Situation: The uncertainty of the estate tax laws has created a dilemma for many taxpayers, estate planners, and insurance professionals. Should moderately high net worth couples take action today to shelter a significant amount from estate tax (under the $11.7 million exemption) by making a large gift; or should they hold off making a large gift and hope that the value of their estate stays under what is likely to be a much smaller exemption in the future?
One of the most obvious examples of this dilemma is found with the traditional irrevocable life insurance trust (“ILIT”), which has played a critical role in estate planning for many years. If an ILIT is established, access is significantly limited. On the other hand, if a decision is made to wait to establish an ILIT, the proposed insured’s health could deteriorate, thus significantly increasing the cost of insurance coverage. Even worse, the individual may become uninsurable and insurance may be unavailable especially in this COVID environment.
The Standby Trust (also referred to as the Wait-and-See Trust) was developed as an alternative to the ILIT because it permits the insureds (i) to purchase survivorship life insurance today based upon current underwriting conditions and (ii) to retain a great deal of flexibility. This Counselor’s Corner provides information about this arrangement.
Solution: In general terms, the Standby Trust arrangement utilizes an ownership and beneficiary structure on a survivorship policy on the lives of a married couple. The insured with the shorter life expectancy is named the initial owner of the life insurance policy (“the insured owner”) and premium payer. At the time the insurance is purchased, a trust (i.e., the Standby Trust) is also established as either an existing stand-alone (revocable or irrevocable) trust or as a testamentary trust and is named the contingent owner and primary beneficiary. If the estate tax continues to not apply to the client’s situation, the Standby Trust may not be utilized. On the other hand, if the estate tax does apply, then the life insurance policy can be transferred to the Standby Trust in an attempt to minimize future estate tax consequences.
Under this arrangement, trust ownership of the policy is normally deferred until after the death of the first insured, thus giving the insureds the time needed to make any irrevocable decisions concerning the ultimate policy ownership. Consequently, during the lifetime of both insureds, this arrangement provides the insured owner of the policy with (i) a great deal of flexibility, (ii) easy access to cash values for retirement and other uses, and (iii) the potential to exclude the net death benefit from the estate of both insureds. It is important to note, however, that there is a price associated with all of the flexibility. In a Standby Trust arrangement, since the insured owner initially owns the policy, the entire cash value will be included in his/her taxable estate if he/she is the first to die. The application of the so-called “three-year rule” of IRC Section 2035 is also a possibility.
 Since this technique does not require ownership of the survivorship policy by the Standby Trust from the inception, it is not necessary to have the Standby Trust in existence at the time of policy application. However, it is prudent to have the trust established as soon as possible.
The industry is constantly evolving, and we continue to see change in many areas that affect the work you do with your clients. The good news? With all of this change comes opportunity. Terri Getman, DBS Business Development Director, has laid out three big opportunities to take advantage of NOW. She’s also identified which of your clients to approach to take advantage of the opportunity. Reach out to Terri at 800.869.1327, extension 230 with your advanced case questions today!
Life Insurance as a Retirement Supplement
- Why Now?
- Prospect of higher income taxes for incomes over $400k
- Potential loss of deduction for qualified plans. Replaced by 26% flat credit
- Recent 7702 legislation, making accumulation focused policies more efficient
- Client Profile:
- Executives, professionals, highly compensated business proprietors
- Usually, ages 40-55
- Maxed out qualified plan contributions
- Healthy clients with a need for life insurance or interest in long-term care/chronic care benefits
Life Insurance to Cover IRD Tax
- Why Now?
- SECURE (December 2019) & Proposed SECURE 2.0
• Delayed start date for Required Minimum Distributions
• Eliminated stretch distribution for most beneficiaries replaced with 10-Year distribution
• Increased income (IRD) taxes for beneficiaries
- SECURE (December 2019) & Proposed SECURE 2.0
- Client Profile:
- Clients with “significant” qualified plan balances
- Usually, ages 60-75
- Those desiring to control distribution from the grave
- Possible desire to provide flexibility to heirs
- Healthy clients – especially if they are also subject to state or federal “death” tax
Gift of Life Insurance to pay Death Taxes
- Why Now?
- High exemption of $11.7M ($23.4M/couple) will sunset in the near future reducing to $5+M (2026
- Low interest rate environment makes many estate techniques attractive
- Possible elimination of many popular estate strategies & possible elimination of basis step-up
- Large gifts today grandfathered – no clawback of gift amount exceeding exemption at date of death
- High exemption of $11.7M ($23.4M/couple) will sunset in the near future reducing to $5+M (2026
- Client Profile:
- Single clients with net worth greater than $5M or married with net worth over $10M
- Usually, ages 60-75
- Clients living in one of the 17 states or DC who are subject to state-level death tax with net worth larger than state exemption
- Younger clients with appreciating assets
Most can agree that 2020 was an unprecedented year, bringing change to nearly all aspects of life. It was certainly felt by the DBS Case Design Team with more change than ever in the form of new products, reprices, illustrated rate changes, and regulation compliance. This was even after losing a number of products as carriers phased them out to comply with the PBR/2017 CSO mortality table deadlines at the end of 2019. Persistent Low-Interest Rate Environment: Though the focus early in the year was on the aftermath of PBR/CSO, we quickly shifted gears when interest rates dropped to 0.25% in March. After this announcement, we saw pricing hikes to no-lapse guaranteed products and lower caps on indexed accounts. COVID 19: The pandemic also hit in March, and we saw carriers make temporary (and sometimes permanent) changes such as enacting age restrictions, premium limitations, table limits, and other changes.
AG 49-A: Life insurance carriers only had a few short months to comply with this deadline, and the responses were varied with some carriers making substantial changes to their products, while others were basically unchanged except for illustrative restrictions imposed by AG 49-A.
Section 7702: In addition, the industry is now reacting to the newly released changes to section 7702 of the tax code dealing with life insurance. Transition rules are not yet clear, but there will no doubt be more changes to come.
What does the future hold?
Your DBS Case Design Analysts are your product specialists, following carrier changes very closely. And, we still have access to the most competitive products available, so you can count on us to help guide you to the best solution for your clients.
As more states experience deficits in their budgets a growing number have begun to impose their own tax on property transferred at an individual’s death. In fact, state death taxes have emerged as the primary concern for most individuals because it’s not unusual for a state to assess taxes even where federal taxes are avoided. Consequently, in light of the recent changes individuals should be reviewing their estate plans. The states listed in the chart below have death taxes.* See PDF
Situation – With the amount sheltered from estate tax (exemption) at a historic high of $11.7M ($23.4M for a couple), many high net worth households are looking for opportunities to minimize their federal or state death tax exposure by gifting assets during their lifetime. By gifting assets when the exemption is high, a high net worth couple can avoid both federal and state “death taxes” on the transferred amount (and the growth on the asset) even if the exemption amount is less at time of death. With President Biden proposing to reduce the exemption amount to somewhere between $3.5M to $5M, time is running out to take advantage of this gifting opportunity. However, even high net worth couples can be reluctant to give away assets. They fear that one day they may need the property if circumstances change. Of course, clients of more modest net worth are going to be reluctant to give up access. If you have married clients who are concerned about giving up access to gifted property, a strategy referred to as the Spousal Limited Access Trust, or Spousal Lifetime Access Trust (SLAT) might be appealing. It’s important for financial advisors to be aware of this planning technique because life insurance is typically purchased as part of the strategy. This Counselor’s Corner will outline the primary planning and tax issues associated with implementing and administering a SLAT, as well as, discuss the use of life insurance in the arrangement. Solution: A SLAT is a lifetime irrevocable trust established by one spouse (the donor spouse) for the benefit of the other spouse (beneficiary spouse) and children (and possibly grandchildren). The trust document is written to allow for distributions to the beneficiary spouse which arguably allows the donor spouse to indirectly benefit from the trust assets. While the trust is written to permit distributions that can benefit the donor spouse it is best to put only those funds in the trust that a donor can reasonably expect to do without. A SLAT can also function as a life insurance trust and acquire a single life policy on the donor’s life or survivorship policy on both spouses.
The terms of a SLAT usually give broad control to the beneficiary spouse similar to a credit shelter trust. For example, the following provisions can be included:
• The beneficiary spouse can be the trustee provided the power to make distributions to him or herself is limited by ascertainable standards of health, education, maintenance, and support (HEMS) assuming the trust does not own a policy insuring the beneficiary spouse (i.e., survivorship policy). Alternatively, if looking for the most flexibility and asset protection an independent trustee may have absolute discretion to make distributions to trust beneficiaries. In both cases, the trust should provide that no distributions can be made to satisfy the donor’s legal obligations of support during the donor’s lifetime to reduce the risk of estate tax inclusion in the donor spouse’s estate.
• The trust can direct that the beneficiary spouse receives a mandatory income interest.
• The beneficiary spouse can have a 5% or 5,000 annual withdrawal power.
• The beneficiary spouse can have a limited power of appointment exercisable at death or in life. In some states, this power can be broad enough to appoint the assets back to the donor spouse as one of many discretionary beneficiaries.
The transfer of assets by the spouse establishing the trust is considered a gift, but sheltered from gift tax through the use of some, or all, of the donor spouse’s gift tax exemption (which may be as large as $11.7M). The assets transferred to the trust, along with their future appreciation, eventually pass to future generations without being included in either the donor spouse’s or beneficiary spouse’s estate for death tax purposes. In the current environment of uncertainty, SLATs can provide several benefits that are attractive for a range of clients from the modest estates needing life insurance to the ultra-high net worth client requiring aggressive estate planning.
Primary Benefits of a SLAT
While a SLAT is primarily promoted as a way to avoid transfer taxes while still retaining access to trust assets following are some of its key benefits:
1. Avoids Probate Assets in a SLAT avoid probate which should reduce settlement costs and time delays since assets in the trust 1 can be available for immediate post-death distribution.
2. Later life planning Several safeguards can be included in SLATs to provide later life planning. For example, a SLAT can have a separate tax ID which can protect identity theft risk. Naming a trust protector to act in a fiduciary capacity can provide an independent person to monitor the trustee performance.
3. Asset protection A SLAT can be structured to provide asset protection from claims of creditors for assets transferred to the 3 trust. This is assuming the transfer is not characterized as a fraudulent conveyance.
4. Serves as an ILIT 4 SLATs can function as an ILIT.
5. Reduces federal estate and state death tax Properly implemented and administered assets transferred to the SLAT, along with their appreciation, avoid 5 both the donor and beneficiary spouse’s estate for estate tax purposes.
6. Grantor trust status SLATs are generally structured as grantor trusts for income tax purposes; thus, the donor spouse is taxed on 6 the trust income. This further reduces the couple’s estate and permits the trust to effectively grow tax-free.
A SLAT may seem like a fairly easy way to use a client’s gift tax exemption while still providing a safety net in the event of an unforeseen need. However, there are some factors to consider before deciding if it’s ideal for your client’s situation. Specifically, the law regarding the use of SLATs is still developing so there is a risk of estate inclusion, especially if proper care is not taken in its implementation and administration. In addition, since the donor spouse’s ability to benefit from the trust is indirectly through the distributions received by the beneficiary spouse practical considerations such as what should happen in the event of the death or divorce of the beneficiary spouse should be addressed.
Major Drawback of SLATs
The primary drawback of a SLAT is that the donor spouse’s ability to benefit from the trust comes only through the beneficiary spouse’s interest in the trust. If the beneficiary spouse dies before the donor spouse, or if there is a divorce, the access can be lost. This is one reason why it is best to put only those funds in the trust that a donor can reasonably expect to do without. In addition, advanced planning can address both concerns. One simple way of addressing the death of the beneficiary spouse, prior to the donor spouse, would be to have life insurance on the beneficiary spouse payable to the donor or to the donor’s trust. Another option may be to grant the beneficiary spouse a limited testamentary power of appointment with the donor spouse as one of many discretionary beneficiaries. However, the use of this technique requires careful drafting to avoid access by the donor’s creditors and/or pulling the trust back into the donor’s estate. To protect against divorce, the SLAT could define “spouse” as the person to whom the donor is married to at the time, rather than naming a specific person. In the event of a divorce, the ex-spouse would cease being the beneficiary and a subsequent spouse would be able to benefit from the trust. Of course, if the donor spouse does not remarry this strategy does not solve the problem. If the donor spouse does not remarry, or the beneficiary spouse predeceases the donor spouse, the trust could include a provision granting an independent trustee or trust protector the ability to add the donor spouse as a beneficiary. If this provision is included in the SLAT, care must be taken to ensure that the donor is one of several beneficiaries. There is no implied understanding as to how the protector will exercise the power and the trust situs is in a jurisdiction that authorizes self-settled asset protection trusts. Life Insurance Considerations Life insurance enjoys many tax-favored benefits that make it an attractive asset to be owned by a SLAT. Specifically, during the lifetime of the insured, policy values accumulate income tax-free; withdrawals from a life insurance policy are not taxable to the extent they do not exceed the cost basis of the policy, and loans of any amount permitted by the insurance carrier can be taken income tax-free. Because of the tax-favored treatment of withdrawals and loans from a life insurance policy many strategies, including SLATs, promote the use of taking withdrawals equal to basis then loans thereafter as a way to access policy cash. The practical effect of such a strategy is that the beneficiary spouse is able to enjoy the policy cash value without income tax consequences. In contrast, investment assets such as stocks, bonds, and mutual funds owned by a SLAT will result in taxation either at the high trust tax rates or to the donor spouse where the trust is a grantor trust. In addition, life insurance death benefit is generally received income tax-free and in a properly maintained SLAT estate tax-free. In contrast, investment asset owned by a SLAT do not get a “step-up in basis.” Consequently, after the death of the donor spouse (who is also the insured) investment asset will be subject to income tax either at the high trust tax rates or the beneficiary spouse’s tax rate depending on whether the earnings are retained in the trust or distributed to the spouse.
However, these life insurance tax benefits can be lost. Following are the most common ways to lose the favorable tax treatment of life insurance.
1. Avoid creating a MEC – One way the tax-favored treatment of life insurance can be lost is by paying too much premium during the first seven years of the contract (or in the 7-pay period after a material change) causing the policy to be classified as a modified endowment contract (MEC). Death benefits from a MEC are still generally received income tax-free under IRC § 101(a). However, lifetime distributions from a MEC are taxed differently than distributions from non-MEC policies. Common policy distributions include withdrawals, loans, and assignments. Distributions from a MEC are taxed as income to the extent of gain first and recovery of basis second. Furthermore, the portion of any distribution that is included in the policy owner’s gross income may be subject to a 10% tax penalty if the policy owner is under the age of 59½. If the SLAT is structured as a grantor trust, the carrier may treat the donor spouse as the policy owner for purposes of determining whether the penalty applies. If it’s contemplated that policy cash values will be accessed to satisfy distributions from the SLAT, you will want to avoid creating a MEC. It should be noted that the recently passed Consolidated Appropriations Act of 2021 included provisions changing the interest assumptions used in calculating the amount of premium that can be paid before a policy becomes a MEC. As a result of the current low-interest rates, it will be possible to put more premium into a policy for the same amount of death benefit; potentially making the IRR of cash value more attractive.
2. Avoid taking withdrawals in the first 15 years on a “cash rich” policy – As previously noted, a withdrawal from a life insurance policy is generally treated as a reduction of basis first and is not subject to tax until the amount withdrawn exceeds the investment in the contract/basis. However, a withdrawal in the first 15 years of a “cash rich policy” is treated as a distribution of gain first, taxable as ordinary income. So, if the trustee of the SLAT desires to take withdrawals from a policy in the first 15-years, it is best to first check with the carrier to determine if the gain will be taxable first under the cash rich rules. Note, assuming the policy is not a MEC, but the cash rich rules apply to make withdrawals taxable it is possible to borrow on a cash rich policy in the first 15-years and avoid income tax under the rule.
3. Avoid having an incident of ownership causing estate inclusion of the death benefit – Inclusion of life insurance death benefit in the insured’s estate will occur if the insured holds any incidents of ownership in a policy on his/her life. Incidents of ownership encompass far more rights than actual policy ownership. Incidents of ownership can be attributed to the insured indirectly, such as a corporate-owned policy where the insured is a majority owner and where the insured is a trustee of a trust owned policy. Because ownership of a trust owned policy can be attributed to the insured in a SLAT with a single life policy, the donor spouse cannot be the trustee (since s/he is the insured), but it is possible for either the beneficiary spouse or adult children to be the trustee. Of course, where a beneficiary spouse is a trustee, the powers over the trust property must be limited to avoid inclusion of the trust in his/her estate. With a survivorship life insurance policy in a SLAT, neither the donor nor the beneficiary spouse can be a trustee, since both are insureds. In a survivorship SLAT situation, one of the insureds will be the donor spouse and the other will be the beneficiary spouse (typically the spouse with the longer life expectancy). There are several other ways that an improperly designed or administered SLAT can end up being included in the taxable estate of the donor or beneficiary spouse. There are other ways that a SLAT can be subject to estate tax. This is just the primary one directly involving life insurance. The other ways will be discussed under “planning considerations.”
4. Manage policy distributions to avoid lapse – Taking withdrawals and loans from a policy can reduce the policy death benefit, the cash value, and may cause the policy to lapse. The lapse of a policy can cause income tax. When accessing policy values to satisfy distributions in a SLAT, it’s important to request inforce policy illustrations on an ongoing basis so the policy can be managed to avoid unintended lapse. It should be noted that some policies have a safety net usually called an overloan protection rider. This rider essentially freezes the policy when the loan’s balances exceed a certain threshold, as a percentage of cash value to prevent policy lapse. If a policy includes this feature, it is important to know when and how to exercise the rider. Most of these riders require a proactive action by the policy owner and require the insured to be at least a specific age.
5. Monitor policy performance to avoid policy lapse – When taking loans or withdrawals from a policy, it’s not only important to avoid the tax land-mines, you also need to consider the practical things like the impact changes in crediting rates and loan assumptions can have on the long-term viability of the arrangement. For example, recently I saw an illustration where a mere decrease in crediting rate from 7.7% to 7.0% caused a policy (with prior distributions) to lapse at the insured’s age 83. Even more problematic, the policy would not accept additional premiums because the policy used the GPT (guideline premium test) life insurance definitional test with a maximum non-MEC premium funding structure which, unlike CVAT (cash value accumulation test), limits the amount of premium. Unable to prevent the policy from lapse, significant phantom income would be recognized. Consequently, it’s very important to conduct ongoing policy performance reviews.
6. Survivorship funding issue – When designing a SLAT with a survivorship policy if the policy is to be funded with annual gifts from the donor spouse, consideration should be given to an alternative funding strategy in the event the donor spouse before premiums on the survivorship policy are fully paid. Otherwise, if the donor spouse is the first of the two to die the SLAT may lack the funds it needs to maintain the policy. One strategy is to purchase a single life policy on the donor spouse or a first-to-die term rider. Another option would be for the donor spouse to bequeath additional funds to the SLAT to complete the funding of the policy.
7. Understand potential issues associated with long-term care riders – Because the risk that more than 50% of the population of the United States will need long-term care at some point in their life, long-term care planning has become a hot topic. With the recent development of long-term care and chronic illness riders on life insurance policies, it was only a matter of time before insureds began putting the rider on policies owned by SLATs. Since the policy in a SLAT is on the donor spouse, the benefits are triggered because of his/her health status. This raises numerous tax questions such as, “Is the benefit still income tax free? Does the payment of benefit cause estate inclusion?”
Unfortunately, there is no specific guidance from the Internal Revenue Service as to the tax effect of long-term care benefits for trust ownership. This is true whether the rider is classified as a reimbursement or indemnity rider. Most commentators raise concerns about using a reimbursement style rider in a trust because bills for the long-term care of the insured are submitted to the insurance company by the trust (which owns the policy). The insurance company then pays the bill to the care provider for expenses incurred on behalf of the insured. This chain of events provides a direct monetary benefit from the trust to the insured and likely will cause estate inclusion.1 In contrast, there is less concern with an indemnity style of rider because payment is not tied to expenses of the insured and the benefit is paid directly to the owner of the contract, which in the case of trust ownership would be the trustee. The payment is essentially an acceleration of death benefit.
Planning Considerations – Fund the trust using separate property. When funding a SLAT, it is important that the donor spouse use only his/her separate assets. If any contributions to the trust are from the beneficiary spouse, the beneficiary spouse would be treated as grantor of the trust. Their status as both grantor and beneficiary may cause inclusion of the trust property within the beneficiary spouse’s taxable estate. Some commentators suggest that it is best to organize SLATs in DAPT (domestic asset protection) states to protect against such slip-ups. It is particularly important to take preventative measures to avoid contributing assets of the beneficiary spouse in community/marital property states where both spouses are considered to own half of all community property. This may be accomplished by partitioning assets for contributions to the trust.
Avoid using split gift election when funding the SLAT – Some have suggested that one spouse can make the entire gift by having the beneficiary spouse make a split gift election.
Split gift is not allowed when the consenting spouse is a beneficiary of the trust unless the beneficiary spouse’s interest in the trust is ascertainable, severable, and de minimums.
One SLAT per couple is preferred to avoid “reciprocal trust doctrine” concerns – At first blush, it may appear that with each spouse establishing a SLAT for the other’s benefit, you can achieve greater benefit. However, spouses making mutual trusts must proceed carefully to avoid running afoul of the reciprocal trust doctrine.This doctrine applies to interrelated trusts that have substantially identical terms and are part of the same transaction or plan. This doctrine assumes that each spouse established a trust for his or her own benefit, thus resulting in estate inclusion for each spouse. If the client can get by creating one SLAT, that is preferable. But, if the client wants two trusts, it is possible to avoid the reciprocal trust doctrine by making the two trusts sufficiently different.
Estate concerns where SLAT beneficiary appoints trust asset for benefit of original donor spouse – When the trust includes a provision giving the beneficiary spouse (or other beneficiaries) the power to appoint the trust assets back to the original donor spouse, the IRS might seek to include the trust in the donor spouse’s estate under either IRC §§ 2036 and 2038. This is especially true if it can be established that there is an implied agreement that the beneficiary spouse would leave the trust back to the original donor spouse.
Possibility trust may be subject to donor’s creditors – Despite the tax rules, for state law purposes, where the trust includes a provision giving the beneficiary spouse the power to appoint the trust assets back to the donor spouse, the trust may be treated as a self-settled trust and subject to the claims of the donor’s creditors. If the donor’s creditors can reach the trust assets, that would cause estate inclusion in the donor spouse’s estate. Therefore, it may be important for the beneficiary spouse to exercise the limited power to establish a new trust in a self-settled trust state.
In Summary – The SLAT can be a useful planning technique to help provide estate tax-free death benefits to heirs, while also providing indirect asses to trust assets. However, the law is still developing. Consequently, clients and their advisors should consider the risks.
Where a trust has not yet been established it is possible to begin the medical underwriting process with the insurance carrier by submitting what is often referred to as a “trial application.” The purpose is to verify insurability. Premium should not be collected at this point. Since premiums are not collected the insured will not have coverage, but this is necessary to avoid estate inclusion.
Draft Trust Agreement
Trusts are complex legal documents which must be drafted by an attorney.
Care should be taken when selecting a trustee. Factors to consider include:
- The trustee may be an individual or a corporation authorized to exercise trust powers (such as a bank or trust company).
- The insurance company will usually not permit the insurance producer be the trustee.
- The insured must not be the trustee if the objective is to avoid having the life insurance included in the insured’s estate.
- Neither insureds should be the trustee if the policy is a second-to-die contract. A spouse of an insured may be a trustee on an individual life policy.
- The trustee and the personal representative of the estate should not be the same person because conflicts may arise upon death.
Special efforts should be made to make sure the trustee is aware of the Crummey withdrawal requirements and that they are aware of their fiduciary responsibilities.
Some of the responsibilities of the trustee regarding the insurance policies in the trust include:
- Notifying the beneficiaries of the contributions (“Crummey” withdrawal notices), if applicable
- Paying the premiums
- Managing and accounting for trust funds
- Periodic review of insurance policies
Acquire Trust’s Federal Tax Identification Number
The attorney or trustee may obtain the federal employer identification number for the trust by filing Form SS-4.
The insurance company will usually want the federal tax identification number assigned to the trust. The trustee should use the number in opening any trust bank account. The trustee should use this number on any required fiduciary income tax return for the trust for any year.
Establish Trust Bank Account
The trustees must open a bank account in the name of the trust. Normally, the account should be non-interest bearing without charges (so that a trust tax return is not required).
The account should contain enough funds to permit the account to remain open (without excessive bank charges) between premium due dates.
Formal Policy Application
The trustee, not the insured, should apply for the policy. The trustee of the trust should be listed as the owner and beneficiary of the policy. If there are multiple trustees, all trustees must sign the application unless terms of the trust agreement or state law specifies otherwise.
If the insured applies for the policy and later gifts it to the trust, the death proceeds will be included in his/her estate if he/she dies within three years of the transfer.
Many insurance companies will require the trustee sign a trustee statement or provide a copy of the executed trust agreement. The trust federal tax identification number should be used when completing the tax certification portion of the application.
All premium notices and other correspondence relating to the policy should be sent to the trustee of the trust.
Transfer of an Existing Policy
Your licensed financial professional will have forms that the insured can use to transfer ownership of the policy to the trust.
Before making the transfer, it should be determined whether the transfer will have any gift tax consequences. The attorney will need to know the value of the policy and the history of the insured’s prior taxable gifts (if any) to determine the gift tax consequences. Your licensed financial professional can obtain the policy value from the service office of the insurance company.
If the transfer of the policy to the trust is structured as a gift, the insured must live three years after the date of the transfer to prevent the policy from being included in the insured’s taxable estate.
Gifts to the Trust
The grantor(s) should gift cash to the trust to allow the trustee to pay the policy premiums and administrative costs.
The gift to the trust should be by check payable to the trustee and should be made far enough in advance of the premium due date to enable notice to the beneficiaries.
If the spouse is a beneficiary of the trust (single life policies only), then each gift to the trust must come from an account that is in the insured’s name, not an account held jointly with the spouse. If the spouse is a beneficiary, the spouse should not make a gift to the trust. In community property states, the grantor should gift cash that is his/her separate property to the trust.
Gift Tax Return: An annual gift tax return (Form 709) must be filed for each year in which the following occurs:
- Annual gifts to the trust are not covered by withdrawal rights of beneficiaries (i.e., the gifts exceed such rights).
- The insured’s gifts, when aggregated with other gifts from the insured to the same beneficiaries during the calendar year, exceed the annual gift tax exclusion, ($15,000 per donor in 2020, indexed).
- The insured and his/her spouse are electing to “split gifts” for gift tax purposes, thereby increasing the amount that can be gifted to the trust without gift tax consequences.
If a gift tax return is required, it must be filed by April 15 of the following year.
Crummey Withdrawal Notices
For each cash contribution to the trust the beneficiaries must be notified of their right to withdrawal the cash contribution when the objective is to have the gift qualify for the gift tax annual exclusion. The trustee should send out written notices to the beneficiaries (or their guardians) apprising them of their withdrawal rights.
- Regular written notices should be given to the beneficiaries.
- Notices should be sent in duplicate. The beneficiaries or their guardians should sign both copies, keep one and return the other to the trustee.
- The trustee should keep records of all notices to substantiate that they were given.
Although it is highly unlikely, if a beneficiary exercises a withdrawal right, the trustee must distribute an amount from the trust equal to the amount properly demanded.
Trustee’s Payment of Premium
The trustee should pay premiums due on policies owned by the trust from the trust bank account. Premium payments made from gifted funds should normally not be made before the expiration of the beneficiaries’ Crummey withdrawal period. However, if any trust-owned policies are being paid by the client’s employer on a group term policy, those premiums may be paid directly to the insurance company.
Given the amount that an individual can give away without incurring gift taxes is at a historic high and the prospect that in the near future this amount could decrease significantly many of your high net worth clients may be considering significant lifetime gifts this year. There may never be such an opportunity again, but it’s important to start early in the year. Understanding the steps to making a gift enables you to help keep the process moving forward.
Estimate the approximate value of the estate.
• Approximate the value of the estate and the assets to be transferred out of the estate.
• The value of the assets should be based on their fair market value.
• Depending on the assets in the estate, the client’s CPA, or qualified appraiser should be able to make this determination.
Identify the assets most advantageous to gift.
• Selection of the appropriate assets is important. Generally, high basis assets that have significant growth potential should be gifted. Life insurance and income-producing assets are frequently selected.
• Advisors typically involved in this step are the client’s CPA, attorney, and insurance professional.
Project the potential estate tax savings of making a gift.
• The client will typically want to understand the tax benefit of making a gift. This will typically require projecting the estate tax liability with and without a gift.
• DBS can assist by conducting an estate tax analysis, but the client may ultimately want the numbers confirmed by either their CPA or legal tax advisor.
Determine the value of the asset to be gifted.
• If the asset to be transferred by gift is hard to value asset, such as a business interest, a qualified appraisal should be acquired; otherwise the client’s CPA should be able to determine value.
• The value should be its fair market value on the date of the transfer
Transfer ownership of the property.
• Title on the asset must be changed. The complexity of changing the title depends on the asset.
• Gift is complete when the donor gives up the ability to control the disposition of the property and the recipient accepts the gift.
Ensure the estate retains sufficient liquidity to pay taxes and other nontax liquidity needs.
• If potential federal or state tax liability still remains after the gift, or if other obligations exist such as funding a business buyout, equalizing the estate between business and nonbusiness heirs, charitable endowment, or providing for an individual with special needs consideration should be given to acquiring life insurance outside of the estate in an ILIT or other vehicle.
• Potential sources of paying the premium include direct gifts to ILITs offset by “Crummey” provisions, previously transferred income producing property, and private or commercial premium financing.
• The time involved in drafting a newly established ILIT, and arranging some of the more sophisticated premium payment structures such as commercial premium financing can be lengthy and should be implemented at least the same time as starting the medical underwriting process.
• In addition to the insurance professional, the client’s legal advisor and perhaps CPA will need to be involved.
File gift tax return for the transferred property.
• In general, all gifts except annual exclusion gifts of $15,000 or less per recipient and certain transfers to educational or medical institutions, charitable organizations, and U.S. citizen spouses must be reported on Form 709.
• Form 709 is usually filed by April 15th following the year of the gift.
• The client’s CPA or tax attorney usually complete and file this return.
A careful review of a client’s tax returns can provide insight into their insurance and financial planning needs. A review of the lines on a tax return can lead to conversations about:
• Basic needs analysis and college funding
• Retirement and extended care planning
• Legacy & charitable planning
• Business planning
Additionally, comparing last year’s tax return to this year’s tax return can shed light on planning opportunities due to major changes in the client’s life.
Form 1040 was redesigned in 2018. Now, everyone will use Form 1040* and Forms 1040A and 1040EZ will no longer be used. The new Form 1040 is shorter, but not necessarily simpler. The new form has numbered schedules in addition to the lettered schedules. Many people may only need to file the 1040 Form and none of the schedules. However, more complex returns may need to file one or more of the schedules.
Tax planning remains an essential aspect in any work with clients at all income levels. A review of your client’s tax return should allow you an opportunity to assist them in addressing decisions that can impact their overall income tax, accumulation, and retirement planning. Life insurance provides features that can help clients particularly in a changing tax environment.
This guide focuses on Form 1040, and Schedule A. The guide is designed to help you review and uncover opportunities within your client’s income tax return. In addition to paying attention to what is disclosed in the client’s tax return, note what is missing. This may also result in opportunities.
Level #1: Transfers Not Subject to Tax
There are several transfers that fall outside federal gift taxation. You can make the following transfers without facing a gift tax:
- Anything given to a U.S. citizen spouse as long as the transfer qualifies under the marital deduction1
- Donations to qualified charitable organizations made in a manner qualifying for the charitable deduction
- Political donations
- Tuition payments made directly to an educational institution for someone else
- Funds paid directly to a medical institution or health insurance provider on behalf of another
Level #2: Annual Exclusion Gifts
Under the annual exclusion an individual can make so called “present interest” gifts of up to $15,000 to an unlimited number of recipients per year without needing to file or report the gifted amount. A couple can give up to $30,000 per beneficiary per year. Consequently, a significant amount can be given away over a number of years where there are multiple beneficiaries.
Level #3: Gifts Sheltered by Exemption
In addition to annual exclusion gifts, an individual can make lifetime gifts with a cumulative total up to the exemption amount without paying tax but will need to file a gift tax return. For 2021 the exemption is $11.7 million. However, the current exemption is scheduled to expire on January 1, 2026 decreasing to $5 million per person (indexed) and may expire sooner if President Biden is able to achieve his campaign proposal. Fortunately, gifts today that are greater than the exemption amount available at death are grandfathered. Thus, wealthy individuals should give serious consideration to making large exemption gifts.
Level #4: Gifts Subject to Tax
Once an individual’s cumulative lifetime gifts exceed the exemption amount federal gift tax will be due. Gift and estate tax rates are the same, but gifts will often result in heirs receiving a larger inheritance because a gift transfer:
- Removes both the appreciation and income from being subject to federal and state estate tax
- Eliminates property from being subject to state death tax, where applicable, without subjecting the property to a state level gift tax
- Is subject to less tax because property used to pay the tax is not subject to gift tax, while property used to pay estate tax is subject to estate tax
No unlimited marital deduction is allowed for gifts to a noncitizen spouse. However, there is a limited exemption if the transfer would otherwise qualify for the marital deduction. For 2020 a maximum of $157,00 per year (indexed) spousal gifts can be given to a non-citizen spouse without being subject to gift tax. 2 Only one state has a state level gift tax – Connecticut. This material does not constitute tax or legal advice. Clients should consult their own advisors. As always, financial professionals and their clients are strongly encouraged to work with the client’s attorney and CPAs to review financial, estate and business planning strategies when considering the potential impacts of the new law and determining the appropriate action based upon the client’s specific facts and circumstances.