Trusts: Beyond the BasicsPower Tools: Advanced Strategies for Positioning Your Estate Irrevocable Life Insurance Trusts (ILIT) My favorite definition of Estate Planning is: I want to control my property while alive, take care of my loved ones and myself if I become disabled, and, upon my death, give what I have to whom I want, the way I want, and when I want. And, if I can, I want to save every last tax dollar, professional fee, and court cost possible. You already have your basic estate planning foundation with your Revocable Living Trust. Your trust has language for an "A/B Split" if you are married. This gives you protection from probate and reduces your federal estate tax as much as possible. Now let's look at some additional estate planning tools that can reduce your estate and/or income taxes and protect your assets from lawsuits. I call these documents "Power Tools." Irrevocable Life Insurance Trust (ILIT)One of the easiest assets to remove from your taxable estate is your life insurance. The ILIT is an irrevocable trust which holds assets outside of your estate. This will exempt these assets from estate taxes upon your death. An ILIT is often named as the owner and beneficiary of a life insurance policy. This will make certain that the insurance proceeds are passed to the beneficiaries without first being taxed. The ILIT produces the following benefits: A. Less Taxes. Because the ILIT now owns the insurance policy, you retain no ownership interest, so the proceeds of your insurance will not be included in your "taxable estate" upon your death. Less taxes means you save money! B. Gift Tax Exclusion. Withdrawal powers are included in the ILIT. This allows you to take advantage of the annual gift tax exclusion to add to the trust or to pay premiums. C. Liquid Funds to Pay Taxes. Upon your death your estate will need to pay its debts, costs, and taxes. If your estate is not liquid, the Trustee of your ILIT may allow the ILIT to make loans to your estate, or allow the ILIT to purchase assets from your estate. This does not cause such payment from the ILIT to be included in your "taxable estate," but still allows liquidity. D. Control. Even though the trust is irrevocable, you still retain control over the financial instruments held by the trust. Here's how to determine if you need an ILIT:
2. Figure your applicable exclusion amount. The Applicable Exclusion Amount ChartFor the year: The Applicable Exclusion Amount is:
3. Figure the amount you will pay estate taxes on. Federal taxes are due on all assets valued at over the applicable exclusion amount(see chart). In the case of a married couple with a tax saving A/B or "marital deduction" living trust, taxes are only due on assets valued at more than twice the applicable exclusion amount. 4. If your life insurance death benefit puts you above the applicable exclusion amount, you should create an ILIT to remove that asset from your taxable estate. Establishing an irrevocable life insurance trust(ILIT) to own your life insurance policies will remove those policies from your taxable estate. Since the trust is irrevocable, and since you are not the trustee, the insurance proceeds are no longer considered a part of your taxable estate. If your estate is approaching the estate tax limits (see chart above), an irrevocable life insurance trust will reduce your estate taxes. With this trust, your life insurance proceeds will not be subject to any federal estate taxes at all. Advantages: Disadvantages:
Q. What is an Irrevocable Life Insurance Trust? A. An Irrevocable Life Insurance Trust is a living trust which cannot be altered, amended or revoked by the person setting up the Trust (the Grantor). This type of Trust owns life insurance policies, pays premiums when due, and designates the distribution of life insurance proceeds to the Trust Beneficiaries. The ILIT has the following characteristics: 1. It is an Irrevocable Life Insurance Trust over which you retain no interest or power that would require the proceeds of your insurance to be included in your taxable estate upon your death. 2. Withdrawal powers are given to the Beneficiaries which allow you to take full advantage of the annual gift tax exclusion to add to the Trust or to pay future premiums. 3. The Trustee of the ILIT has the power to purchase assets from or make loans to your estate for payment of any debts, costs or taxes in the settlement of your estate. This does not cause such payments to be included in your taxable estate, but still allows for estate liquidity. Q. Why should an Insurance Trust be irrevocable? A. If you retain the right to revoke the Trust or if you act as the Trustee, the assets owned by the Trust will still be included in your estate for tax purposes. To avoid the tax on the insurance, your Trust must be irrevocable and you must appoint someone other than yourself to be the Trustee of your Insurance Trust. Q. Why do I need an Irrevocable Insurance Trust? A. With this ILIT, your life insurance proceeds will not be subject to any federal estate taxes whatsoever. When you die, everything in your name and all those things over which you had control are considered to be in your taxable estate. Your taxable estate also includes the amount of death benefits paid by your life insurance if you are the owner or if you paid the premiums. Federal Estate taxes are due on all assets valued at more than the applicable exclusion amount (see chart above). You may establish an Irrevocable Life Insurance Trust to own your policies, to pay the premiums, and to be the Beneficiary of your life insurance. Since the Trust is irrevocable and since you are not the Trustee, the insurance proceeds are not considered a part of your taxable estate when you die. If your estate is above the applicable exclusion amount, the placement of life insurance policies in an Irrevocable Life Insurance Trust will reduce your taxable estate. Q. I have heard there are problems with Irrevocable Life Insurance Trusts — What are the problems? A. Irrevocable Life Insurance Trusts can encounter 3 types of problems. 1. The first problem is that pre-existing policies transferred to the Trust will be brought back into the taxable estate if the Grantor dies within three years of the transfer. 2. The second problem is irrevocability. Once you establish your insurance trust you may not alter or amend the Trust and you loose control over your insurance policies. 3. The third problem is that contributions to the Trust may cause a gift tax. Q. How does the ILIT overcome the problems of an Irrevocable Life Insurance Trust? A. 1. A recommended way to overcome the problem of transferring already existing policies into the Trust is to consider the costs and advantages of simply replacing such policies. If this is not possible, the 3 year rule will apply, but betting that you will live for the 3 years is worth the estate tax saving gamble. With modern Life Insurance Company's new amortization schedules and administration techniques, it is sometimes cost effective and simple to replace existing insurance with a new policy owned by the ILIT, assuming you are still insurable. This allows the ILIT to be the original owner of the insurance and so it will not be included in your estate for tax purposes. 2. The ILIT contains an escape hatch to avoid the problem of irrevocability. The Trust assets can be restored to the Grantor through the Special Power of Appointment Clause. This special power would permit the Grantor's Spouse to appoint the assets back to the Grantor without adverse tax consequences. The person holding this power cannot exercise it for their own benefit. The major problem with this provision is that the Grantor may not always be able to control the Spouse's decisions. 3. The ILIT eliminates the gift tax problem by incorporating "Crummey" withdrawal rights for the Trust Beneficiaries. This allows you to make a gift to the ILIT of up to $10,000 annually for each Trust Beneficiary without incurring any gift tax. (For example: 5 Beneficiaries x $10,000 each = $50,000 annual gift tax free). Q. What are "Crummey" withdrawal rights? A. Gifts of policies with cash value, property or cash to pay premiums, can be converted into present interests which qualify for the annual gift tax exclusion of $10,000 per Beneficiary per year, if the Trust Beneficiary is given an immediate withdrawal right with respect to contributions to the Trust. These withdrawal rights are temporary and, in this Trust, last for thirty days. This technique was established in the court case of Crummey v. Commissioner in 1968. The rights have become known as "Crummey Powers". The Beneficiaries must have notice of the existence of these rights. Crummey withdrawal rights are not designed to be exercised. They are only designed to qualify the Trust for the annual gift tax exclusion. You should be surprised if a Beneficiary exercised his Crummey Power. Such an exercise might make it difficult to pay the premium due on the policy and the Grantor would think twice before making any future contributions to the ILIT. Q. Is it necessary that I set up my ILIT more than 3 years before my death, so that the value of my insurance is not included in my taxable estate? A. The ILIT insulates any policy it holds from the federal estate tax if the policy has been transferred to the Trust more than 3 years preceding the insured's death. If you should die within 3 years of the time the ILIT acquires the policy, the IRS would argue that the insurance should be included in your taxable estate. To avoid the possibility of having the insurance proceeds included in the taxable estate if the insured dies within the 3 years of transferring, you should consider having the Trust apply for and own a new policy from the beginning. This way there is no policy transfer made to bring the insurance back into your taxable estate under the provisions of this part of the tax code. Q. Who should I choose as Trustee of myILIT? A. You may not act as the Trustee of aILIT which holds insurance on your life. This would cause the insurance proceeds to be included in your taxable estate. Choices for Trustee include other trusted family members (as long as they are not minors, your spouse or members of your household), friends or relatives, professionals such as attorneys or accountants and corporations in the business of delivering trust services. You should have a great deal of faith and confidence and be able to work well with the person you appoint as Trustee of your ILIT. The main drawbacks of having a corporate Trustee are the annual administration fees and the occasional inability of the corporate Trustee to relate to the needs of the Trust Beneficiaries. Sometimes a professional or a family member is appointed Trustee when a Trust is created but is charged with transferring the assets to a corporate Trustee for investment purposes once policy proceeds are paid after the Grantor's death. This helps the Trust avoid paying unnecessary annual administration fees until a substantial Trust estate exists. Q. Why should the ILIT be the Beneficiary of the Insurance Policy? A. If you name your Trust as Beneficiary, the insurance company will pay the proceeds to the Trust and your Trustee can then use the funds according to the instructions you put in your Trust. For example, your Trustee could purchase assets from your Living Trust, replacing hard assets with cash to pay income and estate taxes, preventing a distress sale of the assets. Also, if one of your Beneficiaries is incompetent when you die, your Trustee can invest that Beneficiary's share and provide for that Beneficiary's care for as long as needed. If you had named this person as a Beneficiary of the life insurance policy, the insurance company probably would not pay the incompetent person directly, but would insist instead on court supervision through a conservatorship. So, your ILIT should be both the Owner AND the Beneficiary of the Insurance Policy. Q. How are the insurance premiums paid when I have a ILIT? A. After the Grantor has made a gift to the ILIT, the Trustee will pay the premiums to the insurance company. This will mean that the ILIT will have its own bank account. Because a taxpayer I.D. number is required for a bank account, and "Application for Employer Identification Number" (form SS-4) must be filed with the I.R.S. Premiums should NEVER be paid directly to the insurance company by the Grantor.
In the community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin) the Irrevocable Life Insurance Trust will not totally accomplish its intended purpose if any of the existing insurance policies can be classified as community property. The factors to determine whether a policy is community property are: 1) if it is acquired by a married couple while the couple resides in a community property state; 2) if the couple uses community funds to pay premiums; and 3) if the couple does not take affirmative action to show that one spouse gave their community interest to the other, thereby converting the property to that spouse's sole and separate property. If the Grantor's Spouse dies before the Grantor and the policy is classified as community property, then the Grantor's Spouse's estate must include one-half of the value of the community interest in their taxable estate. The disposition of property at death is governed by the laws of the state in which the person lived at the time he died; however, insurance policy proceeds are attributed to the decedent's estate according to the property rights already established in that policy, either as community property or as sole and separate property. The key to avoiding the complications created by community property laws for the Irrevocable Life Insurance Trust is to make sure the life insurance policies are characterized as sole and separate property. When an existing policy is transferred to the Trust, the spouse should take affirmative action to convert each policy into the sole and separate property of the Grantor. Thus the Grantor who owns the policy as his sole and separate property may transfer it directly to the Irrevocable Life Insurance Trust without any community property strings attached. A document entitled Release of Community Property Interest is used to convert the community interest of an existing insurance policy to the sole and separate interest of the Grantor for transfer to the ILIT. Each policy transferred to the Trust should be accompanied by its own release. These releases constitute gifts which avoid federal gift taxes by virtue of the marital deduction. Care should also be taken to make sure the policy is identified on the insurance company's records as the Grantor's sole and separate property. Note: If you are purchasing a new policy through your ILIT then the "Release of Community Property Interest" is not necessary. Family Limited Partnership (FLP)This is becoming one of the most popular methods to pass the equity in a larger estate to the heirs at a discounted rate, while retaining control, and at the same time, protecting the assets from lawsuits. A Family Limited Partnership may be used to begin shifting ownership from your estate to your heirs without losing control. The Limited Partnership is becoming a more popular staple of estate planning for a number of reasons. A major one is for asset protection. A. It enables a parent or grandparent to divert income from partnership assets to children and grandchildren in lower tax brackets. B. It allows gifting of limited partnership interests to reduce the size of your estate without placing cash or property directly in the control of the donees. You retain control over the use and nature of the assets in the Family Limited Partnership. C. Limited partnership interests are also easily divided to enable you to meet the annual exclusion limits. This helps reduce the size of the taxable estate without giving up control. D. The general partner ceases to have any rights to vote or control the partnership upon death. For this and other reasons, partnership interests are subject to various valuation discounts at death that help minimize the size of the estate for estate tax purposes. E. It provides a degree of lawsuit protection. Certain characteristics of the partnership ownership form make it attractive as a means of safeguarding your assets. Here's how it works: If a creditor gets a judgment against one of the partners, the creditor applies for a "charging order" to enforce his judgment. This is an order by the court charging the partnership interest of the debtor partner. This means that if the partnership pays any income to the partner, it now must be paid to the judgment creditor. The creditor does not become a partner of the partnership, but is entitled to receive any distributions which would be given to the debtor partner. Now, here's the fun part. The General Partner of a Family Limited Partnership can choose to distribute the partnership income, or to accumulate such income and reinvest it in the Partnership. But he must still issue a "K-1" (a tax report) showing each partner's share, and tax liability. So, if general partner decides not to make a distribution of income, the creditor only gets the "K-1". He will now have to pay the taxes on the income that was never really distributed. So, transferring assets into a limited partnership, is an excellent way to safeguard your property.
-Asset protection Disadvantages: Charitable Remainder Trusts (CRT)Using this method of charitable giving, you can actually give your assets away and keep them. It's like having your cake and eating it, too! Combined with a wealth replacement irrevocable life insurance trust, you may pass your estate to your heirs tax free! Sometimes you may even be able to increase the amount you would be able to give to your heirs. Charitable giving has always been a fundamental aspect of estate planning. Most people who plan have a strong sense of family and community and are therefore inclined to make charitable gifts a part of an overall estate plan. Many estate planning attorneys have a good deal of knowledge about charitable planning. This knowledge is extremely important given the complex nature of the charitable giving provisions of the Internal Revenue Code. Charitable planning is not an area that should be approached lightly, as you can see from reading this booklet. There are a myriad of issues that must be considered, including control; income, gift, and estate tax ramifications; current finances; future income and principal needs; the extent of your charitable inclination; and the types of property you own. This booklet gives an excellent overview of all of those issues and how to deal with them. It also has a number of examples which will help you visualize the concepts included in the broad topic of charitable planning. Q. Why does a person give to charity? A. Many people give to charity because they are philanthropic. They feel they can benefit society by giving to organizations in which they believe.
The simplest way to give to a charity is by making an outright gift. Outright gifts can be made either during a person's lifetime or at death. Donors of charitable gifts generally receive tax benefits. The availability and amount of those benefits depend on several factors, and the charitable gift must be properly structured to maximize the tax advantages. Some of the factors to be considered are: The type of property given (e.g., cash, stock, real estate, short-term or long-term) Q. Can I actually "make money" by giving to charity? A. If you have any charitable interest to help, for example, the church you attend, the school or college from which you or your children graduated, or the hospital where loved ones have been cared for- then you can "profit" from the pleasure you'll derive by helping a charitable organization you believe in to carry out its worthwhile mission. And if you plan your charitable gift wisely, the combination of tax savings and financial benefits can make your sacrifice almost painless. In fact, you'll probably feel you've come out ahead, all things considered. The key is proper planning. Q. I would like to make a charitable contribution, but I do not have the financial means available to me. Are there any alternatives? A. Outright gifts during life can be made only by persons who can afford to do so. However, charitable giving can include split-interest trusts. These are special trusts which provide both a benefit to a charity and a benefit to a "noncharity." This noncharity is generally the donor and the donor's family. Split-interest trusts have gained popularity because they can satisfy personal financial needs as well as philanthropic desires. The most commonly used split-interest trust is the charitable remainder trust. A less frequently used split-interest trust is the charitable lead trust. Q. What is a charitable remainder trust? A. A charitable remainder trust (CRT) is an irrevocable trust created for the purpose of holding assets given to the trust by a donor during the donor's lifetime or upon the donor's death. A CRT is a split-interest trust. Its donated assets are shared between noncharitable beneficiaries and charitable beneficiaries. Typically, a CRT is designed to pay income to one or more trust noncharitable beneficiaries (usually the donor and the donor's spouse) for life or for a term of years, after which the trust assets are paid to or held for qualified charitable beneficiaries. The percentage of income that must be paid annually to the income beneficiaries cannot be less than 5 percent of the value of the trust assets. There is no limit as to the number or type of income beneficiaries (individuals, corporations, trusts, etc.), except that at least one income beneficiary must be a taxable entity and that unborn individuals (such as grandchildren not yet born when the trust is created) do not qualify unless the trust's duration is limited to a term of years. A CRT can continue for the lifetimes of the persons selected as income beneficiaries or for a term of years not to exceed 20. When the last income beneficiary dies or the term of years expires, all assets remaining in the trust must be distributed to one or more charities, called charitable remaindermen. Q. How does a CRT work? A. To understand how a CRT works, let's look at an example of a typical situation in which a CRT is used: Mr. and Mrs. Smith have stock for which they paid $10,000. The stock has grown in value over the years and is now worth $110,000. The stock pays them a dividend of $1500 per year, which is a 1.36 percent return. Mr. and Mrs. Smith are each 61 years old. Their total estate is large enough for this stock to be taxable in their estate at a 50 percent marginal tax rate. If the Smiths sell the stock, they will have a capital gain of $100,000 ($110,000 sale price - $10,000 basis). Their federal capital gain tax rate is currently 28 percent. Accordingly, if the Smiths sell the stock, they will pay a $28,000 capital gain tax, leaving them with only $82,000 ($110,000 sales price - $28,000 tax) to invest. If they invest the $82,000 and receive a 7 percent return, they will receive $5740 in income. Instead of selling the stock, the Smiths can create a CRT and donate their stock to it. The CRT then sells the stock. Since the CRT is charitable in nature, it pays no capital gain tax. Accordingly, the trust now has $110,000 to invest. The Smiths can write into the trust that they want a 7 percent annual income from the trust. They will then be receiving $7700 per year in income. This income will continue to be paid to the Smiths or, after one of them dies, to the surviving spouse for life. Upon the death of both Mr. and Mrs. Smith, the balance of the funds in the CRT will be paid to a charity which Mr. and Mrs. Smith designate. When the trust is signed and the Smiths contribute their, stock to it, they are making a charitable contribution of a portion of the value of the stock. The value of the charitable deduction that the Smiths receive is the original value of the gift less the present value of the income going to the Smiths on the basis of their actuarial life expectancies. In the case of the Smiths, they receive a charitable deduction of $23,770 (based on a 7 percent rate from IRS tables for the month of contribution), which will save income tax of $9508 (assuming a 40 percent tax rate). Since the stock is now in an irrevocable trust, the $110,000 has been removed from the Smith's estate for estate tax purposes, thus saving $55,000 in estate taxes ($110,000 x 50 percent marginal estate tax rate). Upon the death of both Mr. and Mrs Smith, the balance of the proceeds in the trust will go to the charity or charities of their choice. It is common for a donor to a CRT to establish a wealth replacement trust (an ILIT). This way insurance proceeds in the amount of the gift given to the charity may be distributed to charity. The beneficiaries receive this distribution tax free. PERSONAL RESIDENCE TRUST (GRIT)With a personal residence trust you transfer your home to an irrevocable trust for a period of years (usually 10-15 years). You retain the right to live in and use the home for that term of years. After that time the home belongs to your children. In effect, you are giving your home to your children today, but they will not own it until the end of the trust. Because your children will not actually receive the home until sometime in the future, the value of the gift is reduced or discounted. This uses less of your applicable exclusion amount than if you had kept your home together with its future appreciation, in your estate. If you live longer than the term of the trust, you may have to pay rent and upkeep on the use of the home. Your residence will not receive a "stepped-up" basis when you die. Its basis will be your basis at the time of the gift. So it is necessary to compare the difference between the expected income verses estate taxes. If you should die before the term of the trust is up, the residence will just be included in your personal estate for estate tax purposes. The personal residence trust is also sometimes referred to as a Grantor Retained Income Trust, or GRIT. ANNUITYAnnuities have become a very popular way to protect your assets in the event of a catastrophic illness. An annuity is a "non-countable asset" if you apply for government assistance. When you apply for government assistance, you must list all of your real estate, bank accounts, stocks and bonds, etc. An annuity is a contract between you and your insurance company and is not counted as one of your assets. That means you won't have to spend down the principal. For example, if you have a certificate of deposit of $50,000 with your bank and you need medical assistance for long term care or a nursing home, and you apply for government help, the government agency will tell you that you don't qualify because your net worth is too high. You must first spend that $50,000 and then re-apply for assistance. If that same $50,000 were transferred to an annuity, you could still receive the income from that annuity but you would not have to spend the $50,000 before receiving government assistance. By the way, the annuity would probably pay you a greater rate of interest and you wouldn't have as much of a penalty if you needed to make an early withdrawal.
Because the funds transferred to the insurance company are no longer owned by you, they are no longer in your estate. You are only entitled to receive the agreed upon distribution amount. The annuity usually pays you or accumulates a greater interest on your money than you would have received from your bank certificate of deposit for example. The principal transferred to your annuity is not considered to be owned by you so it will not disqualify you from the right to receive government benefits in the event of a catastrophic illness. You should consider an annuity if you are going to receive lump sum distributions from tax deferred employee benefit plans, IRA's, or KEOGH plans. When used together with wealth replacement insurance trusts, or charities, good results may be achieved. If you have any questions about Estate Planning, or would like to come in for a FREE initial consultation please call: Steven W. Allen ©2003 Steven W. Allen, P.C. |
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Steven W. Allen, P.C.
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©2003 Steven W. Allen, P.C.