Advanced Underwriting Consultants

Question of the Day – May 16

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  My client is going to create an irrevocable life insurance trust (ILIT) to own insurance on her life.  Must the trust have Crummey provisions?

Answer:  Crummey provisions are not necessary for an ILIT to be effective for estate tax purposes.  However, they are most commonly used when the trust’s grantor wants to be able to make annual exclusion gifts to the trust.

The gift tax rules allow a donor to make gifts of up to $14,000 per year to a donee in 2013.  Such gifts, referred to as annual exclusion gifts, do not even require the filing of a gift tax return.

In order for a gift to qualify to the annual exclusion, the IRS has ruled that it must be a gift of a present interest.  A gift of a future interest does not qualify for the annual exclusion.  If a donor makes a gift of a future interest, she must file a gift tax return and use up part of her lifetime exemption ($5.25 million in 2013) to offset the taxable value of the gift.  Any exemption used up during lifetime is not available to offset the taxable estate at death.

When a donor makes a gift into an irrevocable trust, she is making gifts to the beneficiaries of that trust.  If the beneficiaries don’t have immediate access to the money, the IRS has ruled that such gifts are gifts of future interests.

On the other hand, if the trust says that the beneficiaries have the right to withdraw gifts made to the trust, the gifts are considered to be gifts of a present interest—and thus they qualify for the annual exclusion.  The power of a beneficiary to ask the trustee for the beneficiary’s share of a trust contribution is referred to as a Crummey power—named for the court case in which that kind of trust provision was tested and approved.

The IRS has come up with other various specific requirements for Crummey powers to be effective for gift tax purposes.  When placing new insurance to be owned by a Crummey-style ILIT, the financial professional should be in active communication with the client’s attorney to make sure all required steps are followed properly.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – February 28

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question:  Do the assets in an irrevocable life insurance trust (ILIT) receive a step-up in basis at the grantor’s death?

Answer:  In general, the answer is no.

The life insurance owned by an ILIT generates an estate and income tax free death benefit, which passes through to the trust beneficiaries.  However, the question contemplates other capital assets being owned by the ILIT, and inquires as to their basis upon the death of the trust grantor.

In the past, some experts have argued that the capital assets owned by the ILIT should get a step-up in basis at the grantor’s death so long as the trust is a grantor trust.  A grantor trust is considered to be owned by the grantor for income tax purposes (but not estate tax purposes).  Since the grantor was taxed on the trust’s income, the argument went, the assets should also get an income tax increase in basis at the grantor’s death.

In Private Letter Ruling 200937028, the IRS ruled that an ILIT drafted as a grantor trust did not generate a step-up in basis for the capital assets owned by the trust at the grantor’s death.  The Service observed that the property was given away to the trust (and its beneficiaries) prior to the grantor’s death.  It concluded that property transferred prior to death, even to a grantor trust, would not (receive a step-up in basis), unless the property is included in the gross estate for federal estate tax purposes.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

 

Question of the Day – October 3

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  My client owns a term insurance policy on his life.  He intends to convert the coverage.  If he creates an irrevocable life insurance trust (ILIT) and has the new permanent policy owned by the trust, will he avoid the three year estate inclusion rule?

Answer:  No.

Section 2042 of the Revenue Code includes in the taxable estate of an insured all life insurance death benefits payable under personally owned policies.  Section 2036 of the Revenue Code says that the death benefit of life insurance transferred by the insured is included in the insured’s taxable estate:

If—

(1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent’s death, and

(2) the value of such property (or an interest therein) would have been included in the decedent’s gross estate under section …2042

If the insured owned the right to convert a term insurance policy to permanent, and that power was transferred to the trustee of an ILIT, it seems clear that the transfer is subject to the three year inclusion rule of Section 2036.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – August 21

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  My married clients put together an irrevocable trust (ILIT) to own survivorship life insurance a few years ago.  May the same trust own insurance that covers just one of their lives?

Answer:  Probably yes, so long as the surviving spouse does not need access to the life insurance death benefit.

An attorney drafting an irrevocable trust designed to own survivorship insurance will generally include language that the trust is for the sole benefit of the insureds’ children.  That is because if either insured under the survivorship policy is a beneficiary of the ILIT, then the policy’s death benefit may be included in the beneficiary-spouse’s taxable estate.  Most couples who go to the trouble of drafting an ILIT would want to avoid estate tax inclusion of the policy’s death benefit.

An attorney drafting a policy designed to own a single-life policy may draft the ILIT differently.  Many such trusts give the non-insured spouse a limited ability to make claim on the death benefit if needed for health, maintenance and support.  A properly drafted ILIT of this type will keep the death benefit from being included in the taxable estate of either spouse.

A single-life policy can usually go into an ILIT drafted for survivorship insurance, because the lack of access by surviving spouse does not cause an estate tax problem.  However, the surviving spouse would generally not have access to the policy’s cash values or death benefit.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – June 26

Ask the Experts!

Here’s the question of the day.

Question: My client is going to set up an irrevocable life insurance trust (ILIT) to own insurance on his life.  The beneficiaries of the trust and the trustee live in another state.  Where should the trust be drafted?

Answer: Most people who intend to create ILITs will hire an attorney who is located in an area convenient to the insured/grantor.  It makes sense to hire a local attorney, who is in the best position to meet with the client personally, assess the client’s objectives and help determine the proper jurisdiction to govern the trust.

A grantor drafting a trust in Tennessee, for example, may choose to have the trust governed by the rules of Nevada.  Different states’ rules for trusts may allow a trust to last longer or be taxed in a more favorable way.

Each state has its own requirements for allowing a particular trust to be governed by that state’s rules.  For example, the state may require that the trustee—or one of the co-trustees—be a resident of the state.

Choosing the proper governing jurisdiction for a trust can be a highly technical exercise.  We always recommend that trusts be drafted by competent and experienced attorneys.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – February 17

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: I have a married wealthy client who is purchasing permanent insurance on his life.  He wants the insurance to be excluded from his taxable estate, but also wants access to the policy’s cash values during lifetime.  Is it possible to do both?

Answer: Normally, if the insured wants to exclude the death benefit of an insurance policy on his life from his taxable estate, the insured must give up ownership rights in the policy in favor of a third party.  Commonly used third parties are adult children or irrevocable life insurance trusts (ILITs).

If the insured creates an ILIT to own life insurance for the purpose of estate tax avoidance, the trust must not give the insured any right to reach in and enjoy the assets during the insured’s lifetime.  Since that’s the case, the insured normally can’t achieve both estate tax exclusion and lifetime access to a policy’s cash value.

However, if the insured is in a stable marriage, access may be achieved indirectly through the insured’s spouse.  So, for example, if the insured creates an ILIT to own a permanent life policy, the ILIT may allow the insured’s spouse to have some access to the policy’s cash value during the lifetimes of the insured and the insured’s spouse.  This kind of ILIT is sometimes referred to as a spousal lifetime access trusts (SLAT).

The technique has some drawbacks.  The trust needs to be carefully drafted and funded to avoid inadvertent inclusion of the life proceeds in the estate of the insured.  Also, if the couple gets divorced or if the spouse dies before the insured, access to the policy’s cash values may be lost.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – February 2

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: We are in the middle of doing a Section 1035 exchange of an ILIT-owned life insurance policy for a new one.  Would there be a three year estate tax look-back period for the new policy?

Answer: No.  The three year estate tax look-back only applies where the insured is the owner of an existing policy and makes a transfer.  Here’s what Revenue Code Section 2035 says about the three year look-back:

If …the decedent made a transfer (by trust or otherwise) of an interest in any 
property, or relinquished a power with respect to any property, during the 3-year 
period ending on the date of the decedent's death, and…the value of such property 
(or an interest therein) would have been included in the decedent's gross estate 
under section…2042 the value of the gross estate shall include the value of any 
property (or interest therein) which would have been so included.

Code Section 2042 is the part of the tax law dealing with the includibility of the death benefit of personally owned life insurance in the decedent’s taxable estate.

A transfer of a policy by someone other than the insured to an ILIT does not cause a three year problem.  Likewise, in this example, where there is no transfer at all—and a Section 1035 exchange is not a transfer—there’s no estate tax issue.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – December 15

Ask the Experts!

Here’s the question of the day.

Question: My client’s spouse is the owner of an insurance policy on the client’s life.  They want to remove the death benefit from both spouses’ taxable estates.  If the policy is transferred to an irrevocable trust (ILIT), does the three year inclusion rule apply?

Answer: Probably not, although the specific circumstances might cause either a three year problem or a permanent estate tax problem.

Revenue Code Sections 2035 and 2042, read together, say that when the insured under a life policy makes a gift transfer of that policy—or a gift transfer of incidents of ownership—for three years after the transfer, the insurance death benefit is still includible in the insured’s taxable estate.

Where someone other than the insured owns the policy and makes the transfer, the three year rule does not apply.  Using just that analysis, it would seem that having the spouse make the transfer of the insurance on the insured’s life to an ILIT would avoid tax problems.  However, that’s not the end of the analysis.

If it can be successfully argued by the IRS that the insured had incidents of ownership in the life contract due to the marriage relationship with the policy owner spouse, then the three year problem might still exist.  The insured spouse might be imputed ownership, for example, through community property rules in the state of the spouses’ residence.  Even in non-community property states, it’s possible the IRS could argue that the insured spouse has a property right in the life policy due to the marriage.

In addition to the potential for the three year problem in the example above, there’s another issue if the policy owner spouse is a beneficiary of the ILIT.  If that’s the case, the value of the ILIT—including the value of the life policy or its death benefit—would be included in the taxable estate of the non-insured spouse at death.  The authority for that would be from the rules under Revenue Code Section 2036, which subjects lifetime transfers with a retained interest to estate taxes.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 14

Ask the Experts!

Here’s the Question of the Day

Question: Is there a compelling reason for the owner of a closely held business to use money from the business to pay for life insurance needed to pay estate taxes?

Answer: Maybe.

There are usually few, if any, income tax reasons to have the 100% owner of a closely held business use business money to pay for needed life insurance.  However, there may be compelling gift tax reasons to do so.

When life insurance is used to pay for estate taxes, the coverage is usually owned by an irrevocable trust (ILIT), or, in the alternative, adult children.  If the insured transfers money to the ILIT or adult children by gift, the insured must deal with the gift tax limitations imposed by the federal and relevant state governments.

If the insured is worried about gift tax limits, it may be possible to access money from the business in different ways to provide the money needed for the premium:

1. A split dollar plan between the business and the ILIT may lower the gift tax cost of the premium.

2. If the adult children are employees of the business, the business may pay them extra to cover the premiums associated with the life insurance policy.

3. The business may be able to lend money to the ILIT or adult children to provide the premium needed for the coverage.

Each of these alternatives may lower or eliminate the gift tax cost associated with the insurance meant to pay the insured’s estate taxes.  However, each alternative has its drawbacks.  Talk with the proposed insured’s estate planning attorney and accountant to decide whether one of these might be the right choice.

Question of the Day – October 26

Ask the Experts!

Here’s the question of the day.

Question: My client wants to wait to draft his irrevocable trust until after he’s sure he wants to buy the life insurance.  How can I make that work?

Answer: Life insurance death proceeds are includible in the taxable estate of the insured if the insured owns the policy.  If the insured transfers a policy on his life by gift, and dies within three years of the transfer, the death benefit is also included in the insured’s taxable estate.

To avoid having life insurance be included in the insured’s taxable estate, we usually recommend having an irrevocable life insurance trust (ILIT) own the policy from inception.

In a perfect world, ILITs are implemented this way:

  1. The ILIT is created and funded by the grantor.
  2. The trustee of the ILIT sends withdrawal notices to the beneficiaries.
  3. The beneficiaries decide not to withdraw the money.
  4. The trustee decides to apply for insurance on the life of the grantor.
  5. The insurance is approved.
  6. The trustee pays the premium.

The reason for these theoretical steps is to conform to the requirements of the court cases and ILIT rules and regulations.

The procedure described is NOT the only way to achieve estate tax exclusion of the death benefit.  However, some variations from the perfect implementation may create a danger of inclusion in the grantor’s estate for three years after the purchase of the insurance.

According to IRS Technical Advice Memorandum (TAM) 9323002, an application can be submitted to the insurance company without any kind of premium deposit, and so long as the trust is executed by the completion of the underwriting, a new application can be filed with the insurance company.  If the policy is issued with the trust as the owner—and the first actual premium payment is made by the trustee as the owner—then the IRS said there’s no policy transfer.  No transfer means no three year estate tax inclusion.

A prospective insured following the TAM procedure might sign an application, get approved for the coverage, get his lawyer to draft an ILIT in a hurry, and have the agent ask the insurance company to list the trust as owner and beneficiary prior to the policy being put in force.

Of course, the TAM is not authority that any particular taxpayer can rely on, but it is a reflection of how the IRS generally looks at these issues.  The best advice is to let the client’s attorney make the call on whether the attorney is comfortable with the procedure described.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.