- - -- - Subchapter E The irrevocable life trust My total experience in this area has been the result of working with Howard M. Denenberg, a practicing attorney. He wrote the bulk of this section, and most of the ideas are his. Purposes of the irrevocable life trust (lit) A. Principal purpose-eliminate estate taxes The principal purpose of an lit is the elimination of federal estate tax on the proceeds of one or more policies on the life of the husband. If the policy is owned by an lit, under most circumstances the proceeds will not be includable in the estate of either the husband or the wife. Simple analogy An lit is a mirrorlike reflection of the trust B (residuary) portion of a husband's typical marital deduction estate plan. Both the trust and the estate plan come alive on the death of the husband, and just as trust B only begins to operate after funding, so lit begins to function only after funding, in this case with the proceeds. Neither trust B nor an lit is subject to esta te tax on the death of the wife. Of course, the significant difference is that the typical trust B is reduced by the payment of the husband's estate tax: the lit will be free of estate tax at the husband's death. B. Other purposes-trust ys. outright gift of policy J. Use ofproceeds by wife for life An lit enables the wife to use the proceeds during her lifetime without suffering any adverse estate tax consequences. On the death of the wife, the assets are held for the benefit of, or transferred to, the persons (usually the children) to whom the outright transfer would otherwise have been made. 2. Liquidity in husband's estate With a trust there is greater assurance that the insured's estate will have the use of the proceeds for liquidity; the individual to whom the policy would otherwise be gifted might be unwilling to use the proceeds to buy nonliquid assets from the estate. A trustee may be authorized to purchase assets from the insured's estate (at fair market value) and to lend money to the estate (with reasonable security and interest). (Old Colony Trust Co.) Caution If a mandatory provision is made for the proceeds to be paid to the insured's estate or for his estate tax, such will be included in his estate. [Regulation 20.2042-I(b)(l)] 3. General advantages of trusts All other general advantages of trusts, as opposed to outright transfers, are available, such as investment expertise, better handling of substantial sums 389
Chapter VII for children, protection from a beneficiary's creditors, and possible reduction of income taxes. Subchapter E Solving the estate tax problems A. All incidents of ownership in the policy must be transferred The term incidents of ownership relates to the economic benefits of the policy, including the power to change the beneficiary, surrender or cancel the policy, assign the policy, revoke an assignment, pledge the policy for a loan, or obtain from the insurer a loan against the cash surrender value of the policy. [Regulation 20.2042-1 (c)(2)) A party will be deemed to have incidents of ownership even though he can exercise them only in conjunction with others or solely in a fiduciary capacity. [Regulation 20.2024-l(c)(4); Estate of Fruehaufv. Commissioner; C. M. Rose, Trustee) B. Certainrights or powers retained by grantoror given to trustee The proceeds will be included in the grantor/husband's estate if he retains certain rights or powers. I. Section 2036 triggers inclusion of proceeds in the estate. if the grantor has retained for his life (I) "the possession or enjoyment of, or the right to the income from, the property," or (2) "the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.". if the trustee is either required or, in some cases, has the discretionary power to distribute trust income or principal for the maintenance and support of dependent beneficiaries during the grantor's lifetime. Regulation 20.2036-l(b)(2) states that the "use, possession, right to the income or other enjoyment of the transferred property" is considered as having been retained by or reserved to the decedent to the extent that the use, possession, right to the income, or other enjoyment is to be applied toward the discharge of a legal obligation of the decedent, or otherwise for his pecuniary benefit. The term "legal obligation" includes a legal obligation to support a dependent during the decedent's lifetime. t;;.,,.l: ;. 390
Examples of estate tax savings Present estate plan If husband If wife dies first dies first Taxable estate Husband $250,000 $500,000 Wife 250,000 None Estate tax Husband 23,800 108,800 Wife - 23,800 None Combined estate tax $ 47,600 $108,800 Facts on which examples are based Present estate plan Revocable life trust with maximum marital trust, and residuary trust, and pour-over will Assets of husband and wife Equity in house in joint tenancy $ 65,000 Business interest, stocks & bonds (owned by husband) Joint bank accounts ($10,000 cash value) Total 200,000 15,000 220,000 $500,000 Comment: A worksheet, similar to the above, must be completed each time an lit is contemplated. The combined estate tax will dictate to the insured and his estate planner whether an lit is a go or no go situation. Proposed estate plan- transferred To wife To lit If husband If wife If husband If wife dies first dies first dies first dies first $175,625 $280,000 $175,625 $280,000 324,375 10,000 104,375 None None 34,000 None 34,000 49,087 None None None - $ 49,087 $ 34,000 None $ 34,000 Assumptions for tax computations. Husband supplied all consideration for the joint property and no "qualifying" joint tenancy election has been made.. Death after 1980 without either husband or wife having made any prior gifts.. No estate tax deductions other than the maximum marital deduction, but not more than amount necessary to eliminate estate tax after applying credit of $47,000.. No stat death tax credits.. Wife does not leave to husband life she owns on husband's life. '. Although Regulation 20.2036-l(b)(2) relates only to mandatory distributions by the trustee, Section 2036(a)(2) would be applicable to a discretionary power if the grantor is the trustee or a cotrustee, unless the trustee's discretion is governed by determinable standards that a court of equity could administer. (Estate of Budlong; Jennings v. Smith) Caution Having the grantor act as trustee or cotrustee of a discretionary trust for the benefit of a dependent and relying on the use of determinable standards is dangerous. 2. Section 2038 triggers inclusion of proceeds in the estate if the grantor retains a power "to alter, amend, revoke, or terminate" the enjoyment of the asset transferred. 3. Either Section 2036 or 2038 can trigger inclusion of proceeds in the estate if the grantor/wife is the owner of a policy on her husband's life and she transfers the policy to an existing lit. 391
ChapterVII Subchapter E Planning point If the wife is to be a lifetime beneficiary of the lit, using an independent trustee and giving the trustee broad discretionary powers to distribute or accumulate income and principal, rather than giving the wife a right to income or principal, should preclude the application of Sections 2036 and 2038. Solving the gift tax problems A.lnsurance as a gift Insurance is often a better gift than other kinds of property; donor's income nor his security is significantly affected. B. How to obtain the annual exclusion neither the When the gift is a future interest, the $3,000 annual exclusion ($6,000 if married) is not available. See Chapter V for a detailed discussion. Since an lit consists of policies, establishing a present right to income (which will usually qualify for the exclusion) is difficult to accomplish. It is possible, however, to establish a present right to corpus. The problem can be divided into two specific time frames. I. the initial year when the policy is transferred. 2. each year subsequent to the initial year-for the amount necessary to pay the annual premiums. During the initial year Give the grantor's wife and each child a right to withdraw from the trust corpus during the initial year (I) an amount not to exceed $3,000 in the case of the wife and (2) $5,000 in the case of each child. To the extent of such withdrawal rights, the gift to the trust should be considered a present interest qualifying for the annual exclusion with respect to each person who has such a withdrawal right. To the extent unexercised, the right would lapse at year-end. a. As long as no withdrawal right exceeds $5,000, the expiration of each such right at the end of the year without its having been exercised will not constitute a taxable gift, since it will come within the $5,000 or 5% exception under Section 2514. b. The gift with respect to the wife's withdrawal right will not qualify for the gift tax marital deduction because it is a gift of a terminable interest. [Regulation 25.2523(b)-I] c. If the wife joins in the gifts with respect to the $5,000 withdrawal right of each child, each gift can be split between the husband and wife. Thus the combined annual exclusions will make the full $5,000 withdrawal right per child gift tax free. During each subsequent year Extend the withdrawal rights to each subsequent year, subject to a limitation that the current year's withdrawal rights cannot exceed the current additions to trust corpus. 392
-. --- Caution To the extent required to provide the funds subject to the withdrawal rights, the beneficiaries should be given the right to demand conversion of the policies into cash or income-producing assets. The policy should always have a cash surrender value that exceeds the aggregate amount of withdrawal rights. C. Grantor dies within three years of policy transfer to the lit Section 2035(b)(2) provides that a gift made within three years of the grantor's death is not added back to his estate if the gift was excludable in computing taxable gifts by reason of the $3,000 annual exclusion. I. A literal reading of the statute seems to exclude the entire gift if the entire gift tax value qualifies for the annual exclusion. 2. However, the "General Explanation of the Tax Reform Act of '76" issued by the Joint Committee on Taxation states with regard to the $3,000 exclusion exception: "the amount of gifts included is limited to the excess of the estate tax value over the amount excludable with respect to the gifts under the $3,000 annual gift tax exclusion." Example A $100,000 policy with a $3,000 gift tax value is transferred by the insured on his deathbed. The transfer qualifies for the annual exclusion (by a literal reading of the statute) resulting in the entire amount of the proceeds being excluded from the grantor's estate. Following the position of the joint committee, only $3,000 of the policy proceeds would be excluded from the taxable estate and $97,000 would be included. Note: Congress will have to clarify this issue. The expected Technical Changes Act will almost certainly deal with it. Possible solution If the lit itself is the original owner of the policy, the "within three years of death" problem may be eliminated. Caution In cases where (a) policies were purchased by someone other than the insured at the insured's request and less than three years prior to his death; (b) the ownership of the policy was retained by the purchaser until the death of the insured; and (c) the premiums were paid by the insured, the courts have looked through the form to the substance of the transactions and found Section 2035 to be applica ble to the proceeds of the policies. (Bel v. u.s.; Detroit Bank and Trust Co. v. U.S.) What else could be the consequences if Section 2035 pulls the proceeds into the grantor's estate? The proceeds might not qualify for the estate tax marital deduction since the interest of the grantor's wife will probably be a terminable interest under Section 2056(b). Chapter VII Subchapter E 393
Chapter VII Subchapter E Planning point To avoid this possible loss of the marital deduction, provide in the trust agreement that if the proceeds are includable in the grantor's estate for any reason and all other property in the grantor's estate is insufficient to maximize the marital deduction, the grantor's wife will have the necessary specified rights and powers which will qualify the proceeds for the marital deduction. D.Valuing a policy transferred to an lit The gift tax value of an unmatured, premium-paying policy (ordinary life) normally is its interpolated terminal reserve value (usually slightly more than its cash surrender value), increased by any prepaid premiums and reduced by any policy loan. [Regulation 25.2512-6(a)] The gift tax value of a single premium or paid-up policy is the single premium replacement cost which an insurer would charge at the time of the gift. Caution If the insured is in poor health at the time of the gift, the gift tax value of any kind of policy may be determined on a replacement cost basis, which could, in some cases, almost equal the policy's face amount. (Ryerson v. u.s.) The value of the gift can be reduced by borrowing out some or all of the cash surrender value of the policy prior to transfer to the trust. However, there are certain disadvantages to this approach. I. The cash surrender value may be intended to be used at later times for the payment of premiums. 2. If initial or future withdrawal rights are to be given to trust beneficiaries, such rights may not be deemed to be exercisable to the ex tent the cash surrender value is not available for withdrawal. 3. Such borrowing may result in the 4-out-of-7 annual premiums exception of Section 264(c) being inapplicable. 4. The proceeds of such policy loans would be includable in the grantor's estate. Who should pay the premiums? The trust? The husband? The wife? Each offers separate problems. 394 A. The trust-with assets transferred at the inception of the lit I. Under Section 677, for income tax purposes, the grantor is treated as the owner of any portion of a trust whose income is applied to the payment of premiums on policies of on the life of the grantor or the grantor's spouse. 2. Assets other than the policies may be needed or desired for other purposes. 3. A gift of additional assets may increase the gift tax problem. 4. There are administrative problems in holding and investing additional assets.
B. The husband-directly to the company I. The payments may constitute gifts of future interests, eliminating qualifications for the annual gift tax exclusion. 2. Premiums paid within three years of the husband's death will be includable in his estate, even though less than $3,000, to the extent they do not qualify for the annual gift tax exclusion. 3. If all premiums are paid within the three years of death, subject to the possible annual exclusion exception, all proceeds will be includable in the husband's estate. (Rev. Rul. 71-497) Special problem-term policies Since some term policies may be considered to be new policies each year, all proceeds may be includable in the estate of the husband, even though the policy was acquired more than three years prior to his death. The problem should be recognized in connection with the following types of policies: a. one-year renewable term. b. annual renewable group term. c. any other term policy in the year renewed or converted to ordinary life. C. The wife I. To the extent the funds used to pay the premiums can be traced to the husband, the same difficulties that arise when the husband pays the premiums arise when the wife pays them. 2. If the husband is the grantor of the lit, the wife may be considered a cograntor to the extent of her premium payments, thus creating possible adverse estate tax consequences in her estate under Sections 2036 or 2038. Note D.The husband-indirectly The portion of the premium payments allocable to the wife's life estate in the lit could not constitute a taxable gift from her since the transfer would be for her own use and benefit. through annual gifts to the lit I. By making cash gifts to the trust and permitting the trustee to use this cash at his own discretion to payor not to pay the premiums, the husband should not be considered to have made a taxable gift of the premiums to the trustee. 2. Although the cash gifts made within three years prior to the husband's death might be includable in his estate under Section 2035, the danger of the proceeds being so includable is reduced. 3. Gift tax annual exclusions should be available by using the 5% or $5,000 withdrawal rights approach. Annual gifts to the lit by the husband is the recommended premium payment method. Chapter VII Subchapter E " 395 -
Chapter VII Subchapter E Solving the income tax problem Solving this problem is actually the frosting on the cake. First, let's list the ingredien ts. I. Use of Section 264-deducting interest Oilpolicy loans. If a policy transferred to the trust has outstanding policy loans or if any premiums are intended to be paid by policy loans, the requirements of Section 264 should be met so the interest paid on such loans will be deductible for income tax purposes. The interest deduction will generally be more valuable to the grantor than to the trust. (See detailed discussion of Section 264 in this chapter.) 2. Use of Sections 674 and/or 675 to become a grantor trust. If, under Sections 674 or 675, the grantor is treated for income tax purposes as the owner of the trust, then the grantor of the so-called grantor trust must include in his tax computations each item of income and deduction that is attributable to the trust, "as if it had been received or paid directly by the grantor." [Regulations 1.671-2(a) and 1.671-2(c)] a. Under Section 674, subject to several exceptions, the grantor is treated as the owner of a trust of which the benefi,<;ialenjoyment of the corpus of the income is subject to a power of disposition, exercisable by the grantor or non-adverse party, as defined in Section 672. Example If the trustee (a non-adverse party) has a power to add to the beneficiaries or to a class of beneficiaries designated to receive the income or corpus, and such power is not given to provide for after-born or after-adopted children, a grantor trust is created. b. Under Section 675, the grantor will be treated for income tax purposes as the owner of the trust if he retains certain administrative powers that are designated therein. A summary of the llt objectives The cake The proceeds on the life of the husband are not taxable in the estate of either the husband or the wife. The frosting The husband deducts the interest portion of the premium payments on his current income tax return. 396 Some additional points to ponder I. Gift of cash value to wife-after policy loall but before transfer to lit The portion of a policy that is attributable to the cash value can be gifted to the wife after the loan is made on the policy but before it is transferred to an lit. The rights to the death proceeds over and above the cash value are transferred to the trust. Since the loan would be against the cash value, the interest would be the wife's obligation to pay, and she would accordingly receive the income tax deduction. 1 I I!, j 1! -...-
Pitfalls a. To the extent that funds used by the wife to pay interest can be traced to the husband, the same difficulties exist as those with respect to direct payment of premiums by the husband. b. If the husband is the grantor of the trust, the wife may be considered a cograntor to the extent of her interest payments, thus creating possible adverse estate tax consequences in her estate under Sections 2036 or 2038. c. The cash value of the policy would be includable in the wife's taxable estate. 2. You will probably have to choose one or the other-(a) the annual exclusion or (b) the income tax deduction. To the extent the beneficiaries of the trust have been given withdrawal rights, the beneficiaries may be treated under Section 678 as the owners of that portion of the trust corpus which is attributable to their respective withdrawal rights. The beneficiaries might then be required under Section 671 to include in their tax computations each item of income and deduction that is attributable to those respective portions of the trust corpus. It therefore becomes necessary to weigh the value of the annual gift tax exclusions with the possible loss by the grantor of a portion of the income tax deductions for interest payments. 3. Delay the interest deduction until the policy loan builds up. If the interest on policy loans is not expected to be significant for several years, limit the withdrawal rights of the children/beneficiaries to a fixed number of years. Terminate such rights when the interest deduction will be more important than the gift tax annual exclusion. Do not limit the withdrawal rights of the wife because there is no loss of the interest deduction (assuming ajoint return is filed). 4.1f the wife is the grantor of the policies on her husband's life to the llt Section 2036 will undoubtedly cause the policy proceeds remaining in the lit at the wife's death to be included in her estate. S. A n adult child as grantor An lit can perform its tax tricks with a minimum of problems when an adult child is the grantor. A few caveats-the adult child should be the original owner and applicant of the life policy on his father's life; it would be best, unless economically impossible, for the child to use his/her own funds to fund the trust initially or to make future additions; the beneficiaries of the lit should exclude the grantor/child (Section 2036 would rear its head again); and proper language should be inserted in the lit to give the child either the annual exclusion or interest deduction for policy loans. ChapterVII Subchapter E 397