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

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.

Building Flexibility Into Irrevocable Trusts

Irrevocable Trusts are a common estate planning tool to remove assets from the taxable estate. The "grantor" creates the Irrevocable Trust, transfers assets to the Trust, and after accounting for any gift tax issues, the Trust assets are removed from the grantor’s taxable estate for estate tax purposes. However, to obtain the advantage of estate tax removal, the grantor must give up control over the Trust assets, including the right to change the Trust.

However, often times Trusts need to be, or should be, amended. There may be a change in the law or circumstances that require an amendment. Because Irrevocable Trusts are often designed to last many years – sometimes in perpetuity – there can be a number of reasons why it would need to be amended. For example, there could be ambiguities in the language or a drafting error. Perhaps the Trust should be divided to separate assets or, conversely, perhaps different Trusts should be consolidated.

Herein lies the dilemma: we know the grantor cannot amend the Trust or he would lose the estate tax benefits. A common solution to amend a Trust is to ask a judge to judicially reform the Trust. However, this can be expensive and it may require the consent of the beneficiaries.

A second alternative available in certain states is to take advantage of a "decanting" statute. The decanting statutes allow a Trustee, without court involvement, to essentially prepare a new Trust to address changes in circumstances. (Of course, the assumption is that the Trustee is acting pursuant to the grantor’s wishes during the grantor’s lifetime and after his death.) This flexibility is provided by pouring the assets from the old Trust into the new Trust without court involvement or beneficiary permission. At least seven states allow decanting, including Delaware, New York and Florida. Basic requirements are that the Trustee has the ability to invade Trust principal and the beneficiaries of the new Trust will be identical, or at least similar, to the beneficiaries of the old Trust.

Even states that do not have decanting statutes still allow for some limited Trust amendment without court involvement. For example, a properly drafted Irrevocable Trust will allow for changes of Trustees, the merger of identical trusts, and changes in the Trust situs.

In sum, an "irrevocable" trust will be irrevocable but not necessarily inflexible.

Recent Private Split Dollar Ruling

In the February 9, 2009 Virginia Business Online Magazine, I wrote about the advantages of private split dollar life insurance for taxpayers seeking to provide estate tax free insurance protection for their families. The private split dollar planning advantages and the details of structuring a plan are described in the February 11 Post and, therefore, will not be repeated here.

What is worthy of note, however, is that in March the IRS approved the desired tax results for taxpayers who entered into a private split dollar arrangement. The insureds were a married couple who purchased a survivorship policy and titled it in an Irrevocable Trust to remove it from their taxable estates. See Private Letter Ruling (200910002). Although a Private Letter Ruling is not legal precedent, it does indicate the IRS’ position on similar transactions. Of particular note, the IRS agreed with the taxpayers regarding the following:

• The transaction qualified as "non-equity split dollar" under Treas. Reg. Section 1.61-22, and the taxpayers, the grantors of the Trust, were the "owners" for split dollar purposes.

• As the policy owners for split dollar purposes, the gift tax charged to the grantors is the economic benefit that the Trust receives, i.e., generally the cost of the term insurance under Notice 2002-8, 2002-1 CB 398. This amount is significantly less than the premium payment.

• For estate planning purposes, however, the Irrevocable Trust is the owner of the policy. Thus, the insurance death benefit is removed from the taxpayers’ estates. Obviously this is the desired result whenever a second to die policy is used to pay estate tax at the second death.

• In non-equity split dollar, there is a receivable due to the insureds’ estate at the termination of the agreement, which is included for estate purposes.

Private split dollar is a planning alternative to be considered by taxpayers to provide insurance protection for their families in a gift tax efficient manner.

Private Split Dollar Life Insurance

The following two-part article pertaining to the advantages of private split dollar life insurance appeared online in Virginia Business Magazine on February 9, 2009.

 

 

VIRGINIA BUSINESS - OPINION:

Private split dollar: solving estate problems for wealthy business owners

February 09, 2009

John Dedon

Enough about 2008:  let’s start 2009 with a positive planning option for business owners still in need of planning. One strategy worthy of consideration is split dollar life insurance, allowing business owners to pass significant wealth to family members free of the estate tax with relatively minimal gift consequences. 

The explanation is at the “30,000 feet level” due to space limitations.  Notwithstanding, it is a worthy topic because of the substantial advantages split dollar life insurance can provide to a business owner.  Although there are many variations of split dollar, this article discusses “private split dollar” — the parties being just family members and a Trust for family members — versus traditional split dollar where the business is also a party.  According to Jorge Fuentes, vice president of Wachovia Insurance Services Inc. in McLean, this strategy has been used for several clients nationwide with a number of different insurance carriers.

Legal assumptions:

 There is a current $3.5 million exemption that protects an individual from estate tax (with proper planning, $7 million for a married couple).  However, in 2011, the exemption amount is only $1 million, $2 million for a married couple, and the estate tax rate is 55 percent.

 Annual exclusion gifts are currently $13,000. Gifts in excess of these amounts erode the exemption amount available upon death.

Factual assumptions:

 Mom and Dad, now in their mid 60s, ran a successful real estate company.  Their 45-year-old child was not interested in the business, so they sold the company and netted $22 million after tax. Their total estate is $30 million.

 Their child is financially secure.  Therefore, Mom and Dad are not concerned about her, but they do want to provide for their four grandchildren and future generations.

 Upon the second of their deaths, estate tax could be anywhere between $6 million to $14 million, even without asset appreciation.

Solution: Private split dollar

Mom and Dad (collectively Generation 1 or “G1”) pay the premium insuring the life of their child (“G2”).  To remove the death benefit from the taxable estates of Mom, Dad and the child, the owner of the policy is an Irrevocable Trust.  The Trust beneficiaries are Mom and Dad’s grandchildren (“G3”).  (If there was more than one child, there could be more than one policy and more than one Trust.) 

Applying numbers to the facts above, G1 makes a one-time premium payment of $2 million.  Upon G2’s death, insurance proceeds ranging between $11 million and $23 million would be available to the grandchildren estate tax free.  The death benefit depends on the age of G2, the type of policy, and the year of G2’s death.  The Trust could be designed as a dynasty trust, meaning the proceeds are estate tax free in perpetuity. 

And here is a major advantage of private split dollar:  the gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy.  According to Fuentes, this is because the IRS taxes G1 on the “economic benefit” of the premium payment, which is substantially less than the premium payment.  “Current IRS rules and IRS tables indicate that private split dollar may be an effective way to preserve exemptions for other planning,” Fuentes commented.

In this example, absent the IRS rules, virtually all of Mom and Dad’s $2 million premium payment would reduce what they can otherwise protect from estate tax upon their deaths.  Instead, because the gift tax value (economic benefit) is so low, the $2 million premium payment can be absorbed by annual exclusion gifts to the Trust.  What have Mom and Dad accomplished?  At a financial cost of $2 million, which after tax is worth roughly $1 million, they provided $11 million to $21 million of proceeds free from estate taxes for their grandchildren and future generations. These proceeds can also be protected from their grandchildren’s creditors and divorce. And they did so with minimal gift tax consequences. 

As stated above, this is a dramatic simplification of how private split dollar works.  There are also different variations of private split dollar.

VIRGINIA BUSINESS - OPINION:

Exit strategies for split dollar agreements

February 09, 2009

In a previous column, I discussed the advantages of private split dollar for business owners to transfer wealth to future generations.  This article discusses the exit strategy and the effect of the increasing “economic benefit” value. 

In brief, Part 1 presented this example:  Generation 1 (“G1”), which typically would be Mom or Dad, pays a life insurance premium insuring the life of their child (“G2”).  The life insurance policy is owned by an Irrevocable Trust and would pass tax free to the grandchildren (“G3”) upon G2’s death.  Assume G1 makes a one-time premium payment of $2 million.  Upon G2’s death, insurance proceeds ranging between $11 million and $23 million would be available to the grandchildren estate tax free.  Because G1 is taxed on the “economic benefit,” G1’s gift tax attributable to the $2 million premium payment is less than $1,000 for the first 8 years of the policy.  Thus, the $2 million premium is removed from G1’s estate; the gift tax is insignificant (at least in the early years); and substantial tax free death benefit is provided. 

The advantages described above are derived from structuring the split-dollar arrangement as non-equity split dollar U.S. Treasury Regulations.  There must be a contract between, in this example, G1 and the Irrevocable Trust, requiring that G1 is repaid the greater of the insurance premium ($2 million) or the cash value of the policy. The only “economic benefit” the Trust receives is the death benefit. Hence, the Trust does not have any “equity” in the policy.

Because the equity belongs to G1 in the form of the greater of the premium payment or cash value, there is a receivable due G1.  The split dollar contract provides that the receivable is due upon G2’s death — the insured.  And every year that the split dollar arrangement is in effect, the economic benefit increases. Thus, it is desirable to have an exit strategy in place to terminate the split dollar arrangement upon death or perhaps earlier when the premium has been fully paid. Here are various exit strategies:

1) If G2 dies first, G1 receives the greater of the policy cash value or the premium and a large amount of life insurance is inside the Irrevocable Trust tax free for G2’s family. 

2) More likely, G1 dies first.  Because the receivable is not due until G2’s death, which may be many years into the future, the receivable may be substantially discounted.  G1’s estate includes the value of the receivable.  The value may be absorbed by G1’s exemption. G2’s death terminates the split dollar agreement and the receivable. 

3) A third alternative is that, prior to either G1’s or G2’s death, the receivable is sold for its fair market value, which again, may be subject to discount.  The Irrevocable Trust or a new Trust purchases the receivable and the split dollar arrangement is terminated.  The source of the payment has come from gifts by G1 or G2.  Often times the source comes from gifting strategies such as GRATS or gift/sale techniques involving intentionally defective trusts.

The key is to plan for the termination prior to later years where the economic benefit begins to grow.

Appointing and Removing Trustees for Irrevocable Life Insurance Trusts

I have written in the past about Irrevocable Life Insurance Trusts and their advantage in removing life insurance from an individual’s taxable estate. The Grantor (person who creates Trust) forfeits flexibility and the ability to make substantial changes when using an Irrevocable Life Insurance Trust in order to obtain this advantage. For example, a Grantor cannot change the Trust beneficiaries.

However, some flexibility can be retained. The Grantor can remove and appoint a new Trustee, provided the new Trustee is an institution or an individual who is not "related or subordinate" to the Grantor within the meaning of Internal Revenue Code Section 672(c). The new Trustee named should not be the Grantor, or the Grantor’s spouse, parents, children, siblings or an employee of the Grantor. (There is an exception to the related or subordinate rule if the party named is an "adverse party" but that is beyond the scope of this Post.)

The relevant authority interpreting Section 672(c) is Wall Estate v. Commissioner, 101 T.C. 300 (1993) and Rev. Rul. 95-58 1995-2 C.B. 191. Although the Grantor’s ability to name a new Trustee does provide some indirect control over the Trust by the Grantor, any Trustee named must abide by its duty of complete loyalty to the Trust beneficiaries. Thus, regardless of who is named, the Grantor does not directly control the Trust or its assets.

Gifts to Irrevocable Trusts

A previous Post (February 11, 2008) was about using an Irrevocable Trust to remove insurance proceeds from the taxable estate of both a husband and wife even though one or both are the insured's. Because the Irrevocable Trust owns the insurance, and the clients (i.e., the husband and wife in this case) give up control over the policy, the insurance proceeds are not included in their estate. Yet, the surviving spouse and children can still be beneficiaries of the Trust and indirectly the proceeds.

Besides the estate tax advantages of removing the insurance proceeds from the taxable estate, there are also gift tax issues when the premiums are paid. Because the Trust owns the policy, the Trustee must pay the premiums out of funds in a Trust bank account. Thus, the Trustee is receiving the premium payments from the clients. (Note, the Trustee is not typically the clients, but an independent trustee such as a bank or family member.)

The gift issue arises because the clients, when paying the premium to the Trustee, are making gifts to the beneficiaries of the Trust, typically their children. However, the gifts, because they are to a Trust, are not "present interest gifts." Because the gifts are not present interests, the gifts don’t qualify for the annual exclusion, which is currently $12,000 per recipient. As described in the February 11, 2008 Post, that is the purpose of the "Crummey" letter. Without a Crummey letter to qualify the gifts as present interests, the clients are depleting their exemption amount each time a premium is paid.

Irrevocable Trusts

Irrevocable Trusts are often created to own life insurance policies.  The significant advantage is that the death proceeds are not included in the insured’s taxable estate upon his death.  Further, the death proceeds are not taxable in the surviving spouse’s estate, even though she has access to the proceeds to maintain her lifestyle.  Upon the second death, the proceeds pass tax free to the children or beneficiaries of the insured’s choice.  Consider this example:  Dad and Mom have a taxable estate.  They need life insurance in the event Dad prematurely dies.  He purchases a $2 million policy.  Upon the second death of Dad and Mom, if Dad owns the policy the children may receive only $1 million because of federal and state estate taxes.  If Dad’s Irrevocable Trust is the owner and beneficiary of the policy, upon his death the proceeds are available for Mom, and at Mom’s death pass to the children estate tax free.

To achieve the desired estate tax benefit, premiums must be paid by the Trustee on behalf of the Trust as the policy owner.  When Dad writes a check for the premium, the check is written to the Trustee, not directly to the insurance carrier.  This premium payment constitutes a gift to the children because the children are Trust beneficiaries. 

Titling and Beneficiary Designations

When individuals consider how assets pass upon death, they immediately think of Wills (and perhaps Revocable Trusts for probate avoidance).  What often times is not considered, and even misunderstood, is that even if individuals have executed valid Wills, their wishes may not be respected.