for its business operations or alternatively use some or all of the proceeds from the commercial bank loan to extend to the policyholder as part of the Split Dollar Arrangement.
Several decades ago, leveraged corporate owned life insurance (aka COLI) was the best corporate tax shelter on Planet Earth. Members of the Fortune 500 could not buy enough of it! Congress shut this down so tightly that is largely thought that any lending used to purchase life insurance directly or indirectly is impossible. Furthermore, by extension, most advisors believe that the interest could never be deductible under any circumstance. It depends how carefully a policyholder is able to navigate the tightrope.
Generally speaking, the interest on a straight commercial loan between a commercial bank and corporation is fully deductible under IRC Sec. 163. In the planning circumstance intended, the loan transaction is a recourse loan to the corporate borrower and has economic substance. The proposed use of a commercial loan does not rely on any borrowing from the life insurance policy itself.
The corporation's use of the loan proceeds to provide a Split Dollar loan does not violate the rules regarding the systemic use of borrowing of the policy cash value under IRC Sec. 264. Instead the " 4 out of 7" exception provides that the general rule denying the deduction of loan interest will not apply if no part of four of the annual premiums during the initial seven-year period is used by means of indebtedness. The policyholder uses the loan proceeds to fund the policy at maximum non-MEC level in the first three years to fall within this exception. As a consequence, the business is able to fully deduct the interest on its corporate tax return.
Conclusion
The current lending rate from commercial lenders to the best corporate credit risks is approximately 3.5 percent. The deductibility of the interest in the corporate loan used to finance the business' loan to the policyholder provides an additional element of leverage - OPM - Other People's Money, The business is able to turn around and lend those proceeds to the policyholder at the long-term AFR which is currently 1.12 percent. The business will provide its collateral assignment interest in the policy as collateral for the commercial loan or alternatively it may pledge other assets. The Loan Regime Method of Split Dollar story only gets better!