A common estate planning strategy for people with taxable estates is to have an irrevocable trust own life insurance, rather than owning the insurance themselves. Even with the current amount an individual can protect from estate tax at $5,340,000, some affluent taxpayers will benefit if irrevocable trusts own the life insurance. For example, assume Mr. Client has a $1million policy on his life. Upon his death, if he has a taxable estate, his beneficiaries could receive only $600,000 (2015 maximum estate tax rate of 40 percent). However, if Mr. Client's irrevocable trust owns the policy, then the full $1 million is available for Mr. Client's wife and children.
For closely held business owners, life insurance becomes even more important: it is often the source of most or all of the funding for a buy-sell agreement. For example, assume Mr. Client and Mr. Partner are 50 percent business owners, each owning 100 shares. They have insurance on each other's lives to fund the purchase of the deceased's 100 shares. If we assume Mr. Partner dies first, his estate will be required to sell his 100 shares to Mr. Client. Mr. Partner's spouse needs the cash, provided by the insurance death benefit, and Mr. Client ends up with 100 percent of the business by purchasing from Mr. Partner's estate his 100 shares.
This is the desired business strategy. But because Mr. Client has a taxable estate, it will now become more difficult to protect the value of the business upon his death because he now owns 100 percent of the business. Here is the question: can we combine the advantages of the irrevocable trust, whereby the 100 shares Mr. Client purchased from his deceased partner’s estate are not in his estate, with the desired business practice of a buy-sell arrangement?
Yes. This is how it would work. Upon Mr. Partner's death, the purchaser would be Mr. Client's irrevocable trust, the owner of the life insurance, not Mr. Client. Thus, Mr. Partner's stock would be owned in the irrevocable trust after transfer. Mr. Client would not be the trustee, but he could appoint a friendly trustee to work with him on managing the business. His spouse could even be the Trustee and a beneficiary if he desired. Then, upon his death, or if the business was sold prior to his death, 50 percent of the business value would not be in his estate, providing huge estate tax benefits for Mr. Client's family.
The irrevocable trust provides other benefits. It could be designed as a dynasty trust to provide asset protection and estate tax benefits for Mr. Client's children. The trust could be designed as a "grantor trust" (a so-called "intentionally defective trust"), thus providing income tax benefits to Mr. Client and his family. A grantor trust would preserve Mr. Client's S corporation status if the business operated as such. Mr. Client would be considered the owner of the grantor trust for income tax purposes but not for estate tax purposes.
Further, as alluded to above, Mr. Client’s spouse could be the Trustee, as well as a beneficiary (i.e., a "spousal access" trust). This provides even more access for him and his family even though the assets are in an irrevocable trust.
One technical issue to consider is whether the irrevocable trust would have an insurable interest in the policy on Mr. Partner's life. Without an insurable interest, no one can obtain insurance on another's life. Common insurable interests are spouses, parents and children. Insurable interests are determined under state law. For example, under Virginia law, an insurable interest means a "lawful and substantial economic interest in the life, health and bodily safety of the insured." In the case of a trustee of a trust that owns a life insurance policy, the trustee will have an insurable interest in each individual in whose life the owner of the trust for federal income tax purposes has an insurable interest.
If the irrevocable trust in Mr. Client's case is a grantor trust, so that Mr. Client is treated as the owner, he would have an insurable interest in Mr. Partner because it is generally accepted that business partners have an economic interest in each other's lives. Thus, the irrevocable trust, treated as a grantor trust, could purchase the insurance policy on Mr. Partner's life and thereby Mr. Client would receive both estate tax and business advantages.
Where would the cash come from for the irrevocable trust to pay the premiums? If Mr. Client pays the premium on the life insurance, there would be gift tax consequence. The gift tax consequence on the premium payment could be handled by annual exclusion gifts, with the help of a "Crummey" letter. Or, if Mr. Client made a one time gift to the insurance trust, using up a portion of his exemption amount, and income was then derived from the gift, perhaps there would not be the need for annual exclusion gifts. For example, Mr. Client could gift S corporation stock that produced dividends, or real estate that produced rental income, which could be the source of the insurance premium payment. There are a number of different ways to combine the premium payment with gifting strategies to further enhance the benefit of the irrevocable trust.
Perhaps the primary estate planning strategy utilized in reducing gift and estate tax for several decades has been taking advantage of discounts for family transfers of closely held businesses and real estate interests. These same discounts also apply to marketable securities if packaged properly in an LLC or a Family Partnership.
The value of the transferred interests are often in the form of non-voting stock or a non-controlling limited partnership interest or assignee interest. E.g., Dad places marketable securities, with a value of $1 million into a Limited Partnership. Next, Dad transfers a 99% Limited Partnership interest to his children or a Trust for his children. Because the Limited Partnership interest has no control and is not freely marketable, the value of the 99% Limited Partnership interest for gift tax purposes is $643,500, not $990,000, because of a combined 35% market and minority discount.
Depending on the assets transferred and the facts, the discounts can range from 20% to as much as 45% or 50%, provided they are supported by an appropriate appraisal. The IRS’ position is that these discounts are not appropriate within a family setting. According to the IRS, these family transfers are done only for tax planning and the family remains in direct or indirect control of the transferred asset. (In contrast to an arm’s length purchase of a minority interest by a non-related third party.)
However, the Service has met with limited success in combatting these discounts. The success they have had is often due to the taxpayer’s poor planning or the taxpayer’s failure to observe the formalities of the transfer and of the post-transfer ownership requirements. When done appropriately, the discounts are allowed although there is often a compromise if a taxpayer is audited. E.g., Taxpayer claims a 44% discount, the IRS initially offers a 15% discount, the parties settle for a discount of 35%.
Now, the IRS may be receiving more ammunition to combat discounting of family transfers. Proposed regulations are due out by the end of 2015, which would impose restrictions on intra-family transfers designed to obtain valuation discounts. When the regulations under Internal Revenue Code Section 2704 come out, and what precisely they say, is uncertain. What is certain, however, is that the IRS will not stop challenging the discounts. From the taxpayer’s perspective, any potential planning would be better implemented now versus later when the IRS may have additional authority on its side.
Asset Protection continues to be a major concern for professionals, board members, business owners and others in this litigious society. Professionals, such as doctors, lawyers, and architects, should be concerned about asset protection. In recent years, a proliferation of lawsuits against directors and officers also has caused concern. Business owners are worried creditors will "pierce the corporate veil" and sue them personally. These threats to assets are as concerning as a 50% income tax liability or a 40% estate tax liability.
For some, traditional asset protection tools, such as holding property tenants by the entirety, self-settled trusts in jurisdiction such as Delaware, Alaska or Nevada, and charging order protection under LLCs, is not enough. They have looked to more favorable asset protection jurisdictions outside of the United States, such as the laws of the Cayman Islands, Cook Islands, or Nevis. The question, however, is whether going offshore, particularly in today’s environment of increased tax scrutiny and compliance, is worth the perceived benefit? Moreover, is there even a benefit?
In several cases, U.S. courts have held that the U.S. taxpayer was in contempt of court for relying on laws of foreign jurisdictions. In such contempt of court cases, taxpayers have been jailed for failing to comply with a U.S. judge’s order.
The leading case is a 1999 Ninth Circuit case, FTC v. Affordable Media, LLC (the "Anderson" case). Other cases also illustrate a court’s contempt powers. E.g., U.S. v. Bilzerian a 1991 Second Circuit case, and In re Lawrence, a 2000 Florida bankruptcy case. However, those utilizing foreign trusts and foreign asset protection strategies argue contempt is only a concern if the protective measures are taken on the eve of a court order. See Barry Engle’s Asset Protection Planning Guide, published in 2013.
My experience is that, for virtually all clients concerned with asset protection, domestic asset protection strategies are effective and far less costly and complicated than relying on offshore planning. And for those clients who would be vulnerable to fraudulent conveyance claims in the U.S., the same clients would be vulnerable relying on offshore asset protection planning (not to mention contempt of court).