Tax and Estate Impacts of Premium Financing: Loans, Imputed Interest, and Estate Inclusion

Premium financing is a powerful technique for high-net-worth (HNW) clients to acquire large, wealth-transfer life insurance policies while preserving liquidity and investment flexibility. But the tax and estate implications can be decisive to whether the structure succeeds — or generates unexpected estate inclusion, imputed interest, or taxable events. This article, focused on the United States (with examples in New York, California, and Texas), explains the key tax rules, common lender pricing, practical illustrations, and trust/ownership structures that HNW advisors should analyze.

Executive summary (what HNW clients in NY, CA, TX must know)

• Premium financing uses third‑party debt to pay all or part of life insurance premiums; typical deal sizes for HNW clients range from $1M to $50M+ of annual premium or funded single premiums for large death benefits.
• Imputed interest rules (IRC §7872) can apply to below‑market loans or intra‑family financing and create taxable interest income or gift/compensation implications.
• Estate inclusion depends on the insured’s incidents of ownership (IRC §2042), transfers within 3 years of death (IRC §2035), and whether the policy is properly owned by an Irrevocable Life Insurance Trust (ILIT) and out of the insured’s control.
• Pricing from private banks typically follows market reference rates (now SOFR) plus a spread; typical lending spreads are roughly SOFR + 1.50%–3.00% (150–300 bps) depending on borrower credit, collateral, and lender. Major private banks involved in these deals include J.P. Morgan Private Bank, Goldman Sachs Private Wealth Management, and Bank of America Private Bank.

External references:

• Premium financing primer: Investopedia — https://www.investopedia.com/terms/p/premium-financing.asp
• Below-market loan rules (IRC §7872): Cornell LII — https://www.law.cornell.edu/uscode/text/26/7872
• Federal estate tax overview (exemption amounts & basics): IRS — https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax

How premium financing works (tax-relevant mechanics)

• Borrower (policy owner or trust) obtains a loan from a bank or specialty lender to pay life insurance premiums.
• The policy is either:
  • Owned by the insured (risky for estate inclusion), or
  • Owned by an ILIT or other irrevocable vehicle (better for estate planning if structured correctly).
• Lenders often require a collateral package (policy assignment, additional collateral like securities or real estate) and interact with the insurer to ensure collateral values meet loan covenants.

Key tax touchpoints:

• Imputed interest on below-market or deferred interest loans (IRC §7872).
• Estate inclusion if insured retains incidents of ownership (IRC §2042) or if the policy is transferred within 3 years of death (IRC §2035).
• Gift tax issues when an insured makes gifts of premiums into a trust or when a lender forgives interest or principal as a gift.

Imputed interest: when the IRS treats “cheap money” as taxable income

IRC §7872 governs below-market loans. In premium financing, this can arise in two ways:

1. Direct lender pricing that is below applicable federal rate (AFR) — rare for large banks, but relevant for intra‑family loans or private lending where below‑market terms are used.
2. Economic benefits transferred to the borrower (e.g., loan forgiveness, lender-paid interest) — potentially treated as taxable income or gifts.

Practical notes:

• Most institutional lenders price at or above market (SOFR + spread), which avoids Section 7872 issues for the loan itself.
• If a lender offers a promotional or subsidized rate, compute imputed interest using AFR or Section 7872 formulas — this can create taxable interest income to the lender or imputed income/gift to the borrower.
• Document true economic terms and avoid non-arm’s-length forgiveness or side arrangements.

Reference: Cornell LII on §7872 is the authoritative statutory text and mechanics: https://www.law.cornell.edu/uscode/text/26/7872

Estate inclusion: incidents of ownership, transfers, and ILIT best practices

Life insurance proceeds are includible in the insured’s gross estate if certain ownership rights exist under IRC §2042 (incidents of ownership). Common incidents include:

• The right to change beneficiaries
• The right to pledge or assign the policy
• The right to surrender or borrow against the policy

Ways estate inclusion commonly happens in premium-financed deals:

• The insured personally retains ownership or control over the policy (common in poorly structured deals).
• The policy is assigned by the insured to a trust within three years of the insured’s death (see IRC §2035).
• The insured retains any of the incidents of ownership (e.g., ability to change beneficiaries, control policy loans).

How HNW clients avoid estate inclusion:

• Use a properly funded, irrevocable ILIT where the insured never retains incidents of ownership.
• If a sale/assignment occurs, satisfy the three‑year transfer rule: avoid transfers of policies or control within three years of death.
• Ensure the lender’s collateral position does not create de facto control by the insured.

Statutory references for estate inclusion and transfer timing: see IRC §2042 and §2035 (Cornell LII).

Example scenarios — numbers and comparisons (NY and CA examples)

Assumptions:

• $20,000,000 death benefit UL policy purchased by an ILIT.
• Annual net premium required: $500,000 (illustrative).
• Loan funds 100% of premium; lender charges SOFR + 200 bps; assume SOFR = 1.00% → loan rate = 3.00%.
• Client resides in New York or California (both high‑tax, high‑regulation states; collateral rules and state law can affect gifting/assignment enforcement).

Calculation table (annual)

Notes:

• If financing allows the ILIT to fund a larger policy sooner and avoids selling appreciating assets, the effective wealth-transfer benefit can exceed the financing cost.
• Real lender pricing varies; for sizable deals ($5M+ loan balance) private bank spreads commonly fall in the SOFR + 150–300 bps range.

Lender and insurer considerations — who to use and what pricing looks like

Common participants in premium financing:

• Lenders: J.P. Morgan Private Bank, Goldman Sachs Private Wealth Management, Bank of America Private Bank, Northern Trust. These lenders price loans for HNW clients as market-rate private bank loans — typically SOFR + 1.50%–3.00% depending on credit, size, and collateral.
• Insurers: New York Life, MassMutual, Northwestern Mutual, Prudential — each offers large-capacity UL/GUL solutions often used in premium-financed structures.

Example (pricing context):

• A typical private bank may offer a 5‑year term loan with interest payable quarterly at SOFR + 200 bps and a covenant requiring policy cash value to maintain a specified loan-to-cash‑value ratio. Pricing and deal covenants are negotiated case-by-case.

Because pricing and underwriting are institution-specific, advisors should solicit multiple term sheets and run stress tests under rising-rate scenarios (see internal resource: Interest-Rate Risk and Stress Tests for Premium-Financed Policies: Modeling Scenarios).

Practical tax and structuring checklist for advisors (NY / CA / TX focus)

• Confirm policy ownership and remove all incidents of ownership from the insured.
• Use an ILIT that is properly drafted and administered; avoid premium gifts within three years of anticipated death when possible (see Structuring Financing with ILITs and Other Trusts to Preserve Estate Tax Benefits).
• Obtain arm’s‑length loan documentation; avoid any forgiveness or side deals that could create imputed interest under IRC §7872.
• Run interest-rate and collateral stress tests (rising SOFR scenarios) before closing — see Interest-Rate Risk and Stress Tests for Premium-Financed Policies: Modeling Scenarios for modeling approaches.
• Compare the financed approach with alternative wealth-transfer mechanics (e.g., gifting cash into ILIT, using smaller policies funded over time). See background primer: Premium Financing 101: Leveraging Debt to Acquire High-Value Life Insurance for HNW Clients.

Closing considerations

Premium financing can materially enhance wealth transfer efficiency for HNW clients in New York, California, Texas and across the U.S., but only if tax, lending, and trust-ownership details are aligned. Pay special attention to loan pricing mechanics (SOFR + spread), clear avoidance of incidents of ownership, and documentation that precludes imputed interest or gift issues. When properly executed with market-priced lenders (e.g., J.P. Morgan Private Bank, Goldman, Bank of America) and reputable insurers (New York Life, MassMutual, Prudential), premium financing remains a commercially viable tool for sophisticated estate plans.

Further reading from this cluster:

• When Premium Financing Improves Wealth Transfer Efficiency: Key Metrics and Case Examples
• Negotiating Loan Documents: Covenants, Repayment Triggers, and Default Remedies for HNW Deals