Estate Planning Doesn’t Need To Be Complicated To Be Effective
Recently, an agent asked me for some estate planning advice for a fairly typical prospect. Josephine is 77-years-old. Her husband, Sylvester, died almost 10 years ago. At the time of his death, Sylvester and Josephine had a sizeable estate of approximately $3 million. At the advice of their attorney, Sylvester had a typical “A/B will” that left $600,000 to a credit shelter trust and the remainder of his estate to a marital (QTIP) trust for the lifetime benefit of Josephine.
Because Sylvester wanted to be certain that Josephine would be adequately cared for, both trusts direct the trustee to distribute all trust income to Josephine. Trust corpus is available for her health, education, maintenance, and support.
Josephine and Sylvester shared a happy, but conservative life together. Since his death, Josephine has continued with her modest lifestyle. Because of her conservative nature and the trustees successful investment strategy, Josephines assets have grown considerably since her husbands death. Currently, her estate consists of nearly $1 million of individually owned assets (largely consisting of her personal residence), $5 million in the QTIP trust, and $2 million in her credit shelter trust. Several years ago, she made a gift of $600,000 in real estate to her childusing her lifetime gift tax exemption.
Josephine and her daughter (her only child) are concerned about the impact taxes will have on Josephines estate. While they are aware that the estate tax is scheduled to be repealed in 2010, they also know the repeal is temporarycurrently scheduled to last for only one year. Under current law, if Josephine should live past 2010, estate taxes will take approximately one-half of her estate. In rough terms, the estate tax liability on her current estate (ignoring future appreciation) is nearly $3 million.
Josephine and her advisors were considering life insurance as a means of protecting her estate against taxes. However, the $3.5 million in coverage they are considering has an annual premium of more than $150,000. Because Josephine has already used $600,000 of her lifetime gift tax exemption (the exemption will grow to $1 million in 2002 as a result of the recent tax legislation), she can only pass an additional $400,000 free of gift taxes. With only one child and two grandchildren, it does not appear that she can create an irrevocable life insurance trust and purchase the desired amount of life insurance protection without considerable gift tax cost.
Because of the gift tax concerns, the agent called me looking for possible solutions. How could Josephine fund the insurance program without considerable current gift tax liability? Several ideas were considered.
What about private split dollar? It was rejected because the economic benefit costs at age 77 for a single life policy were still considerably more than the available annual exclusions.
What about premium financing? Sure, it has its advantages. But, Josephines daughter and her tax advisors were not comfortable with the interest rate risk associated with a premium financing program where the interest rate was annually adjustable. Interest rates are very attractive today, but what about the future? If interest rates should increase, the principal and interest payable to the lending source could substantially deplete the coverage needed by the family. Although premium financing was given a lot of thought, it was ultimately rejected.
So, what was the solution? In this case, the best alternative was so simple that Josephines advisors had failed to even consider it. Why not have the policy owned by the credit shelter trust that was created at Sylvesters death? After all, the credit shelter trust was already funded with $2 million in assets that were outside of Josephines taxable estate.
Rather than use the entire credit shelter trust amount immediately to single pay the premium, we settled on a premium schedule of $400,000 per year for five years. Assuming that Josephine was a standard underwriting class (non-smoker), the credit shelter trust could purchase more than $3.5 million of coverage.
What did this arrangement accomplish for Josephine?
First, she was able to get $3.5 million of life insurance coverage outside of her estate without any gift tax liability.
Second, by owning life insurance inside of the credit shelter, the trust would no longer earn ordinary incomethus avoiding taxation at the highest marginal individual income tax rate (over 40% with state taxes considered).
Third, since the trust no longer had ordinary income, no annual distributions were required to be made to Josephinethus stopping the required distributions that were increasing the size of her individually owned taxable estate. After all, distributions from the credit shelter trust to Josephine represented property that was migrating from an estate tax-free environment to Josephines taxable estate.
Fourth, Josephine is a beneficiary of the credit shelter trust. While she doesnt anticipate needing assets in the credit shelter trust for support during her lifetime, she has not given up the right to receive distributions from the credit shelter trust. As long as someone other than Josephine is serving as the trustee of the credit shelter trust, the trustee should be able to make distributions from the trust to Josephine if needed for her health, education, maintenance, and support.