Dedon on Estate Planning

Virginia Business Magazine Insurance Ownership Article

Attached is a recent article that was published in Virginia Business Magazine that I wrote pertaining to Buy-Sell Agreements and Irrevocable Trusts.

Download Va bus art - buy-sell arrangements and irr ins trusts

IRA Designations and Estate Planning

Planning for IRA assets is complex. There are overlapping income and estate tax issues regarding the beneficiary designations and passing IRA assets upon death. One important objective often is to allow the children to "stretch" the IRA assets over a child's lifetime. An IRA stretch allows the child to take a required minimum distribution, which is tied into the child's life expectancy, but any asset appreciation above the required minimum distribution grows income tax free, providing a substantial retirement asset for the child.

However, there are complications. Assume that Frank, the father, wants his IRA to be available for his wife, Mary, if she survives him. Only at Mary’s death would the children inherit the IRA. Thus, it would be natural to leave the IRA to Mary. Mary could then name the children as her beneficiaries upon her death, allowing the children to stretch the IRA as described above. But what if Mary is a second spouse? Perhaps Mary would choose to rollover Frank's IRA into her own IRA, and then name her own children as beneficiaries, not Frank's children.

Frank could name a Trust for Mary as his IRA beneficiary. But if Frank names a Trust, with Mary as the beneficiary, Frank's children are then precluded from stretching the IRA over their lifetimes upon Mary’s death. Thus, although Frank obtains the control advantages of naming a Trust for Mary as his IRA beneficiary, it comes at a price for his children. If IRA assets remain upon Mary’s death, they will be distributed to Frank's children using Mary’s remaining life expectancy. On the other hand, if Frank trusted Mary to carry out his wishes and forgoes a Trust, Mary could elect the spousal rollover and then the IRA assets in Mary’s name could pass to the children over the children’s lifetimes.

This is just one example of complications arising from IRA planning.

Buy-Sell Arrangements and Irrevocable Insurance Trusts

A common estate planning strategy for taxpayers with taxable estates is to have an irrevocable trust own life insurance, rather than having the taxpayer-insured own the policy. With the amount an individual can protect from estate tax dropping to only $1 million under federal law in 2011, there will be many more taxpayers who will need to consider irrevocable trusts to own policies. For example, assume Mr. Client has a $1 million policy on his life. Upon his death, if he has a taxable estate, his beneficiaries could receive only $450,000 (2011 maximum estate tax rate of 55%). However, if Mr. Client's irrevocable trust owns the policy, then the full $1 million is available for Mr. Client's wife and children estate tax free.

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, Mr. Client and Mr. Partner are 50% 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% of the business by purchasing from Mr. Partner's estate his 100 shares.

Although this is the desired business strategy, because Mr. Client has a taxable estate, it will now become more difficult to protect the value of the business upon his death for the simple reason that he now owns 100% of the business rather than only 50%. Here is the question: can we combine the advantages of the irrevocable trust, whereby the assets are not in Mr. Client's estate, with the common business practice of a buy-sell arrangement?

Yes. How would it 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. Then, upon his death, or if the business was sold prior to his death, 50% of the business value would not be in his estate, providing huge estate tax benefits for Mr. Client’s family.

The irrevocable trust could provide 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 election 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.

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 and parents and children. Insurable interests are determined under state law. For example, under Virginia law, Section 38.2-301(B)(2) of the Virginia Code provides that, an "insurable interest" means a "lawful and substantial economic interest in the life, health, and bodily safety of the insured." Section 38.2-301(B)(5) provides that 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 because a partner would expect to suffer a direct financial loss if the other partner dies. 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? Assuming it came from Mr. Client, would there be gift tax consequences? There are answers and solutions to these questions, although outside the scope of this Post.

Protecting Tax Exempts From Liability

Tax exempt entities, such as schools, churches and hospitals, own property that can subject them to tort liability for accidents, just as for-profit entities. To help segregate liability, the tax exempt entity should consider owning the property in a separate entity. The design tax exempt entities should consider to achieve this liability protection is a Type I Supporting Organization.

The Supporting Organization would be organized as a separate corporation (or trust) under state law. Type I Supporting Organizations are described in Section 509(a) (3) of the Internal Revenue Code and, more specifically, in Treas. Reg. §1.509(a)-4(g) (1). The newly created supporting organization ("SO") would be "operated, supervised, or controlled" by the tax exempt entity ("Charity"). This degree of operation, supervision and control would be shown by the Charity having the right to appoint a majority of the SO’s officers and directors. In fact, the Charity and the SO can have identical officers and directors if desired. Thus, the Charity would have 100% control over the SO with respect to all of the SO’s policies, programs and activities. All of the SO’s revenue can pass solely to the Charity. This relationship is equivalent to a corporate parent and its wholly owned subsidiary in a for-profit context.

This Type I Supporting Organization design can shield the Charity from liability resulting from the property and its facilities. If there is a lawsuit against the SO arising from a tort on the property, the Charity's assets would be protected. Further, although there may be identity of officers and directors, this factor would not help a plaintiff pierce the corporate veil and impose liability against the Charity. See, e.g., United States Fire Insurance Company v. Allied Towing Corp., 966 F.2d 820 (4th Cir.1992), where the Court held that, where "no other justification for piercing the veil appears in the record," the fact that the two corporations "effectively have identical officers and directors [is] alone insufficient to permit the piercing of the corporate veil."

Thus, a Charity can create a non profit corporation under state law to own property and seek IRS approval as a Type I Supporting Organization. Once IRS approval is granted, it would be retroactive to the SO’s organization date under state law.  This can help protect the Charity's assets.