Estate planning strategies using life insurance in a trust Options for handling distributions, rollovers and conversions

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1 Estate planning strategies using life insurance in a trust Options for handling distributions, rollovers and conversions Life s better when we re connected

2 Table of contents Find your questions review potential strategies Children as beneficiaries of your estate...4 Transferring your family business to children...6 Having charities benefit from your estate plan...6 Additional trust planning strategies...7 Estate planning strategies Irrevocable Life Insurance Trust (ILIT)...8 Spousal Lifetime Access Trust (SLAT)...9 Dynasty Trust Leveraged Credit Shelter Trust...11 Special Needs Trust Encouraging positive behaviors using an Incentive Trust with Life Insurance Life Insurance for the blended family estate plan Family buy/sell succession strategy Charitable gifts of life insurance Installment sale to an Intentionally Defective Grantor Trust (IDGT) Grantor Retained Annuity Trust (GRAT) with an ILIT Wealth replacement strategy...20 Loans from an Irrevocable Life Insurance Trust (ILIT Loans) Repositioning IRA assets for wealth transfer...22 Annuity Repositioning for wealth transfer...23 Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), a registered broker-dealer, Member SIPC, and other subsidiaries of Bank of America Corporation (BofA Corp.). Insurance and annuity products are offered through Merrill Lynch Life Agency Inc. ( MLLA ), a licensed insurance agency. Investment, insurance and annuity products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Are Not Deposits Are Not Insured By Any Federal Government Agency Are Not a Condition to Any Banking Service or Activity 2

3 Your Merrill Lynch financial advisor can help you determine which estate planning strategies are right for you and how life insurance fits with them. Planning your estate involves planning for the people important to you and identifying your goals. For many of us, our lives revolve around our children and our business. This guide starts with these two categories to help you navigate through an array of estate planning strategies that may benefit your family and help transfer your business to your beneficiaries. Building a plan means more than complying with current tax laws. It requires ongoing discussions among you, your heirs and your professional advisors, including your legal and/or tax advisors to make sure your hopes and dreams are met. To use this guide, start with these simple steps: Find your questions under the Questions You May Have portion of the tables Review the Strategies to Consider Read the convenient summaries of suggested estate planning strategies that describe how each works with life insurance 3

4 Children as beneficiaries of your estate Find your questions review potential strategies. Categories Questions You May Have Strategies to Consider Children How can I pass assets at my death with the least amount of tax? How can I provide cash for my children at my death? Irrevocable Life Insurance Trust (ILIT) See Page 8 Spousal Lifetime Access Trust (SLAT) See Page 9 Spouse and Children How can I provide cash for my spouse and children at my death? Spousal Lifetime Access Trust (SLAT) See Page 9 Minor Children Even though my children are minors, can they own a life insurance policy on my life? Is it possible to name my minor children as beneficiaries of my life insurance policy? Is it possible to name my children as beneficiaries of my life insurance policy but withhold distributions until each child reaches a certain age? Irrevocable Life Insurance Trust (ILIT) See Page 8 Spousal Lifetime Access Trust (SLAT) See Page 9 Encouraging Positive Behavior in Children and Heirs How can I encourage my heirs to become productive members of society? How can I encourage my heirs to attend college and graduate school? Is it possible to allow distributions from an irrevocable trust only when the beneficiaries achieve certain goals I have established? If one of my children has a career helping others but does not earn a lot of money, is it possible to make special provisions for that child and allow him/her to receive more assets than my other children who have higher salaries? How can I supplement the income of my child who truly enjoys his/her job working at a charity but does not earn a lot of money? Encouraging Positive Behaviors Using an Incentive Trust with Life Insurance See Page 13 Incentive Provisions in an ILIT, SLAT, Dynasty Trust, and/or Leveraged Credit Shelter Trust See Pages 8, 9, 10 & 11 Children from a Prior Marriage How can I provide for my children from a prior marriage and also ensure my current spouse has enough assets for his/her living expenses? Although my current spouse and I have created the majority of our net worth, how can I leave assets to my children from a prior marriage at my death? Is it possible to structure my estate plan so assets my current spouse receives at my death are completely separate from the assets I leave my children from a prior marriage? Irrevocable Life Insurance Trust (ILIT) See Page 8 Life Insurance for the Blended Family Estate Plan See Page 14 4

5 Categories Questions You May Have Strategies to Consider Charity and Children Special Needs Child or Heir Grandchildren and Future Generations Grandchildren and Family Business Income- Producing Assets and Children Can I name a charity and my children as co-beneficiaries of a life insurance policy? Is it possible to provide for my child with special needs in my estate plan but not disqualify my child from the government benefits he/she currently receives? How can I leave assets to help provide for my children, grandchildren, and future generations? How can I provide for my grandchildren since my children already have enough assets? Is it possible to leave assets to my children, grandchildren, and future generations in some type of structure that would operate similar to a Family Bank? Because my grandchildren show an interest in continuing the family business, how can I ensure that they have enough money to buy the business at my death? If I have income-producing and highly appreciating assets that I want to give to my heirs during my life, what are some methods I can use to transfer the assets to avoid or minimize gift tax? Charitable Gifts of Life Insurance See Page 16 Special Needs Trust See Page 12 Special Needs Provisions in an ILIT, SLAT, Dynasty Trust, and/or Leveraged Credit Shelter Trust See Pages 8, 9, 10 & 11 Dynasty Trust See Page 10 Dynasty Trust See Page 10 Family Buy/Sell Succession Strategy See Page 15 Grantor Retained Annuity Trust (GRAT) with an ILIT See Pages Installment Sale to an Intentionally Defective Grantor Trust (IDGT) See Page 17 5

6 Transferring your family business to children Find your questions review potential strategies. Categories Questions You May Have Strategies to Consider Children and Family Business Children from a Prior Marriage and Family Business Children, Family Business, and Limit Gift/ Estate Tax Impact How can my child who is active in the family business buy the business from my estate and/or my spouse at my death? How can I leave my family business to one child at my death without disinheriting my other children? Is there a way to equalize my estate to my children by leaving my family business to one child and cash to another? How can I achieve my goals of wanting my children from a prior marriage to inherit my family business and also ensure my current spouse has enough assets for his/her living expenses? What are some gift and estate tax savings strategies I can use when I gift or sell my family business to my heirs? Is it possible to transfer my family business to my heirs but limit the potential gift and/or estate tax liability my estate will face? Irrevocable Life Insurance Trust (ILIT) See Page 8 Family Buy/Sell Succession Strategy See Page 15 Irrevocable Life Insurance Trust (ILIT) See Page 8 Life Insurance for the Blended Family Estate Plan See Page 14 Family Buy/Sell Succession Strategy See Page 15 Grantor Retained Annuity Trust (GRAT) with an ILIT See Pages Installment Sale to an Intentionally Defective Grantor Trust (IDGT) See Page 17 Having charities benefit from your estate plan Categories Questions You May Have Strategies to Consider Charities and Tax Savings Charities and Life Insurance Gifts Is it possible to avoid triggering capital gains tax on the sale of a highly appreciated asset? Is there a way to create an income stream from a highly appreciated asset without triggering capital gains tax? Being a charitably inclined individual, is it possible to benefit a charity at my death but avoid disinheriting my children? Is it possible to leave assets to charity at death but replace that amount by providing assets to my children? Can I name a charity as the sole beneficiary of a life insurance policy? What type of tax benefit will I receive if I name a charity as the beneficiary of my life insurance policy? What type of tax benefit will I receive if I name a charity as the owner and beneficiary of my life insurance policy? How can I receive a charitable income tax deduction for the life insurance premiums I pay when a charity is the beneficiary of the life insurance policy? Wealth Replacement Strategy Using a Charitable Remainder Trust with Life Insurance See Page 20 Charitable Gifts of Life Insurance See Page 16 6

7 Additional trust planning strategies Categories Questions You May Have Strategies to Consider Access to Assets Held by a Trust Trust Flexibility Trust Left by Deceased Spouse Strategies for Unneeded Retirement Assets: Individual Retirement Account (IRA) Strategies for Unneeded Retirement Assets: Annuities Is it possible for me to personally benefit from assets held by an irrevocable trust? Is it possible to take loans and/or withdrawals from a life insurance policy owned by an irrevocable trust for my benefit? Is it possible to create an irrevocable trust with flexibility to adapt to changes in the estate tax laws? If my spouse has passed away and I am a beneficiary of a Credit Shelter Trust, is it possible to increase the amount of those assets in the Credit Shelter Trust for my children because I do not need the assets? Because my spouse has died and named our family as beneficiaries of a Credit Shelter Trust, do I need to establish a separate irrevocable trust to own life insurance on my life? Now that my spouse has passed away and a Credit Shelter Trust has been established, how can I provide cash to my heirs to help pay for any estate tax that may be due at my death? Knowing that my IRA will be subject to both income and estate taxes if I die with my children as beneficiaries, what options are there to avoid or minimize these taxes my children will face? If I have an IRA that I no longer need, is it possible to leave that asset to my children free from income tax? When I take money out of my IRA, how can I increase the value of these IRA distributions for my children because I do not need the distributions? Knowing that my annuity will be subject to both income and estate taxes if I die with my children as beneficiaries, what options are there to avoid or minimize these taxes my children will face? If I have an annuity that I no longer need, is it possible to leave that asset to my children free from income tax? When I take money out of my annuity, how can I increase the value of these annuity distributions for my children because I do not need the distributions? Spousal Lifetime Access Trust (SLAT) See Page 9 Loans from an Irrevocable Life Insurance Trust (ILIT Loans) See Page 21 Spousal Lifetime Access Trust (SLAT) See Page 9 Leveraged Credit Shelter Trust See Page 11 Repositioning IRA assets for wealth transfer See Page 22 Annuity Repositioning for wealth transfer See Page 23 7

8 Irrevocable Life Insurance Trust (ILIT) An Irrevocable Life Insurance Trust (ILIT) is one of the most common types of irrevocable trusts. With the assistance of an estate planning attorney, you can establish an ILIT to be the owner and beneficiary of a life insurance policy insuring your life. You can transfer cash to the ILIT in order for the trustee of the ILIT to pay life insurance premiums. It is important to remember that an ILIT is irrevocable, and you will not be able to change its terms after the ILIT has been established. Also, the assets that you transfer to the ILIT are no longer your assets. The person or bank you have chosen as trustee will manage the ILIT assets, and the individuals who have been named as beneficiaries will receive those assets pursuant to the terms of the ILIT. Whether or not these transfers are subject to gift tax depends on your ability to make annual exclusion gifts or to use your lifetime gift tax exemption. In addition to life insurance, an ILIT can own most any kind of asset cash, stocks, bonds, mutual funds and real estate. Who will be the trustee of the ILIT? Who will be the beneficiaries of the ILIT? All assets owned by an ILIT, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax, assuming the ILIT is properly created and maintained. After your death, the life insurance death benefit proceeds can be used by the trustee of the ILIT to purchase assets from or lend money to your estate in order to provide your estate with the liquid assets necessary to pay any estate tax due. When will the beneficiaries receive the ILIT assets? Who will help the trustee administer the ILIT? How will the ILIT be funded? Will annual gift tax returns need to be filed when funding the ILIT? 8

9 Spousal Lifetime Access Trust (SLAT) A Spousal Lifetime Access Trust (SLAT) is one type of irrevocable trust. Only those clients who are married can benefit from a SLAT because one spouse, the grantor spouse, will establish the SLAT and the other spouse will be a beneficiary of the SLAT along with the clients heirs. Similar to an ILIT, a SLAT can be established with the assistance of an estate planning attorney, and the SLAT can be the owner and beneficiary of a life insurance policy insuring one or both spouses. The grantor spouse will transfer cash to the SLAT in order for the trustee of the SLAT to pay life insurance premiums. Whether or not these transfers are subject to gift tax depends on the grantor spouse s ability to make annual exclusion gifts or to use the lifetime gift tax exemption. By structuring the SLAT with the non-grantor spouse as beneficiary, the trustee has the discretion to take federal income tax-free loans or cash withdrawals from the life insurance policy and distribute those assets from the SLAT to that beneficiary spouse during his/her lifetime. 1 Upon death, the life insurance death benefit proceeds can be used by the trustee of the SLAT to purchase assets from or lend money to your estate in order to provide your estate with the liquid assets necessary to pay any estate tax due. It is important to remember that the grantor spouse must transfer his/her separate property to the SLAT in order to properly fund the SLAT. Also, a SLAT is irrevocable, and you will not be able to change its terms after the SLAT has been established. Finally, all assets owned by a SLAT, including the life insurance death benefit proceeds, will be excluded from both the grantor s and the non-grantor s taxable estates and, as a result, will not be subject to estate tax. Which spouse will be the one creating the SLAT and which spouse will be the beneficiary? Who will be the beneficiaries, in addition to the non-grantor spouse? Who will be the trustee? Remember that an insured of a life insurance policy should not serve as trustee. Therefore, for a second-to-die policy, a third-party trustee must serve as trustee. When will the beneficiaries receive the SLAT assets? Who will help the trustee administer the SLAT? How will the SLAT be funded? Does the grantor spouse have adequate separate property to transfer to the SLAT to pay the life insurance premiums? If the grantor spouse were to pass away first, there must be another source of cash to continue to pay premiums if a second-to-die policy is owned by the SLAT. Therefore, a term policy on the grantor s life should be considered in the event the grantor spouse were to pass away first. Will annual gift tax returns need to be filed when funding the SLAT? Identical SLATs (one for each spouse) do not work under the reciprocal trust doctrine. The SLATs must differ in some important provisions or they may be considered reciprocal and the tax benefits will not be provided. It is important to work with a knowledgeable estate planning attorney when establishing them. 1 For federal income tax purposes, tax-free income assumes: (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) policy remains in force until death or maturity; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. 9

10 Dynasty Trust A Dynasty Trust is another type of irrevocable trust that is appropriate for those clients who want to leave a legacy for children, grandchildren, and future generations. Dynasty Trusts are designed to continue for multiple generations and protect the assets in the trust from not only future gift and estate taxes but also from the generation-skipping transfer tax (GST tax). 2 With the assistance of an estate planning attorney, you can establish a Dynasty Trust, which can be the owner and beneficiary of a life insurance policy insuring your life. You can transfer cash to the Dynasty Trust in order for the trustee of the Dynasty Trust to pay life insurance premiums. Whether or not these transfers are subject to gift tax depends on your ability to make annual exclusion gifts or to use your lifetime gift tax exemption. In addition, you will need to allocate some or all of your generationskipping transfer tax exemption (GST tax exemption) to the contributions made to the Dynasty Trust to avoid the GST tax and to ensure Dynasty Trust assets will not be subject to estate tax in future generations. 3 Who will be the trustee of the Dynasty Trust? Who will help the trustee administer the Dynasty Trust? Should a corporate trustee or a corporate co-trustee be named since the Dynasty Trust will continue for many years? Who will be the beneficiaries of the Dynasty Trust? When will the beneficiaries receive the Dynasty Trust assets? How will the Dynasty Trust be funded? Who will help file the annual gift tax returns necessary because GST tax exemption will need to be allocated to the contributions in order to properly fund the Dynasty Trust? All assets owned by a Dynasty Trust, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax or GST tax. The duration of the Dynasty Trust may be indefinite or limited to a number of years, depending on the laws of the state which govern the terms of the Dynasty Trust. 2 The GST tax is a flat tax at the highest federal gift and estate tax rate that applies to transfers during lifetime or at death to skip persons, i.e., persons two or more generations younger than the transferor. This tax is assessed in addition to other federal transfer taxes, such as gift or estate taxes. 3 The GST tax exemption is the amount that can be allocated to transfers to skip persons during lifetime or at death. To the extent that a generationskipping transfer is sheltered by the exemption, no GST tax is due. 10

11 Leveraged Credit Shelter Trust Upon the death of a client with a will or properly funded living trust, a Credit Shelter Trust usually is established and funded with an amount equal to the deceased spouse s estate tax exemption. This Credit Shelter Trust is sometimes referred to as the Exemption Trust, Decedent s Trust, or B Trust. Maximizing the assets transferred to the beneficiaries of the Credit Shelter Trust can be achieved by funding the Credit Shelter Trust with life insurance because all assets owned by a Credit Shelter Trust, including the life insurance death benefit proceeds, will be excluded from the surviving spouse s taxable estate and, as a result, will not be subject to estate tax. At the first spouse s death, an amount equal to the deceased spouse s estate tax exemption will be funded to the Credit Shelter Trust. The trustee of the Credit Shelter Trust may purchase a life insurance policy insuring the surviving spouse using the assets in the Credit Shelter Trust. The Credit Shelter Trust will be the owner and beneficiary of the life insurance policy. Frequently, the surviving spouse is named as the trustee of the Credit Shelter Trust and is given a power of appointment over the assets in the Credit Shelter Trust. Before the life insurance policy is purchased, however, the surviving spouse must resign as trustee and must relinquish any powers of appointment over the Credit Shelter Trust assets. This will prevent the life insurance policy death benefit proceeds and other Credit Shelter Trust assets from being included in the surviving spouse s taxable estate. Because Credit Shelter Trust assets are used to pay life insurance premiums, the Credit Shelter Trust can serve as a substitute for an ILIT. What assets from the deceased spouse s estate will be used to fund the Credit Shelter Trust? Is the surviving spouse the trustee of the Credit Shelter Trust? If so, who will be the successor trustee of the Credit Shelter Trust? Who will help the successor trustee administer the Credit Shelter Trust? Does the surviving spouse have any powers of appointment over Credit Shelter Trust assets that must be relinquished? 11

12 Special Needs Trust 4 Planning by parents for a disabled child should be aimed at creating a structure to provide for this beneficiary s welfare and financial security. The name Special Needs Trust typically refers to an irrevocable trust with certain provisions which control how distributions for the benefit of a disabled child will contribute to the beneficiary s quality of life; the amounts and purposes of such distributions will be determined in the discretion of the trustee. These special needs provisions can be used in ILITs, SLATs, Credit Shelter Trusts, and Dynasty Trusts. With the assistance of an attorney who specializes in special needs planning, you can establish a Special Needs Trust to be the owner and beneficiary of a life insurance policy insuring your life. Your transfers of cash to the Special Needs Trust in order for the trustee of the Special Needs Trust to pay life insurance premiums will use all or a portion of your lifetime gift tax exemption. All assets owned by a Special Needs Trust, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax. The terms of the Special Needs Trust allow the trustee the discretion to make distributions of life insurance death benefit proceeds for the benefit of the disabled child in order to contribute to the beneficiary s quality of life. Who will be the trustee of the Special Needs Trust? Who will be the beneficiaries of the Special Needs Trust? Who will help the trustee administer the Special Needs Trust? How will the Special Needs Trust be funded? Who will help file the annual gift tax returns necessary because lifetime gift tax exemption will be used in order to properly fund the Special Needs Trust? What impact will the Special Needs Trust have on the government benefits available for the disabled child? What assets will be distributed to children who are not beneficiaries of the Special Needs Trust? Who will benefit from your assets that are distributed from your will or living trust? 4 Due to the specialized nature of these trusts, U.S. Trust offers agency services for the Special Needs Trustee. 12

13 Encouraging positive behaviors Using an Incentive Trust with Life Insurance 5 The name Incentive Trust typically refers to an irrevocable trust with certain provisions that can promote positive behaviors in beneficiaries. These incentive provisions can be used in ILITs, SLATs, Dynasty Trusts, and Credit Shelter Trusts. The goal of incentive trust planning is to ensure that inherited wealth creates a positive rather than a negative legacy. If you want to convey your values, foster education, and encourage productivity in your heirs, you may consider including incentive provisions in your estate planning documents. Common provisions contained in incentive trusts include: rewarding educational goals that are achieved such as earning a degree or maintaining a certain grade point average, recognizing work-related success by providing funds which match earnings, and providing additional income to a beneficiary in an important yet low-paying career. An Incentive Trust can be established with the assistance of an estate planning attorney, and the Incentive Trust will be the owner and beneficiary of a life insurance policy insuring one or both spouses. You can transfer cash to the ILIT in order for the trustee of the ILIT to pay life insurance premiums. Whether or not these transfers are subject to gift tax depends on your ability to make annual exclusion gifts or to use your lifetime gift tax exemption. All assets owned by an Incentive Trust, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax. Are there any restrictions on when the beneficiaries will receive distributions of assets from the Incentive Trust? In what ways should positive behaviors be encouraged through distributions of assets from the Incentive Trust? Who will be the trustee of the Incentive Trust? Who will be the beneficiaries of the Incentive Trust? Who will help the trustee administer the Incentive Trust? How will the Incentive Trust be funded? Will annual gift tax returns need to be filed when funding the Incentive Trust? 5 U.S. Trust offers agency services to individual trustees of incentive trusts. 13

14 Life Insurance for the blended family estate plan Traditional estate plans do not anticipate the special considerations and planning needed for blended families. Life insurance insuring a spouse with children from a previous marriage can provide the liquidity and funding for an equitable division of assets upon the death of these children s parent. marriage and, as a result, will not be subject to estate tax. The death benefit proceeds are distributed to the children from a previous marriage as directed by the terms of the ILIT. This gives these children an inheritance prior to the death of the surviving non-parent spouse. With the assistance of an estate planning attorney, an ILIT can be established to be the owner and beneficiary of a life insurance policy insuring the life of the spouse with children from a previous marriage, and the beneficiaries of this ILIT will be the children from the spouse s previous marriage. Will children from a previous marriage also benefit from your assets that are distributed from your will or living trust? Who will be the trustee of the ILIT? One or both spouses will transfer cash to the ILIT in order for the trustee of the ILIT to pay life insurance premiums. Whether or not these transfers are subject to gift tax depends on the ability of one or both spouses to make annual exclusion gifts or to use lifetime gift tax exemption. Who will be the beneficiaries of the ILIT? When will the beneficiaries receive the ILIT assets? Who will help the trustee administer the ILIT? How will the ILIT be funded? Will annual gift tax returns need to be filed when funding the ILIT? All assets owned by an ILIT, including the life insurance death benefit proceeds, will be excluded from the taxable estate of the spouse with children from a previous 14

15 Family buy/sell succession strategy The Family Buy/Sell Succession Strategy is designed to provide family members who are active in the family business with a source of cash to purchase the business from your estate or from your surviving spouse after you have passed away. Your children who are active in the family business will be the owners and beneficiaries of a life insurance policy insuring your life. Although your business interests would be included in your taxable estate, the life insurance death benefit proceeds used to purchase your business interests would be available to offset any estate tax liability. There are certain buy/sell structures, such as a trusteed cross purchase arrangement, often used when there are multiple business owners, whereby policies on each business owner are held in a trust to limit the number of policies required to be purchased. Because these children most likely are employees or partial owners, the family business can be used to support the life insurance policy owned by these active family members. Generally, this would be accomplished through bonus payments to the active family members; your children would use these bonus payments, after paying income tax, to pay premiums on a life insurance policy insuring your life. Which family members will be the owners and beneficiaries of the life insurance policy insuring your life? How will life insurance premium payments be made? Upon your death, the life insurance death benefit proceeds are distributed to your children active in the family business, and they would use these funds to purchase the family business from your estate or your surviving spouse under the terms of the family buy/sell agreement. What assets will be distributed to children not involved in the family business? Who will benefit from your assets that are distributed from your will or living trust? 15

16 Charitable gifts of life insurance Charitable gifts of life insurance are usually structured in one of the following ways: The charity is the owner and beneficiary of the life insurance policy insuring your life; or You are the owner and the charity is the beneficiary of the life insurance policy insuring your life; or You donate an existing policy insuring your life to a charity so the charity is the owner and beneficiary of the life insurance policy. If you want to receive an immediate charitable income tax deduction for the life insurance premium amount, the charity must be the owner and beneficiary of the life insurance policy. You would donate cash directly to the charity so the charity may pay the life insurance premiums. At your death, the charity would receive the life insurance death benefit proceeds. If you want to retain ownership of the life insurance policy, you may name a charity as the beneficiary of the policy. This does not provide you with a charitable income tax deduction and the death benefit proceeds will be included in your estate for estate tax purposes; however, the life insurance death benefit proceeds paid to the charity will qualify for a charitable estate tax deduction. This structure would be appropriate if you want the ability to take federal income tax-free loans or cash withdrawals from the life insurance policy as a means to supplement your retirement but you ultimately want to benefit a charity. 6 payments. These additional donations generally will be income tax deductible. At your death, the charity would receive the life insurance death benefit proceeds. There are certain trust structures that can be used to make your charitable gifts more efficient. Additionally, other ideas will be explored in the Wealth Replacement Strategy section later in this brochure. Because the rules regarding charitable income tax deductions are complex, consult your legal and/or tax advisor to determine the amount of your deduction. Which charity or charities do you want to benefit? Will the charity be the owner and beneficiary of the life insurance policy so you can receive a charitable income tax deduction? Will continuing life insurance premiums need to be made? Will the charity only be the beneficiary of the life insurance policy so you can receive a charitable estate tax deduction? If you have an existing life insurance policy, you may donate the policy to a charity. You will receive a charitable income tax deduction. If further life insurance premiums are needed, you may continue to make annual donations to the charity for the additional premium 6 For federal income tax purposes, tax-free income assumes: (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) policy remains in force until death or maturity; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. 16

17 Installment sale to an Intentionally Defective Grantor Trust (IDGT) An Installment Sale to an Intentionally Defective Grantor Trust (IDGT) is a deferred sale arrangement between the grantor and an irrevocable trust that allows the grantor to make gift tax-free transfers of appreciating assets and the corresponding income to the irrevocable trust beneficiaries. This irrevocable trust is Intentionally Defective for income tax purposes because the grantor s social security number is the tax identification number for the IDGT. This type of irrevocable trust is also known as a grantor trust. With assistance from an estate planning attorney, the grantor begins this transaction by transferring assets to the IDGT which uses all or a portion of the grantor s lifetime gift tax exemption. These seed assets should give the IDGT economic substance in order to enter into the installment sale. Next, the grantor sells property to the IDGT in exchange for an installment note payable over a term of years the grantor selects. The trustee of the IDGT uses the income from the assets held by the IDGT to make the installment note payments. 7 Because the IDGT is Intentionally Defective, all income generated by the assets held in the IDGT is reported on the grantor s income tax return; there will be no change from an income tax perspective after this arrangement has been established. As a consequence, the installment note payments from the IDGT to the grantor are not subject to income tax. The Installment Sale to an IDGT allows the grantor to reduce his/her taxable estate if the assets sold to the IDGT produce income and appreciate in value greater than the interest the IDGT owes on the installment note because the IDGT retains excess income and appreciated asset value. If the grantor fails to survive the term of the installment note payments, the value of the remaining note payments will be included in the grantor s estate for estate tax purposes. Also, the IDGT could be structured as a Dynasty Trust if the grantor s desire is to benefit his/her children, grandchildren, and future generations; generation-skipping transfer tax exemption 8 can be allocated to the initial transfer of assets to the IDGT. Oftentimes, the IDGT has sufficient excess income after making the annual payments on the installment note to fund the purchase of a life insurance policy also owned by the IDGT. By structuring the ownership of the life insurance policy in the IDGT, the income generated by the assets in the IDGT will pay the life insurance premiums due. This avoids the need to establish a separate ILIT to be the owner and beneficiary of a life insurance policy insuring your life. Upon death, all assets owned by an IDGT, including the life insurance death benefit proceeds, will be excluded from the grantor s taxable estate and, as a result, will not be subject to estate tax. What high income-producing and appreciating assets do you have which would be appropriate to fund the IDGT? Who will be the beneficiaries of the IDGT? Who will be the trustee of the IDGT? Who will help the trustee administer the IDGT? Who will help file the gift tax return necessary because lifetime gift tax exemption most likely will be used to seed the IDGT when it is established? When will the beneficiaries receive the IDGT assets? Will there be other available assets in the IDGT to pay life insurance premiums if the assets sold to the IDGT do not generate sufficient income to make installment note payments and premium payments? What happens if the grantor fails to survive the term of the installment note payments? 7 The interest rate on the installment note is based on the government s Applicable Federal Rate (AFR) based on the length of the note. 8 The GST tax exemption is the amount that can be allocated to transfers to skip persons during lifetime or at death. To the extent that a generationskipping transfer is sheltered by the exemption, no GST tax is due. 17

18 Grantor Retained Annuity Trust (GRAT) with an ILIT A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust that allows you to retain a fixed annuity from property you transfer to a trust for a defined time period, pass the remainder interest to your beneficiaries and exclude that property from your taxable estate. While there is an initial gift when the property is contributed to the GRAT, the taxable gift is equal to the fair market value of the property reduced by your retained annuity interest. 9 Based on the term and the retained annuity stream of the GRAT, there may be little or no gift tax imposed at the time the GRAT is established. 10 At the expiration of the term of the GRAT, ownership of the remaining property passes to the remainder beneficiaries of the GRAT without the imposition of additional gift tax. If you fail to survive the selected term of the GRAT, the entire value of the transferred property will be included in your estate for estate tax purposes. If your desire is to benefit grandchildren, a GRAT would not be an appropriate strategy because generation-skipping transfer tax exemption 11 cannot be allocated to the initial transfer of assets to the GRAT. 12 Similar to other types of irrevocable trusts, a GRAT should be established with the assistance of an estate planning attorney. Life insurance should not be purchased in the GRAT because there is the possibility that you will die during the GRAT term which would cause the GRAT assets, including the life insurance death benefit proceeds, to be included in your taxable estate. However, life insurance held in a separate ILIT may be appropriate because your taxable estate may be illiquid, and the trustee of the ILIT may use the life insurance death benefit proceeds to purchase assets from or lend money to your estate in order to provide your estate with the liquid assets necessary to pay any estate tax due. Also, in the event you pass away during the term of the GRAT, all of the assets in the GRAT will be included in your estate for estate tax purposes and thus increase your taxable estate. 18

19 With assistance from an estate planning attorney, you can establish an ILIT and name your heirs as beneficiaries. The ILIT will be the owner and beneficiary of a life insurance policy insuring your life. You can transfer cash to the ILIT in order for the trustee of the ILIT to pay life insurance premiums. Whether or not these transfers are subject to gift tax depends on your ability to make annual exclusion gifts or to use your lifetime gift tax exemption. However, at your death, all assets owned by an ILIT, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax. What appreciating assets do you have which would be appropriate to fund a GRAT? Who will be the beneficiaries of the GRAT? Who will be the trustee of the GRAT? Who will help the trustee administer the GRAT? Who will help file the gift tax return necessary because a small amount of lifetime gift tax exemption will be used when the GRAT is established? Who will be the trustee of the ILIT? Who will be the beneficiaries of the ILIT? Who will help the trustee administer the ILIT? When will the beneficiaries receive the ILIT assets? How will the ILIT be funded? Will annual gift tax returns need to be filed when funding the ILIT? 9 10 IRS Section 7520 rate is used to value the GRAT. Your contribution to the GRAT may be valued at zero or at an amount close to zero for gift tax purposes if the GRAT is structured as a zeroed-out GRAT. With a zeroed-out GRAT, you are not treated as making a gift to the beneficiaries of the GRAT because the value of your retained annuity interest is equal to the value of the property you transferred to the GRAT. Recently proposed federal legislation would limit use of the GRAT technique. You should consult with legal counsel prior to any implementation. It is recommended that the term of the GRAT be at least 10 years. 11 he federal generation-skipping transfer tax exemption ( GST tax exemption ) is the amount of assets that each person can pass to grandchildren and T skip persons during life and at death free from federal GST tax. 12 IRC Section 2642(f) prohibits the allocation of GST tax exemption during an estate tax inclusion period ( ETIP ). The selected term of a GRAT is an ETIP because the value of all assets held by the GRAT will be included in the individual s gross estate if he or she dies during the selected term. 19

20 Wealth replacement strategy Using a Charitable Remainder Trust with Life Insurance A Charitable Remainder Trust (CRT) may provide you with an income stream from the sale of a highly appreciated asset, may allow you to avoid paying immediate capital gains tax on the sale of that asset, and may qualify you for a charitable income tax deduction. With the assistance of an estate planning attorney, you can establish a CRT and transfer a highly appreciated asset to the CRT. 13 You can receive a charitable income tax deduction based on the calculated value of the gift to the charity. The trustee of the CRT can sell the highly appreciated asset, not incur capital gains tax on the sale, and reinvest the sale proceeds in incomeproducing assets. Depending on how the CRT income stream is structured, you will receive taxable income from the CRT for your life, for the lives of you and your spouse, or a specified term not to exceed 20 years. At the termination of the CRT income stream, the remaining assets in the CRT will be distributed to a charity. When a CRT is used in conjunction with a Wealth Replacement Strategy, you would establish an ILIT with assistance from an estate planning attorney and name your heirs as beneficiaries. The ILIT will be the owner and beneficiary of a life insurance policy insuring your life. All or a portion of the income stream you receive from the CRT can be used as the source of funds to transfer to the ILIT in order for the trustee of the ILIT to pay the life insurance premiums. Whether or not these transfers are subject to gift tax depends on your ability to make annual exclusion gifts or to use your lifetime gift tax exemption. At your death, all assets owned by an ILIT, including the life insurance death benefit proceeds, will be excluded from your taxable estate and, as a result, will not be subject to estate tax. The death benefit proceeds distributed to the ILIT beneficiaries will replace the asset that was transferred to the CRT and ultimately to the charity because the ILIT beneficiaries normally would have been the recipients of such asset. Which charity or charities do you want to name as beneficiary of the CRT? What highly appreciating assets do you own that could be funded to the CRT? Who will be the trustee of the CRT? Who will help the trustee administer the CRT? Who will be the trustee of the ILIT? Who will be the beneficiaries of the ILIT? When will the beneficiaries receive the ILIT assets? Who will help the trustee administer the ILIT? How will the ILIT be funded? Will annual gift tax returns need to be filed when funding the ILIT? 13 For CRTs created on or after June 28, 2005, Revenue Procedure requires an irrevocable waiver of the statutory right of election from the grantor s spouse in order for the trust to qualify as a CRT under IRC 664 if the laws of the state provide that the grantor s spouse has the right to receive a statutory share of the grantor s estate that could be paid from the CRT s assets. Subsequent to Revenue Procedure , the IRS issued Notice , which indefinitely suspends the date upon which irrevocable waivers for CRTs must be executed. Currently, the IRS does not require waivers where a surviving spouse has a right of election. Please consult your tax and legal advisor with regard to this issue. 20

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