Estate Planning Strategies Using Life Insurance In Times of Estate Tax Uncertainty

Transcription

1 Estate Planning Strategies Using Life Insurance In Times of Estate Tax Uncertainty This has been prepared by the Marketing Staff of Prudential to assist our producers. It is designed to provide general information in regard to the subject matter covered. It is published with the understanding that Prudential is not providing legal, accounting or tax advice. Such services should be provided by the client s own advisors. The Prudential Insurance Company of America, 751 Broad Street, Newark, NJ IFS-A063862, Ed. 08/04, Exp. 02/06 For internal use only. Not for use with the public.

2 Economic Growth & Tax Relief Reconciliation Act of 2001 Created three distinct estate tax periods which has caused uncertainty, complexity, and confusion. Phase I: Phase-in period of tax rate reduction and exemption increases Phase III: 2011 On Estate, gift and GST tax reverts back to the present law Phase II: 2010 Temporary repeal of estate and generation skipping transfer (GST) tax, replaced by a complex carryover basis tax on appreciated assets

3 Phase I Changes Calendar Years Slow reduction of maximum estate, gift & GST tax rates elimination of 5% surtax on assets valued between $10 million and $17,184,000. Slow increase in estate exemption/applicable exclusion gift exemption/applicable exclusion increases to $1 million and remains at this level. Calendar Year Estate & GST Tax Death Time Transfer Exemption 675,000 1,000,000 1,000,000 1,500,000 1,500,000 2,000,000 2,000,000 2,000,000 3,500,000 Gift Transfer Exemption 675,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Tax Rates 55%* 50% 49% 48% 47% 46% 45% 45% 45% *Plus 5% Surtax on assets valued between $10 million and $17,184,000

4 Phase I Changes Calendar Years Repeals special deduction provided to farms and family businesses (qualified family owned business deduction). Phase-out state estate tax credit % reduction % reduction % reduction 2005 credit repealed and replaced with a deduction for taxes actually paid to states Expands availability of installment payment relief. Expands estate tax rule for conservation easements.

5 Vulnerable to legislative changes.. Slow back- loaded phase-in takes place over 4 Congressional and 2 Presidential elections which makes it vulnerable to legislative changes. Throughout our history when the need for revenue was great, estate tax played a role. Analysis of Phase I Changes Time Period of Uncertainty Short History of Estate & Gift Tax 1797: Enacted - federal stamp tax to pay for naval build-up up for undeclared war with France. 1802: Repealed When threat of war ended. 1862: Enacted Inheritance tax to pay for civil war expenses. 1864: Enacted First gift enacted to pay for mounting civil war expenses. 1870: Repealed When Civil War costs diminish. 1898: Enacted Inheritance tax is imposed to fund Spanish American War. 1902: Repealed when war ended. 1916: Enacted - Estate tax as a means of wealth redistribution. 1924: Enacted Gift Tax as a back-up to estate and income tax. 1926: Repealed Gift Tax 1936: Enacted Gift Tax to finance government during depression : Numerous revisions. *Information taken from A.M. Best Special Report dated May 21, 2001.

6 Analysis of Phase I Changes Time Period of Uncertainty Cost of the legislation was estimated to be $133 billion. Because of the back-loaded nature of the legislation the costs nearly triples between the fifth and ninth year and jumps another 50% between the ninth and tenth years. In contrast, the pre-2001 law was estimated to generate $410 billion in revenue. * The greatest cost of the legislation will occur in 2010 just as the baby-boomers boomers reach retirement and begin to affect the budget. *Estimate is based on the Joint Tax Committee report

7 Analysis of Phase I Changes Time Period of Uncertainty Congress faced with a budget shortfall, could modify, delay or repeal the legislation to pay for programs. Since passage of the legislation there have been numerous congressional bills; some seek to extend the length of the repeal, some seek permanent repeal and others seek to reform the estate tax system with lower tax rates and higher exemption amounts.

8 Analysis of Phase I Changes Time Period of Uncertainty Modest tax relief.. Changes during this period provide only modest federal tax relief over the present laws. Moe Wyzzer,, a surviving spouse, has a house worth $2.75 million with a basis of $500,000, investments worth $7 million with a total basis of $2 million and home furnishings that cost $250,000 and are worth the same amount. Assuming she has cash equal to debt, funeral costs and estate administration her net estate is $10 million in The calculations for the chart on the following slide assumes no growth and growth (3% house, 8% investments, none balance).

9 Analysis of Phase I Changes Time Period of Uncertainty Exemption Estate Tax No Growth* Estate Tax Growth* N/A $675,000 $1,000,000 $1,000,000 $1,500,000 $1,500,000 $2,000,000 $2,000,000 $2,000,000 $3,500,000 N/A $1,000,000 $4,920,250 $4,430,300 $4,065,000 $4,065,000 $3,985,000 $3,680,000 $3,600,000 $3,600,000 $2,925,000 N/A $4,795,000 $4,920,250 $4,751,815 $5,007,815 $5,060,032 $5,333,229 $5,392,718 $5,688,794 $6,133,015 $5,935,558 N/A $10,136,235 The Changes Provide Only Modest Federal Tax Relief *The calculation do not take into consideration state death tax credit

10 Analysis of Phase I Changes Time Period of Uncertainty De-coupling of state death taxes can lead to higher total taxes.. Change to how the federal estate and state death taxes interact have lead states to de-couple their tax from the federal. Pre legislation most state death taxes didn t actually increase the total amount of tax paid because the federal estate tax provided a dollar for dollar credit for state taxes paid up to a certain amount. Most states crafted their tax to equal this credit pick-up tax.

11 Analysis of Phase I Changes Time Period of Uncertainty By 2005 the federal credit will be replace by a tax deduction. Changes to the federal state estate tax credit eliminates estate tax revenue to states with a pick-up tax. This has lead some of these states to de-couple their death tax and enact their own death taxes. Because the value of a tax deduction is less than a credit, even where the state death tax is maintained at the current level total taxes can actually increase.

12 Analysis of Phase I Changes Time Period of Uncertainty Higher taxes are only part of the problem. Many of the de-coupled states have not linked the value of assets exempt from state death taxes to the increase estate tax credits enacted by the legislation. In these states it s possible to trigger state death taxes at first death even where they are exempted from federal estate taxes.

13 Analysis of Phase I Changes Time Period of Uncertainty Planning Dilemmas. Changes do not materially alter the present estate tax structure; however, the changes do impact common estate strategies. Such as... Gifting dilemma. Prior to the legislation, lifetime gifts - including taxable gifts - provided a greater transfer of wealth than a transfers at death. Post legislation gifting for moderately wealthy estates may not make sense because asset retained qualify for modified step up while gifted assets do not. For the large estates taxable gifts in particular may not be practical as long as there is the possibility death transfers may occur tax-free.

14 Analysis of Phase I Changes Time Period of Uncertainty Discounting dilemma. Discounting values for gift tax is only an advantage if there is an estate tax. If the estate tax is replaces with a capital gains tax, discounting techniques will cause additional capital gains tax since the carryover basis is also discounted.

15 Analysis of Phase I Changes Time Period of Uncertainty Marital & credit trust planning - the all or nothing dilemma. To escape estate taxes on the death of the first spouse many estate documents provide a formula provision that an amount equal to the unified credit pass in a B trust to non-spouse heirs and the remainder go to the surviving spouse, who takes an unlimited amount tax-free under marital deduction. Post legislation these formula provisions can result in unintended distributions. For Example...

16 Analysis of Phase I Changes Time Period of Uncertainty Assume a couple with an estate of 3,000,000 having a typical formula clause passing maximum credit amount to children balance to spouse. Death 2003 surviving spouse receives $2M. Death 2006 surviving spouse receives $1M Death 2009 surviving spouse is disinherited* Death 2010 children are disinherited * Calendar Year * Consider the impact on second marriages with children from prior marriage. Children 1,000,000 1,500,000 2,000,000 3,500, ,000 1,000,000 Spouse 2,325,000 2,000,000 1,500,000 1,000, ,500,000 2,000,000

17 Phase II Changes Calendar Year 2010 The legislation simply replaced one death tax for another. Legislation provides a temporary one year repeal of the estate and GST tax, replacing it with a complex modified carryover basis tax. Repeals step-up in basis which currently shelters heirs from capital gains taxes on sale of appreciated assets received from a decedent.

18 Phase II Changes Calendar Year 2010 Establishes complex modified carryover basis adjustment equal to: Lesser of: (has been referred to as step-down rules ) Adjusted basis of decedent or Fair market value on date of decedent s death Plus step-up in basis allowed for: Assets valued up to 1.3 million for transfers to any beneficiary; plus Assets valued up to 3 million for transfers to surviving spouse. (qualified spousal property)

19 Phase II Changes Calendar Year 2010 Selected assets do not qualify for step-up under the modified carryover basis system (i.e., IRD assets such as annuities, qualified plans, and nonqualified deferred compensation arrangement) Only assets transferred from the decedent are eligible for the modified carryover basis adjustment. Repeals unlimited estate tax marital deduction. Gift tax continues with $1 million exemption and tax rate equal to the top individual income tax rate (currently scheduled to be 35%).

20 Analysis of Phase II Changes A Time Period of Complexity Complexity. The carryover basis provision enacted in this legislation is more complex than the provisions enacted in The 76 provisions were retroactively repealed in 1980 as unworkable. Unequal taxation for similar estates. Families with most of their wealth in IRD items (annuities, qualified plans) will be worse off than other families with appreciated assets who will qualify for partial basis step-up.

21 Analysis of Phase II Changes A Time Period of Complexity Burdensome record keeping. Imposes complicated record keeping on family members. Increase strife & litigation. Increases potential of family strife and litigation for executors who must allocate 1.3 million step-up among different assets and heirs. Tax inequity among heirs. Potential inequity among heirs with some receiving high basis assets and others low basis assets.

22 Analysis of Phase II Changes A Time Period of Complexity Increase tax on assets passing to spouse. With the loss of the unlimited marital deduction, the surviving spouses may pay more tax under a carryover basis system than under the current structure. Increase tax on buy sell arrangements.. With the loss of the step-up basis, mandatory buy sell arrangements triggered by death may cause taxation.

23 Analysis of Phase II Changes A Time Period of Complexity Less tax motivation for charitable gifts. Some of the tax incentive to make charitable bequests will be gone; limited to appreciated capital gains property in excess of modified step-up in basis adjustment. Increase use of charitable remainder trusts.. CRTs may become more popular because of their ability to avoid capital gains taxation on the sale of appreciated assets inside the trust.

24 Analysis of Phase II Changes A Time Period of Complexity Eliminates Zero tax plan ability. Under current law a decedent can avoid all tax with proper planning. Estate tax is completely voluntary; the capital gains approach offers less planning opportunities.

25 Analysis of Phase II Changes A Time Period of Complexity Life insurance more attractive.. Life insurance may become a more attractive financial vehicle for the wealthy client due to its income-tax-free death benefit under Section 101(a) of the Code. Life insurance death benefit can help recoup income taxes which will continue to burden many assets such as qualified plans, IRAs and annuities. Life insurance can help replace lost wealth transferred to a CRT.

26 Phase III Changes Calendar Years 2011 and Thereafter Estate, gift and GST tax laws revert back to present law $1,000,000 exemption/applicable exclusion Unified exemption/applicable exclusion 55% top tax rate and 5% surtax Step-up in basis Unlimited marital deduction In this world nothing can be said to be certain, except death and taxes Benjamin Franklin

27 Summary Between the current estate tax structure is not materially altered and presents only modest relief the legislation simply replaces one tax for another potentially more complex tax and thereafter the estate tax laws as they existed prior to the 2001 legislation are restored. Given the uncertainty of the current estate tax system planning ideas which provide flexibility to respond to a complex and uncertain future are needed now as much as ever!

28 What are some of the flexible life insurance planning techniques that make sense regardless of the estate tax situation?

29 Flexible Irrevocable Trust Document Design

30 Flexible Irrevocable Trust Document Design Irrevocability does not prevent a trust from being flexible Key is in careful drafting For Example...

31 Flexible Irrevocable Trust Document Design Changes in marital status Spouse at date trust comes into existence. Trustee changes Beneficiaries can be given power to change trustees. Grantor can be given power within limits to change trustee. Changes in Crummey power holders Grantor can be given power to exclude a beneficiary from exercising Crummey withdrawal power. Grantor can name alternate Crummey power holders if a power holder dies or is removed.

32 Flexible Irrevocable Trust Document Design Trustee Powers Broad powers to non-beneficiary trustee Power to change non-dispositive provisions Discretionary distribution to trust beneficiaries Power to terminate and distribute trust assets to beneficiaries Limited powers to trust beneficiary Limited power of appointment Power limited by ascertainable standards (HEMS)

33 Flexible Irrevocable Trust Document Design Powers of Appointment Limited Power.. Power holder given power to appoint trust property to a limited class of beneficiaries excluding the himself, his estate, his creditors or creditors of his estate. Example -- Spouse given power to appoint trust assets at her death to whichever of the children she chooses, in any amount she chooses. Ascertainable Standards.. Power holder can appoint to himself for his/her for limited purpose of health, education, maintenance or support (HEMS).

34 Getting A Policy Out Of An Existing Irrevocable Trust

35 ILIT Rescue: Getting A Policy Out Of An Existing ILIT If current trust does not meet client s needs what are the options for removing policy? Check trust terms to see if they provide for distribution of assets. If yes determine whether the distribution meets objectives (is to appropriate person). Determine whether a judicial order under state law is possible. If yes does the distribution meet objectives (is to appropriate person).

36 ILIT Rescue: Getting A Policy Out Of An Existing ILIT If current trust does not meet client s needs what are the options for removing policy? (continued) Purchase new policy in new trust stop paying premium in old trust, but... Client s health must be assessed Assess options for old policy Transfer existing policy to new trust,, but watch out for... Transfer-for-for- value issues Three year estate tax inclusion issues What are the methods....

37 ILIT Rescue: Getting A Policy Out Of An Existing ILIT Options for transferring existing policy to new trust: #1 Sale to insured followed by gift to ILIT Sale to insured avoids transfer for value Gift transfer to trust possible problem if significant policy values Taxable gain to the trust if policy is in gain position except where trust is grantor trust 3 years rule applies

38 ILIT Rescue: Getting A Policy Out Of An Existing ILIT Options for transferring existing policy to new trust: (continued) # 2 Sale to insured followed by sale to ILIT Sale to insured avoids transfer for value Gift transfer of cash to the new trust to purchase policy may be a problem if significant Taxable gain to the old trust if policy is in gain position except where trust is grantor trust 3 years rule is avoided if sale is for full consideration Sale to new trust needs to be structured to avoid transfer for-value (partner, partnership, grantor trust)

39 ILIT Rescue: Getting A Policy Out Of An Existing ILIT Options for transferring existing policy to new trust: (continued) #3 Sale from old ILIT to new grantor ILIT Sale to grantor ILIT may be considered a transfer to the insured possibly avoiding transfer for value Gift transfer of cash to trust to purchase policy may be a problem if significant Taxable gain to the old trust if policy is in gain position except where trust is grantor trust 3 years rule is avoided if sale is for full consideration

40 ILIT Rescue: Getting A Policy Out Of An Existing ILIT Options for transferring existing policy to new trust: (continued) #4 Sale to grantor s spouse gift to new ILIT Sale to grantor s spouse avoids transfer for value because under IRC 1041 sale to a spouse is deemed a gift, thus qualifies under the carryover basis exception of the transfer for value rule Gift transfer of cash to trust to purchase policy may be a problem if significant Taxable gain to the old trust if policy is in gain position 3 years rule does not apply, but proceeds included under IRC in spouse s estate if spouse beneficiary of the new trust

41 Support Trusts Single Life & Survivorship

42 Facts Client Facts Married Couple Need for life insurance coverage Obstacles Hesitant about placing insurance in an ILIT because of changing estate tax applicable exclusion which may shelter their estate from estate tax Desire Access policy cash values if needed

43 What Is A Support Trust? ILIT with trust provisions permitting broad access/ distribution of trust assets for benefit of trust beneficiary. Can be structured using single life or survivorship life insurance Single Life. Spousal support trust (SLAT) Survivorship. Survivorship support trust

44 Single Life Spousal Support Trust Structure Grantor insured establishes and ILIT. Non-grantor spouse is named one of the trust beneficiaries and may also be trustee depending on powers given to trust beneficiary. Grantor insured funds the premium gift to the ILIT out of his/her separate property. Individual life insurance coverage on the grantor s life is purchased by the trustee of the ILIT.

45 Single Life Spousal Support Trust Structure ILIT is drafted allowing the trustee broad powers to make distributions of income and principal to the insured s spouse and children. Where trustee is the non-insured spouse the spouse trustee can have following powers: Health, education, maintenance and support All trust income Greater of $5,000 or 5% of trust principal An independent trustee can be given discretionary distribution powers over trust income and principal.

46 During Life of the Insured Insurer Life Insurance Policy Insured Gifts Premium Spousal Support Trust Owner & Ins. Beneficiary Insured Spouse Trust Beneficiary Spouse of insured entitled to: Income > $5,000 or 5% Health, Education, Maintenance, Support

47 At Death of Insured Spouse Beneficiary Survives Insurer Death Benefit Insured Spousal Support Trust Spouse Trust Beneficiary Spouse of insured entitled to: Income > $5,000 or 5% Health, Education, Maintenance, Support

48 Death of Spouse Beneficiary Insurer Husband Trust Benefits Spousal Support Trust Wife Children

49 Benefits Access to policy cash values to benefit the non- insured spouse if spousal support becomes necessary.* Estate tax-free death benefit. * Of course loans and withdrawals cause a reduction in cash values v and death benefits, may affect any policy guarantees against lapse, and may y have tax consequences.

50 Survivorship Support Trust Structure Similar to single life structure. Grantor insured establishes and ILIT. Grantor insured funds the premium gift to the ILIT out of his/her separate property. Non-grantor spouse is named one of the trust beneficiaries ILIT is drafted allowing the trustee broad powers to make distributions to the beneficiary spouse and children. Neither of the insureds may be trustee.

51 Survivorship Support Trust What if the grantor spouse dies first? Problem of on- going premium requirement. Testamentary bequest of unused estate tax applicable exclusion amount to ILIT. ILIT could borrow money from surviving spouse/ trust beneficiary. Term insurance or single life rider on grantor spouse for amount of contemplated premium.

52 B Trust Funding

53 Facts B Trust Funding Moderately wealthy widow /widower. Credit shelter B trust established by estate of deceased spouse. Does not need income from trust. Needs life insurance to pay estate taxes. Obstacles Family currently using gift annual exemptions. Balks at using personal assets to pay premiums. Desire Fund insurance without paying gift tax.

54 B Trust Structure Bypass trust is reviewed by legal advisor to determine whether it can acquire insurance without causing adverse tax issues in the estate of the spouse. Insured spouse should not trustee if also trust beneficiary Insured spouse should not have limited power of appointment Insured spouse should not contribute premium to the trust Insured spouse can be trust beneficiary: Income Discretionary distribution of principal Trustee purchases life insurance on life of the surviving spouse using B trust assets.

55 Creation of B Trust Estate of Deceased Spouse Insurer Premium Transfer of Estate Assets Life Insurance Policy on Surviving Spouse CST Owner & Ins. Beneficiary Life Insurance Surviving Spouse

56 During Life of the Insured Beneficiary Spouse Insurer Estate of Deceased Spouse Surviving Spouse Income Discretionary principal CST Owner & Ins. Beneficiary Life Insurance on W

57 Death of Insured Beneficiary Spouse Insurer Death Benefit Estate of Deceased Spouse CST Owner & Ins. Beneficiary Trust Benefits Wife Children

58 Benefits Cash value in the life policy grows tax-deferred. In contrast, investment assets are subject to the high trust tax rates. Access to trust assets is available to Insured Spouse on a tax-favored basis. No annual exclusions or Crummey withdrawal powers need be used to fund the trust.

59 Benefits Death benefit leverages value of applicable exclusion amount. Life insurance proceeds pass to the heirs estate tax- free as well as income tax-free (under IRC 101(a)). In contrast, trust assets do not receive basis increase at death of surviving spouse. If carryover basis tax replaces current federal estate tax this may be an attractive feature for the estate heirs.

60 Survivor Standby Trust

61 Survivor Standby Trust Facts: Married couple Need for survivorship coverage Obstacles: Hesitant about making irrevocable estate liquidity decisions because of estate tax legislation Desire: Fund estate tax Retain access to policy cash values

62 Survivor Standby Trust Structure During Lifetime of Both Insureds Survivorship policy on a married couple. The oldest/unhealthy spouse: Primary owner and names a stand-alone alone standby irrevocable trust as the successor owner of the policy, or Primary owner and names a standby testamentary trust (credit shelter trust) establish in his/her will as successor owner,or His/her revocable trust as the owner Standby trust (SST) is named the beneficiary. If the insured is the owner the SST should be listed as the contingent owner. The policy owner must pay the premium out of his/ her separate funds.

63 Survivor Standby Trust Structure During Lifetime of Both Insureds Standby Trust Specifics: The trust can be stand-alone alone irrevocable trust or B trust established under terms of the owner s estate documents. Not necessary that the standby trust be in existence from the inception; however, it is prudent establish the trust as soon as possible. Of course, if the trust is not in existence an alternative beneficiary must be identified. The SST should not contain any provisions which would attribute incident of ownership to the non-owner owner insured spouse (i.e. trustee of the SST). Non-owner owner spouse should not be estate executor where insured is the owner or successor trustee where revocable trust is the owner.

64 Three Different Stages of the Arrangement Both Insured Living Premium Insurer Owner Spouse Primary Owner Survivorship Policy Survivorship Life Insurance Policy Cash Value Access No Gift of Premium Survivorship Standby Trust Contingent Owner & Primary Beneficiary Non-owner Spouse

65 Survivor Standby Trust Structure at Death of Owner At death of owner/insured, prior to non-owner owner insured, policy passes into the SST. Non-owner owner insured spouse can be an generally is beneficiary of the SST. Independent trustee can access trust assets (including policy cash values) for the benefit of the insured spouse.* Where non-owner owner insured spouse is beneficiary of the SST he/she should not contribute on-going premium to the SST. * Of course loans and withdrawals cause a reduction in cash values and death benefits, may affect any policy guarantees against lapse, and may have tax consequences.

66 Three Different Stages of the Arrangement At Death of Insured Owner Insurer Estate of Owner Spouse Survivorship Life Insurance Policy* *Cash value included in Owner s estate Survivorship Standby Trust Owner & Beneficiary Survivorship Policy Non-owner Spouse Trust Beneficiary Cash Value Access

67 Survivor Standby Trust Structure at Death of Non-Owner Insured At death of non-owner/insured, owner/insured, after death of owner insured, death proceeds pass into the SST. Proceeds can be used to generate estate liquidity in the same manner as an ILIT.

68 Three Different Stages of the Arrangement At Death of Non-Owner Insured Insurer Death Benefit Owner Spouse Survivorship Standby Trust Non-owner Spouse Children Trust Beneficiaries

69 Intended Tax Treatment Insured Owner Dies First No gifts during lifetime of both insureds. Policy cash values can be accessed on a non-mec policy through withdrawals and loans generally income tax- free. At policy owner s death, cash value is included in his/her estate. At the death of the non-owner owner spouse the policy proceeds paid to the trust are estate and income tax- free (under IRC 101(a)).

70 But What If Non-Owner Spouse Dies First Younger, healthier spouse dies first: Policy owner gifts policy to trust; cash value is taxable gift. On-going gifts of premium payment. Policy is included in his estate for 3 years Alternative option: Trust purchases policy from insured owner 3 year rule does not apply to sale for full consideration; immediately excluded from estate Transfer-for-value for-value applies making death proceeds subject to income tax except where transfer is to exempt transferee.

71 Benefits No gift during the lifetime of both insureds. Access to cash values during the lifetime of the insureds and for the surviving insured s lifetime as a beneficiary of the SST. Potential estate exclusion of the death benefit at the surviving insured s death Cash value will be included in owner/insured s estate offset by any remaining applicable exclusion. Planning Flexibility. Owner has complete flexibility if estate tax reduced or repealed in future.

72 Tax Issues

73 IRC Section 2042 This section causes life insurance death proceeds to be included in estate of the insured where: Payable to or for estate of insured or Extent insured has an incident of ownership of a policy on his/her life

74 IRC Section 2042 Application to Standby Trust Incident of ownership can occur where insured has rights in individual or fiduciary capacity. In standby trust common situations where this can occur: If non-owner owner dies first and insured continues to own the policy at death proceeds in estate Insured should not be trustee if beneficiary of SST or executor of estate if policy passes under its term Provisions in SST can cause incident of ownership such as where insured is given limited power of appointment but non-owner owner spouse can be trust beneficiary with income and discretionary rights to principal

75 IRC Section 2036 This section provides that an estate will include the value of property to the extent a decedent has made a transfer and retained either: Possession or enjoyment of right to income, or Right to control someone else s beneficial enjoyment over the property

76 IRC Section 2036 Application to Standby Trust In standby trust common situations where transfer with retained enjoyment or income can occur: Community property states it is essential that premiums be paid from the policy owner insured s separate property. If any premiums come from the trust beneficiary s (i.e non- owner insured) community property a proportionate amount of the death benefit will be included in the trust beneficiary s estate. Similarly, if at the death of the insured owner the surviving insured pays on-going premium and is trust beneficiary a portion of the proceeds will be include in the trust beneficiary s estate.

77 IRC Section 2035 This section requires estate inclusion of the death proceeds where an insured transfers ownership of a policy and dies within 3 years of the transfer. Transfer must be for less than full and adequate consideration

78 IRC Section 2035 Application to Standby Trust Common situation where transfer within 3 year rule applies in a standby trust include: If the non-owner owner insured predeceases the owner insured to avoid estate inclusion of the death proceeds the insured owner must transfer the policy and live 3 years or alternatively the transfer must be for full consideration. Simultaneous deaths of insureds the entire death benefit may be included in estate of insured owner. However, it may be possible to avoid inclusion estate inclusion if estate document contain provision that the insured owner presumed to die first in which there would be no 2035 lifetime transfer because the policy would pass to the SST at death of insured.

79 Gift Tax Issues Transfer of the policy.. Gift occurs if the policy is transferred during lifetime of insured owner such as when the non-owner owner insured predeceases the owner. Premium payments.. If premiums are required after transfer to the SST the gift tax issues are the same as with an ILIT taxable unless Crummey withdrawal rights are granted.

80 Income Tax Issues One of the reasons for using the SST concept is the desire to have access to policy cash value to supplement income in the event needed. Income taxation on policy withdrawals and loans Non-MEC policy loans are income tax free and with- drawals are generally income tax free to extent of basis. * Cash rich policy and MEC policies withdrawal and loans may be taxable. * Of course loans and withdrawals cause a reduction in cash values and death benefits, may affect any policy guarantees against lapse and may have tax consequences.

81 Income Tax Issues Transfer-for-value for-value and discharge of indebtedness If policy ownership is transferred while subject to a policy loan that exceeds basis the transfer-for for value rule will cause the proceeds to be subject to income tax except where transfer is to an exempt transferee In addition, where transfer of ownership discharges the owner s obligation to repay the policy loan, the owner will recognize gain where debt exceeds owner s basis.

82 Estate Tax Repeal Hedge Plan Term to Survivorship

83 Facts Estate Tax Repeal Hedge Plan Term to Survivorship Married Couple Need for survivorship insurance Obstacles Hesitant to make irrevocable estate liquidity decisions because of estate tax uncertainty Will not purchase permanent insurance until more confident their estate will be subject to tax. Desire Solve problem as inexpensively as possible Preserve options for future

84 Estate Tax Repeal Hedge Plan Structure ILIT purchases 2 term policies, one on each insured from a carrier that permits change of their term policies to a survivorship policy Insureds gift term insurance premium to ILIT Once insured becomes more confident they will be subject to estate tax (and during the conversion period) the term coverage is changed on an attained basis to a survivorship policy..

85 Trust Purchases Term on Insureds Insureds Insurer Premium Term Premium Gifts Term Life Insurance Policies ILIT Owner & Ins. Beneficiary Term on H Term on W

86 Term Change to Survivorship Insurer Term to Survivorship Conversion Insureds Premium Survivorship Premium Gifts ILIT Owner & Ins. Beneficiary Survivorship

87 Benefits Immediate insurance protection. Term classification guaranteed to carry over to survivorship with no new underwriting. If clients determine they need permanent survivorship coverage they will be in nearly the same cost position if they had waited to purchased the survivorship policy. Planning flexibility; coverage assured if clients estate is subject to estate tax or alternatively only incurred term cost if it s determined coverage is not needed. * Of course loans and withdrawals cause a reduction in cash values s and death benefits, may affect any policy guarantees against lapse, and may have tax consequences.

88 Summary The climate of uncertainty and complexity created by the act has made careful estate planning more important than ever. Given the uncertainty of the current estate tax system, clients are demanding life insurance planning techniques which provide flexibility. Flexible life insurance planning techniques worth considering NOW include support trust, survivorship standby trust, B trust funding and estate tax repeal hedge plan.

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