Level 2 Planning - The Irrevocable Life Insurance Trust
Situation
Estate is projected to be over $1,000,000 ($2,000,000 for married couples) at time of death.
Objectives
- Remove life insurance proceeds from the insured's gross estate while still providing benefits to the surviving spouse and descendants.
- Take advantage of the $11,000 ($22,000 for married couples) annual gift tax exclusion per donee as indexed for inflation.
- Leverage the annual gift tax exclusion through the purchase of life insurance, particularly second-to-die life insurance.
- Use tax-free death benefit to provide liquidity to the estate through the purchase of assets from the estate or loans to the estate.
Tools & Techniques
- Irrevocable Life Insurance Trusts.
- Dynasty Trusts.
Disadvantages
- Grantor-insured cannot act as the trustee of an Irrevocable Trust.
- Trust is irrevocable and, therefore, cannot be amended or revoked.
- Grantor cannot directly reach trust property (i.e. cash values) during lifetime. However, the trustee can use cash values for the benefit of the grantor's spouse and descendants during grantor's lifetime. Moreover, grantor can give certain individuals (i.e., spouse, oldest living child, brother, sister, etc.) the power to appoint trust property back to grantor.
The "Crummey" Trust
This type of Irrevocable Life Insurance Trust is a popular device used in making gifts that qualify for the $12,000/$22,000 annual exclusion from gift tax. Most other forms of gifts that qualify for the annual exclusion require an immediate or at least a very early (i.e., age 21) distribution of the assets to the beneficiary. After 1998, the gift tax annual exclusion is indexed annually for inflation. The "Crummey" Trust takes its name from a court case upholding this type of trust and supporting its tax benefits.
Each time a contribution is made to a Crummey Trust, a temporary right (i.e., 30 days) to demand withdrawal of that contribution from the trust is available to the beneficiaries. If the demand right is not exercised, the contribution remains in the trust for management by the trustee.
Because the right of withdrawal is not usually exercised, the trustee may use the funds (income and/or principal) for some purpose desired by both the trust grantor and the beneficiaries. Paying premiums on insurance on the life of the grantor is its typical use. When the grantor-insured dies, the insurance proceeds are used to provide benefits to the surviving spouse, children and/or grandchildren. Properly structured, the insurance proceeds are not taxed in the estate of the grantor nor the estate of the grantor's spouse. Moreover, when both spouses have died, the insurance proceeds can then be used to help pay the Federal Estate Tax that may be due. This is accomplished by having the Crummey Trust purchase assets from, or loan money to, the estates of the grantor and/or the grantor's spouse as allowed in the trust document.
The main advantage of an Irrevocable Life Insurance Trust is the reduction of the gross estate by the annual gifts to the trust and the exclusion of the life insurance policy from the estate. As long as the grantor-insured establishes an irrevocable trust and retains no "incidents of ownership" over the policy, and no powers over the trust that could be construed as ownership, the insurance proceeds received by the trust will be excluded from the grantor's gross estate.
For an existing policy transferred to the trust, the grantor-insured must survive at least three (3) years from the transfer of the policy to the trust. Otherwise, the insurance proceeds will be included in the grantor's estate. This three-year-rule can be avoided for a new policy by having the trust apply for the policy as the initial owner.
In funding the Crummey Trust, the vehicle of choice is invariably life insurance because: (i) it increases substantially in size upon the grantor-insured's death – generally, both federal income and estate tax free; (ii) it can usually be funded with gifts qualifying for the $12,000 /$22,000 gift tax annual exclusion per beneficiary; (iii) the cash value of a permanent policy permits funding flexibility since the cash values can be used to pay the premiums after a period of years; and (iv) the insurance proceeds can eventually be used to provide liquidity to help pay the grantor's estate taxes.
In essence, the Irrevocable Life Insurance Trust allows death taxes to be paid for the estate rather than from the estate.
Click on the image below for a larger view of the living trust with irrevocable life insurance diagram.
Generation Skipping Transfer Taxes
A generation-skipping transfer ("GST") tax applies to lifetime or deathtime transfers to a member of a generation more than one generation younger than the donor (i.e., grandchildren). The GST tax is in addition to the gift or estate tax. However, there is an exemption against the GST tax. The GST tax exemption is generally the same as the estate tax exemption, and GST tax rate is the same as the highest estate tax rate (see table on page 2). In 2010, the GST tax is repealed. However, under the "sunset" provision of the Economic Growth and Tax Relief Reconciliation Act of 2001, on January 1, 2011 the GST tax is reinstated with a $2 Million exemption (as adjusted for inflation) and a flat 55% tax rate.
Dynasty Trusts - Leveraging The GST Exemption
A Crummey Trust funded with life insurance can leverage a grantor's GST exemption. For example, a married couple could gift up to $2,000,000 to a Crummey Trust using the $11,000/$22,000 annual gift tax exclusion per beneficiary and/or the $1,000,000/$2,000,000 estate/gift tax exemption. The trustee could in turn use these gifts to purchase a second-to-die life insurance policy on the grantors.
Let's assume this results in a $10,000,000 policy being purchased. Upon the death of the surviving spouse, the following benefits would be realized:
- The entire death proceeds received by the Crummey Trust would generally be received income tax free under Section 101(a) of the Internal Revenue Code.
- The entire proceeds would be estate tax free because the grantors did not possess any "incidents of ownership".
- The children and grandchildren would receive the income from the trust and any principal needed for their health, education, maintenance and support.
- There would be no generation skipping tax because the grantors' $1,100,000/$2,200,000 (2002) GST exemption was used to make the trust "GST exempt".
- Upon the death of the children, the property (including any appreciation) would pass estate tax free to the grandchildren and perhaps even the great grandchildren.
- The assets in the Crummey Trust would be outside the reach of the beneficiaries' creditors, including divorced spouses.
Click on the image below for a larger view of the dynasty trust diagram.
Special Section
Keeping the Family Business in the Family
The most valuable asset in a business owner's estate is often the business itself. If the business owner's objective is to pass the family business down to those children who are active in the business, then special planning techniques are required.
Let's assume that a father is the sole owner of a corporation and that his wife is not interested in continuing the business after his death. Let's also assume that there are three children, but that only one of them is active in the business. How can the father pass the family business down to the active child, and still treat his three children equally at the death of the surviving spouse?
The simplest way to accomplish the father's objectives would be for the father and the active child to enter into a buy-sell agreement. Such an agreement would provide that upon the death, disability or retirement of the father, the active child would purchase all of the father's stock at such price and upon such terms as are set forth in the buy-sell agreement. To fund the obligation, the active child will own a life insurance policy on the father's life. The business can help the active child to pay the premiums on this policy with an annual bonus. Upon the father's death, the insurance proceeds can be used to help provide income to the surviving spouse, to pay estate taxes upon the death of the surviving spouse, and to provide an inheritance for the non-active children.
To minimize the cost to the active child of purchasing the business, and to freeze the value of the business, the father could begin gifting stock to the child. The stock can be gifted outright or in trust, through the use of a Family Limited Liability Company, or through the use of a Grantor Retained Annuity Trus. Moreover, these gifts can be made with the father and mother's $11,000/$22,000 annual gift tax exclusion, or with their unused $1,000,000-/$2,000,000 gift tax exemption. As long as the gifted stock represents a minority interest or lacks marketability, the gift will qualify for a valuation discount.
If the value of the business, including the portion of the business gifted to the active child, makes up more than 50% of the father's estate, the estate may qualify for a "family-owned business deduction." In general, the deduction (when used in combination with the estate tax exemption) shelters from estate taxes the first $1.3 Million of value of a business interest from a decedent's estate. However, under the Economic Growth and Tax Relief Reconciliation Act of 2001, the deduction is repealed effective for estates of decedents dying after 2003, but reinstated for decedent's dying after 2010 because of the Act's sunset provision. Moreover, overly complicated and restrictive ownership, participation and recapture rules, as well as the impact of inflation, make this deduction of little practical value to most business owners.
Finally, while gifting the business to the active child makes for good tax planning, it does not treat the nonactive children equally. In such a case, it is often recommended that an Irrevocable Life Insurance Trust for the benefit of the non-active children be used as an "estate equalization" device.