Avoiding the Generation-Skipping Transfer Tax on Life Insurance Proceeds

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

Can arrangements for payment of the proceeds of life insurance and annuity contracts attract the generation-skipping transfer tax?

Yes. Regardless of what form an arrangement may take (whether, for example, the arrangement is a life insurance trust, an agreement with the insurer for payment of proceeds under settlement options, or an outright payment to a beneficiary), if an insured (or annuitant) transfers benefits to a “skip person,” generally, the insured has made a generation-skipping transfer.

For purposes of the generation-skipping transfer tax, the term “trust” includes any arrangement (such as life estates, estates for years, and insurance and annuity contracts) other than an estate that, although not a trust, has substantially the same effect as a trust. In the case of an arrangement that is not a trust but that is treated as a trust, the term “trustee” means the person in actual or constructive possession of the property subject to such arrangement.

The IRS has been given authority to issue regulations that may modify the generation-skipping rules when applied to trust equivalents, such as life estates and remainders, estates for years, and insurance and annuity contracts. The committee report states that such authority, for example, might be used to provide that the beneficiary of an annuity or insurance contract be required to pay any GST tax.

Regulations provide that the executor is responsible for filing and paying the GST tax if (1) a direct skip occurs at death, (2) the property is held in a trust arrangement, which includes arrangements having the same effect as an explicit trust, and (3) the total value of property subject to the direct skip is less than $250,000. The executor is entitled to recover the GST tax attributable to the transfer from the trustee (if the property continues to be held in trust) or from the recipient of the trust property (if transferred from the trust arrangement).

Regulations provide a number of examples that treat insurance proceeds as a trust arrangement. Where insurance proceeds held by an insurance company are to be paid to skip persons in a direct skip at death (a direct skip can occur whether proceeds are paid in a lump sum or over a period of time) and the aggregate value of such proceeds held by the insurer is less than $250,000, the executor is responsible for filing and paying the GST tax. Consequently, the insurance company can pay out the proceeds without regard to the GST tax (apparently, the insurance company could not do so if the executor attempts to recover the GST tax while the company still holds proceeds). When the value of the proceeds in the aggregate equals or exceeds $250,000, however, the insurance company is responsible for filing and paying the GST tax.

Can the transfer to an irrevocable life insurance trust of an amount used to make premium payments qualify for the generation-skipping transfer tax annual exclusion?

Yes.

If certain requirements are met, a transfer to an irrevocable life insurance trust can qualify for the annual exclusion (and thus avoid the generation-skipping transfer tax). A nontaxable gift, which is a direct skip, has an inclusion ratio of zero (i.e., it is not subject to GST tax). Nontaxable gifts are defined as gifts eligible for the annual exclusion (doubled if gifts are split between spouses), as well as certain transfers for educational or medical expenses. However, with respect to transfers after March 31, 1988, the nontaxable gift that is a direct skip to a trust for the benefit of an individual has an inclusion ratio of zero only if (1) during the life of such individual no portion of the trust corpus or income may be distributed to or for the benefit of any other person, and (2) the trust would be included in such individual’s estate if the trust did not terminate before such individual died. Thus, separate shares or separate trusts, as described in the preceding sentence, must be created for each such individual if premium payments are to be covered by the annual exclusion for GST tax purposes

How can the generation-skipping transfer (GST) tax exemption be leveraged using an irrevocable life insurance trust?

Leveraging of the GST tax exemption can be accomplished by allocating the exemption against the discounted dollars that the premiums represent when compared with the ultimate value of the insurance proceeds. However, in the case of inter vivos transfers in trust, allocation of the GST exemption is postponed until the end of an estate tax inclusion period (ETIP). In general, an ETIP would not end until the termination of the last interest held by either the transferor or the spouse of the transferor during the period in which the property being transferred would have been included in either spouse’s estate if that spouse died.

Of course, the transferor should be given no interest that would cause the trust property to be included in the transferor’s estate. Furthermore, the transferor’s spouse should be given no interest that would cause the trust property to be included in the transferor spouse’s estate if the transferor spouse were to die.

The property is not considered as includable in the estate of the spouse of the transferor by reason of a withdrawal power limited to the greater of $5,000 or 5 percent of the trust corpus if the withdrawal power terminates no later than sixty days after the transfer to the trust. Also, the property is not considered as includable in the estate of the transferor or the spouse of the transferor if the possibility of inclusion is so remote as to be negligible (i.e., less than a 5 percent actuarial probability). Furthermore, the ETIP rules do not apply if a reverse qualified terminable interest property (QTIP) election is made. Otherwise, if proceeds are received during the ETIP, the allocation of the GST exemption must be made against proceeds rather than premiums and the advantage of leveraging is lost.

Example 1.  G creates a trust for the benefit of his children and grandchildren. Each year he transfers to the trust $50,000 (to be used to make premium payments on a $2 million insurance policy on his life) and allocates $50,000 of his GST exemption to each transfer. Assuming G makes no other allocations of his GST exemption, the trust will have a zero inclusion ratio (i.e., it is not subject to GST tax) during its first twenty years. At the end of twenty years, G will have used up his GST exemption and the trust’s inclusion ratio will increase slowly with each additional transfer of $50,000 to the trust. If G died during the twenty-year period, the insurance proceeds of $2 million would not be subject to GST tax. Part of the $2 million proceeds may be subject to GST tax if G died in a later year. To ensure that the trust has a zero inclusion ratio, use of a policy that becomes paid-up before the transfers to trust exceed the GST exemption may be indicated.

Example 2. Same facts as in Example 1, except that the trust is created for G’s spouse, S, during her lifetime, and then, to benefit children and grandchildren. If the trust is intended to qualify for the marital deduction (apparently, other than if a reverse QTIP election is used), the valuation of property for purpose of the ETIP rule is generally delayed until G or S dies because the property would have been included in S’s estate if she died during the ETIP. Consequently, if the $2 million insurance proceeds are received during the wife’s lifetime, the GST exemption is allocated against the $2 million proceeds, and a substantial amount of GST tax may be due upon subsequent taxable distributions and taxable terminations from the trust. Because allocation of the exemption must be made against the proceeds if they are received during the ETIP, the advantage of leveraging enjoyed in Example 1 is lost.

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