SCINS and Private Annuities: Using Bet-to-Die Estate Planning Techniques

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1 SCINS and Private Annuities: Using Bet-to-Die Estate Planning Techniques Wednesday, November 20, 2014 OUR EXPERTS: Robert S. Keebler Keebler & Associates, LLP, Green Bay, WI Steven J. Oshins Oshins & Associates, LLC, Las Vegas, NV Bruce A. Tannahill MassMutual Financial Group, Phoenix, AZ

2 American Bar Association Section of Real Property, Trust and Estate Law 321 North Clark Street Chicago, IL , select option 2 CDs, DVDs, ONLINE COURSES, PODCASTS, and COURSE MATERIALS ABA-CLE self-study products are offered in a variety of formats. To take advantage of our full range of options, visit the ABA Web Store at The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association, Section of Real Property, Trust and Estate Law for Continuing Legal Education unless adopted pursuant to the bylaws of the Association. Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only American Bar Association. All rights reserved. This publication accompanies the audio program entitled SCINS and Private Annuities: Using Bet-to-Die Estate Planning Techniques broadcast on November 20, 2014 (Event code: RP4TSC).

3 To register for this and additional programs, visit the Section at: PLEASE CONSIDER THE ENVIRONMENT WHEN PRINTING MATERIAL

4 SCINS and Private Annuities: Using Bet-to-Die Estate Planning Techniques November 20, :00 PM Eastern Sponsored By The ABA Section of Real Property, Trust & Estate Law Robert S. Keebler Keebler & Associates, LLP Green Bay, WI Steven J. Oshins Oshins & Associates, LLC Las Vegas, NV Bruce A. Tannahill MassMutual Financial Group Phoenix, AZ

5 The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association, Section of Real Property, Trust and Estate Law for Continuing Legal Education unless adopted pursuant to the bylaws of the Association. Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only American Bar Association. All rights reserved.

6 Balancing Bet-to-Live and Bet-to-Die Strategies It s a Balancing Act Bet to Live? Bet to Die?

7 Key Strategies Bet-to-Live Strategies Lifetime Gifts Annual Exclusion Gifts Lifetime Gift Tax Exemption Gifts Taxable Gifts Grantor Retained Annuity Trust (GRAT) Dynasty Trust Sale to an Intentionally Defective Grantor Trust (IDGT)

8 Key Strategies Bet-to-Die Strategies Self-Canceling Installment Note (SCIN) Private Annuity Charitable Lead Trusts Life Insurance

9 SELF-CANCELING INSTALLMENT NOTE (SCIN) SALE TO AN IDGT

10 Self-Canceling Installment Note Transaction similar to an ordinary installment sale to an IDGT 9-to-1 debt/equity Cancellation-at-death feature added to note Premium must be paid, either in the form of additional principal or increased interest rate to compensate for the cancellation-at-death feature OBJECTIVE: Reduction of estate tax if premature death occurs

11 Types of SCINs Hedge SCIN A SCIN designed to hedge against the possibility of death during a bet-tolive strategy (taxable gifts, GRAT, etc ) Mortality SCIN A SCIN designed for those who have a high likelihood of dying within a short period of time

12 Sample of SCIN Interest Rate Risk Premiums SINGLE LIFE Total Interest Rate Age 1 Age 2 JOINT LIFE Total Interest Rate Age SCIN Risk Premium AFR SCIN Risk Premium AFR % 2.970% 3.840% % 2.970% 3.037% % 2.970% 4.316% % 2.970% 3.123% % 2.970% 5.012% % 2.970% 3.302% % 2.970% 6.153% % 2.970% 3.712% % 2.970% 8.085% % 2.970% 4.645% % 2.970% % % 2.970% 6.524% *Assumptions Term of Note 10 AFR 2.97% Payment Frequency Annually Type of Note Interest Only with Balloon Payment

13 SCIN Sale to an IDGT Example Year Beginning Balance Taxable Income Annual Ending Balance 10.00% Payment 1 $ 10,000,000 $ 1,000,000 $ (700,140) $ 10,299,860 2 $ 10,299,860 $ 1,029,986 $ (700,140) $ 10,629,706 3 $ 10,629,706 $ 1,062,971 $ (700,140) $ 10,992,537 4 $ 10,992,537 $ 1,099,254 $ (700,140) $ 11,391,650 5 $ 11,391,650 $ 1,139,165 $ (700,140) $ 11,830,675 6 $ 11,830,675 $ 1,183,068 $ (700,140) $ 12,313,603 7 $ 12,313,603 $ 1,231,360 $ (700,140) $ 12,844,823 8 $ 12,844,823 $ 1,284,482 $ (700,140) $ 13,429,165 9 $ 13,429,165 $ 1,342,917 $ (700,140) $ 14,071, $ 14,071,942 $ 1,407,194 $ (7,700,140) $ 7,778,996 BENEFIT: $7,778,996 transferred to beneficiaries estate/gift tax-free *NOTE: Assuming a 78-year-old seller and a $7,000,000 (after valuation adjustments) interest only, balloon payment feature installment note with a % annual interest rate (2.2% % mortality risk premium)

14 Why a SCIN Sale to an IDGT Works Back-end loading of installment payments Payment of trust income taxes by the grantor Valuation adjustments Cancellation-at-death feature Difference between actual rate of return and risk-adjusted AFR

15 Advantages Future appreciation above the note interest rate, including the risk premium, is removed from the grantor s estate Asset not included in grantor s estate in case of premature death during SCIN term Value of assets transferred out greatly exceeds value of payments coming back into the estate of the grantor if he/she passes away prematurely

16 No gain or loss on sale Advantages Trust income taxable to grantor allows for greater appreciation to inure to future generations, thereby creating an additional tax-free gift Valuation adjustments increase effectiveness of sale for estate tax purposes

17 Disadvantages Complex calculation of risk premium Possible gift tax exposure if SCIN risk premium is inadequate Possible gift tax exposure if trust is insufficiently funded

18 Disadvantages No step-up in basis at grantor s death Possible acceleration of capital gain at grantor s death Disliked by the IRS

19 ESTATE OF DAVIDSON

20 Estate of Davidson William Davidson was president, chairman and CEO of Guardian Industries He owned 78% of Guardian common stock before December 2008 He also owned Guardian preferred stock October and December 2008 his doctor stated he had no current conditions affecting his actuarial life expectancy Died March 13, 2009

21 Estate Planning Gifts of stock to new grantor trusts Exercise of power of substitution to grantor trusts Sales of stock to grantor trusts for SCINs Sales of stock to grantor trusts for regular notes Merger of some trusts Creation of GRATs

22 Amounts at Issue Tax GST Tax Penalty Total Forms 709 $ 699,741,451 $199,496,559 $1,253,055 $900,491,065 Form 706 1,870,610,411 15,884, ,120 $1,886,668,341 Totals $2,570,351,862 $215,381,369 $1,466,175 $2,787,159,406

23 Grandchildren SCIN Transactions 1/2/2009 sale of Guardian common and preferred stock to 6 irrevocable trusts for his grandchildren in exchange for SCINs Each trust received shares valued at $27,107,949

24 5 year term Grandchildren SCIN Terms Interest at the January 2009 section 7520 rate of 2.4% Principal amount of $50,993,000 $23,885,951 premium reflected risk Mr. Davidson would die before full amount paid Based on Section 7520 using IRS Mortality Table Secured by stock and other trust assets

25 Children SCINs 1/21/2009 Guardian common and preferred and cash transferred to trusts for two children in exchange for SCINs Ethan s Trust received $246,628,570 of stock and cash for a $246,628,570 SCIN Marla s Trust received $184,971,430 of stock and cash for a $184,971,430 SCIN

26 5 year term Children s SCIN Terms Interest rate of 15.83% (section 7520 rate was 2.40%) Interest premium reflected risk Mr. Davidson would die before full amount paid Based on Section 7520 using IRS Mortality Table Secured by stock and other trust assets

27 All SCINs Annual payment of interest Principal due at end of 5-year term SCINs disclosed on gift tax returns 4 doctors reviewed his medical records after his death All 4 found a greater than 50% chance of living for more than 1 year on dates of SCINs 5.8 year IRS Mortality Table life expectancy

28 Gift and Estate Tax Returns Gift tax return disclosed all exchanges of stock for SCINs No taxable gift reported Estate tax return did not include any portion of the SCINs

29 CCA No gift if property exchanged for a note is substantially equal to the value of the notes Based on value of stock transferred and Value of notes, including self-canceling feature Estate must demonstrate trust can repay the note Section 7520 tables cannot be used must use willing buyer-willing seller test, considering decedent s health

30 CCA Unlikely full amount would be paid Decedent s health Balloon payment Note was worth less than its stated amount Difference between note s FMV and stated amount was a gift

31 Issues in Tax Court Appropriate calculation method for SCIN premiums Whether the SCIN interest was an interest for life or a term of years under Section 7520 Whether the AFR or 7520 rate is the appropriate base rate for SCINs Whether the proper mortality table was used to calculate the SCIN premium

32 Issues in Tax Court Mr. Davidson s life expectancy and impact on SCIN calculation Whether the trusts had sufficient assets to fully satisfy the notes

33 PRIVATE ANNUITY

34 Private Annuity Parent Sale Annuity payments Children / Trust The seller s age and the current IRC 7520 rate are used for purposes of determining the amount of the annuity. Provided that the annuity is calculated correctly, the future value of the assets sold less the future value of the payment stream retained by the seller inures to the buyer (beneficiaries) free of transfer taxes, thus effectively freezing the growth of assets at the IRC 7520 rate. The IRC 7520 rate for September 2014 is 2.2%

35 Private Annuity Commonly a lifetime annuity However, a private annuity for the shorter of a term or life (PASTL) is also possible

36 Sample of Lifetime Private Annuity Amounts Age Annuity 53 $ 357, $ 405, $ 468, $ 555, $ 680, $ 860,331 Assumptions Value of Assets Sold $7,000,000 IRC 7520 Rate 2.20% Payment Frequency Annually Timing of Payment End of Period

37 Private Annuity Example Year Beginning Balance Growth Annual Ending Balance 10.00% Payment 1 $ 10,000,000 $ 1,000,000 $ (860,331) $ 10,139,669 2 $ 10,139,669 $ 1,013,967 $ (860,331) $ 10,293,305 3 $ 10,293,305 $ 1,029,330 $ (860,331) $ 10,462,304 4 $ 10,462,304 $ 1,046,230 $ (860,331) $ 10,648,204 5 $ 10,648,204 $ 1,064,820 $ (860,331) $ 10,852,693 6 $ 10,852,693 $ 1,085,269 $ (860,331) $ 11,077,632 7 $ 11,077,632 $ 1,107,763 $ (860,331) $ 11,325,064 8 $ 11,325,064 $ 1,132,506 $ (860,331) $ 11,597,239 9 $ 11,597,239 $ 1,159,724 $ (860,331) $ 11,896, $ 11,896,632 $ 1,189,663 $ (860,331) $ 12,225,964 Benefit: $12,225,964 Transferred to Beneficiaries Tax-Free * Assuming a 78-year-old seller and a $7,000,000 (after valuation adjustments) sale price

38 Advantages Provides an income stream to the seller for life Asset not included in seller/grantor s estate in case of premature death during the annuity term Value of assets transferred out of the seller s estate greatly exceeds value of payments coming back if he/she passes away prematurely Valuation adjustments increase effectiveness of sale for estate tax purposes

39 Disadvantages Under the Proposed Treasury Regulations, an immediate gain would be recognized by the seller The buyer s payments are not deductible as interest, thus causing more ordinary income to be recognized (double taxation)

40 Disadvantages Potential upstream transfer if seller lives for a long period of time (especially if the seller lives longer than his/her life expectancy) If assets are sold to a trust, possible gift tax exposure could occur if the trust has inadequate assets to support the payments

41 Private Annuity Sale to a Trust Annuity interests are ordinarily valued using the IRC 7520 tables, but there are a number of exceptions One is the exhaustion test of Reg (b)(1)(iii) There is an annuity payable from a trust or other limited fund The payor would be expected to run out of funds before the full amount of the annuity is paid assuming growth of assets at the 7520 rate If so, the annuity can be valued only until the funds would be expected to run out rather than for the full annuity term This rule applies to a private annuity sale to a trust

42 Exhaustion Testing In a private annuity sale, the seller generally takes back a life annuity Thus, the question is whether the stated annuity payments could be made for the seller s life For this purpose, the IRS takes the position that the seller could live for up to 110 years

43 Exhaustion Testing Example T, age 78, sells assets worth $1,000,000 to a trust and takes back a private annuity for life in September 2014 when the IRC 7520 rate is 2.2% The life annuity factor under these facts is Thus, if not for the exhaustion test, the payment necessary to set the value of the annuity equal to $1,000,000 would be $122,905 ($1,000,000/8.1364) To avoid the exhaustion test, these payments would have to last for 24 years (110 86) Given the 2.2% growth rate, however, the trust assets would last for less than 10 years so the exhausting rule would apply.

44 Effect of the Exhaustion Test If the exhaustion test applies, the annuity must be valued as an annuity for the shorter of term or life rather than as a life annuity The term of years is the length of time the payments would be expected to last in our example, a little more than 6 years Using shorter of term or life reduces the value of the payment stream and creates a taxable gift for the seller

45 Planning for the Exhaustion Test Make the private annuity sale to an individual Use seed gifts to increase trust corpus so that trust assets are sufficient to make payments to age 110 Use an annuity for shorter of term or life with a term less than 110 seller s age rather than a life annuity

46 Private Annuity Sale To An Individual The exhaustion test only applies if the annuity payments are made from a trust or other limited fund The rule evidently doesn t apply to a sale to an individual regardless of the individual s financial circumstances

47 Seed Gifts The exhaustion test doesn t apply if the trust has sufficient assets to make payments until the seller reaches age 110 Example: Assume the same facts as on the earlier slide: 78 year-old seller 2.2% 7520 rate $1,000,000 private annuity sale

48 Calculating Seed Gifts Life annuity factor (age 78, 2.2% 7520 rate): Amount of annual annuity payments: $122,905 (1,000,000/8.1364) For a 78 year-old, the payments would have to last 32 years (110-78) The annuity factor for a 32 year straight term annuity and a 2.2% 7520 rate is Thus, to make the payments last for 32 years you would need total funding of $2,802,277.

49 Private Annuity for Shorter of Term or Life (PASTL) The amount of the seed gift can be greatly reduced by creating an annuity for shorter of term or life rather than a life annuity Term should be greater than seller s life expectancy to avoid possible re-characterization as a SCIN (GCM 39503) Make term as short as possible without going under life expectancy

50 Private Annuity for Shorter of Term or Life (PASTL) - Example Create private annuity for shorter of life or 10 years-- same facts as in previous examples STL annuity factor for 78 year-old and 10-year term: STL payout necessary to zero out without regard to exhaustion test: $ 153,494 ($1,000,000/6.5194) 10-year term certain annuity 2.2%: Amount necessary to make 153,494 annual payment for 2.2%: $1,364,454 ( x $153,494)

51 Private Annuity for Shorter of Term or Life (PASTL) - Example Compare the total funding needed for each strategy: Life Annuity: $2,802,277 PASTL: $1,364,454 The PASTL also has the advantage of preventing a large upstream transfer back to the seller if the seller lives well beyond life expectancy

52 COMPARISON OF STRATEGIES

53 Grantor Dies During Term - Year 5 Net Wealth to Family $18,000,000 $16,000,000 $15,934,123 $14,000,000 $12,000,000 $12,797,400 $14,004,137 $13,481,225 $10,000,000 $9,663,060 $9,663,060 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $0 No Planning GRAT Sale to IDGT SCIN to IDGT Private Annuity - Life Private Annuity - Term Assumptions Gross Value of Assets Transferred $10,000,000 Net Value of Assets Transferred $7,000,000 IRC 7520 Rate 2.20% AFR 2.97% Term / Life Expectancy 10 Years Payment Frequency Annually Type of Payment (Installment Note/SCIN) Interest Only with Balloon Payment Age of Seller / Annuitant 78 Estate Tax Rate 40%

54 Grantor Survives Entire Term - Year 10 Net Wealth to Family $25,000,000 $20,000,000 $20,917,371 $21,812,069 $22,691,088 $20,452,840 $19,087,774 $15,000,000 $15,562,455 $10,000,000 $5,000,000 $0 No Planning GRAT Sale to IDGT SCIN to IDGT Private Annuity - Life Private Annuity - Term Assumptions Gross Value of Assets Transferred $10,000,000 Net Value of Assets Transferred $7,000,000 IRC 7520 Rate 2.20% AFR 2.97% Term / Life Expectancy 10 Years Payment Frequency Annually Type of Payment (Installment Note/SCIN) Interest Only with Balloon Payment Age of Seller / Annuitant 78 Estate Tax Rate 40%

55 Grantor Substantially Outlives Term - Year 15 Net Wealth to Family $40,000,000 $35,000,000 $34,496,589 $35,128,554 $36,544,223 $30,000,000 $30,838,541 $30,741,051 $25,000,000 $25,063,489 $20,000,000 $15,000,000 $10,000,000 $5,000,000 $0 No Planning GRAT Sale to IDGT SCIN to IDGT Private Annuity - Life Private Annuity - Term Assumptions Gross Value of Assets Transferred $10,000,000 Net Value of Assets Transferred $7,000,000 IRC 7520 Rate 2.20% AFR 2.97% Term / Life Expectancy 10 Years Payment Frequency Annually Type of Payment (Installment Note/SCIN) Interest Only with Balloon Payment Age of Seller / Annuitant 78 Estate Tax Rate 40%

56 CONCLUSION

57 The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association, Section of Real Property, Trust and Estate Law for Continuing Legal Education unless adopted pursuant to the bylaws of the Association. Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only American Bar Association. All rights reserved.