Estate Planning Doesn’t Need To Be Complicated To Be Effective

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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 While they are aware that the estate tax is scheduled to be repealed in 2010, they also know the repeal is temporarycurrently scheduled to last for only one year.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.

Fifth, Josephine was surprised to learn that the cash value of a life insurance contract grows on a tax-deferred basis and distributions can be taken by the trustee up to cost basis without triggering taxable gain. Because the credit shelter trust is taxable at the highest individual income tax rates, Josephine and the trustee were excited to find a trust investment that was tax-deferred.

Sixth, Josephine will be able to use her remaining unified credit ($400,000 in 2002) to establish a QPRT (see NU, Aug. 27, 2001) to transfer her personal residence to her daughter at a considerable gift tax discount. In addition, her annual exclusions can be used to provide her daughter with cash for current living expenses. In this instance, simplicity appeared to be the best solution.

Now that Ive explained why using the credit shelter trust created at Sylvesters death as a funding source for life insurance was such a great planning idea for Josephine, Ill go back and provide a little more detail on credit shelter trusts and what needs to be considered when using them for life insurance planning.

Beginning next year, an individual can leave $1 million ($675,000 in 2001) of property without paying gift taxes or estate taxes. This amount is known as the “applicable exclusion amount”formerly the “unified credit equivalent.” Most married couples are aware of this tax provision and plan their estates to take advantage of it. Upon the death of the first spouse, the deceased spouses estate is divided into two shares. One share, the “applicable exclusion amount,” will often pass into a “Credit Shelter Trust”sometimes referred to as a “Family Trust” or “By-pass Trust.” The other share will ordinarily pass outright, or in trust, to the surviving spouse in a manner that qualifies for the “unlimited marital deduction.” Thus, because of the applicable exclusion amount and the unlimited marital deduction, estate taxes are typically deferred until the death of the surviving spouse. As a result, estate planning is often ignored until after the first spouses death.

Credit shelter trusts have been a popular estate planning concept for many years. As a result, countless credit shelter trusts are currently in existence. In many instances, these trusts have a significant amount of assets. Assets held in a credit shelter trust are not subject to estate taxes at the surviving spouses death. Because assets held in a credit shelter trust ordinarily pass to children (and/or grandchildren) after the death of the surviving spouse, a credit shelter trust can be an ideal way to fund the purchase of insurance on the surviving spouses life.

In most instances, a credit shelter trust can own insurance on the surviving spouses life. However, the credit shelter trust should not own insurance on the surviving spouses life if it would cause the surviving spouse to have any “incidents of ownership” with respect to the policy. To determine if the surviving spouse would have incidents of ownership in a life insurance policy, the following items should be considered:

Trustee Authority to Purchase Life Insurance. Most well-drafted trust documents contain language specifically authorizing the trustee to purchase life insurance. However, even if life insurance is not specifically mentioned as a permissible trust investment, this will not ordinarily prohibit the credit shelter trust from owning it. Most trust documents contain extremely broad trustee investment powers that give the trustee virtually unlimited investment discretion. Moreover, trustees have liberal authority to make investment decisions in most states. Usually, the purchase of life insurance is a permissible trust investment as a matter of trustee discretion.

Surviving Spouse as Trustee. When the surviving spouse is serving as trustee, estate tax inclusion can ordinarily be avoided by allowing the surviving spouse to resign as trustee prior to purchasing the life insurance policy. Resignation after the policy is purchased would subject the insurance policy to the “three year rule”meaning that the surviving spouse would need to live at least three years after resignation to keep the insurance proceeds out of his or her estate.

Surviving Spouse as Trust Beneficiary. The surviving spouse will usually be a beneficiary of the credit shelter trust. The surviving spouses right to receive distributions of trust income should not cause the death benefit to be included in his or her estate. In PLR 9748020, the IRS ruled that a credit shelter trusts purchase of life insurance on the surviving spouse did not result in estate tax inclusion. Under the facts of that PLR, all income from the credit shelter trust was payable to the surviving spouse and trust principal could also be distributed to the surviving spouse to provide for the spouses health, support, and maintenance.

Special Powers of Appointment. In some instances, a surviving spouse is given a “special power of appointment” over assets held in a credit shelter trust. For example, the trust may provide that trust assets will pass to children upon the surviving spouses death unless the surviving spouse otherwise directs in his or her will. A special power of appointment held by a surviving spouse will ordinarily cause estate tax inclusion when the credit shelter trust owns insurance on the surviving spouses life. If planning is done within a short time after the first spouses death, it may be possible for the surviving spouse to disclaim his or her special power of appointment. Even if the power cannot be disclaimed, state law may allow the “release” of the special power of appointment.

“Five and Five” Powers. In some instances, a surviving spouse may be given the right to withdraw an amount equal to the greater of $5,000 or 5% of the trust balance. If the trust has sufficient assets other than life insurance to satisfy the right of withdrawal, then the “five and five” power may not cause estate tax inclusion. However, if the trust does not have sufficient other assets, then the surviving spouses “five and five” power may be an incident of ownership that would cause estate tax inclusion.

When a married couple defers payment of estate taxes until the surviving spouses death through the use of a credit shelter trust and the unlimited marital deduction, ownership of life insurance by the credit shelter trust can provide advantages not available with an ordinary ILIT. Unlike an ILIT, the surviving spouse need not fund the credit shelter trustit already contains assets outside of his or her estate. Therefore, there is no need to limit gifts to the annual gift tax exclusion or give trust beneficiaries a “Crummey” notice prior to purchasing life insurance. Unlike an ILIT, the insured may have access to the policys cash value. However, because assets already outside of the insureds taxable estate are used to purchase insurance inside a credit shelter trust, the insureds taxable estate is not reduced. An ILIT and a credit shelter trust are not always alternatives. In addition, a “Private Split Dollar” arrangement between a credit shelter trust and an ILIT can be used to leverage the surviving spouses lifetime gifting program. The chart on this page compares owning insurance inside a credit shelter trust and an ILIT.

Owning life insurance inside a credit shelter trust is an excellent way for the surviving spouse to leverage his or her spouses applicable exclusion amount. Unlike other possible trust investments, life insurance will ordinarily provide substantial growth regardless of the length of time the surviving spouse lives.

In some instances, ownership of insurance by a credit shelter trust may be more advantageous than ownership by an ILIT or adult children. In other instances, a credit shelter trust may be a source of premium dollars in addition to an ILIT funded with annual exclusion gifts. The surviving spouses attorney should review the credit shelter trust carefully to make sure the insurance policy will not be included in the surviving spouses estate.

This case was a great reminder for me that “advanced marketing” is sometimes most effective when kept simple. Estate planning isnt always about finding the most unique or “cutting-edge” solution. Instead, it is about finding the best solution for the client. In this instance, using the credit shelter trust was simple enough for Josephine and her daughter to appreciate the benefits. And, it accomplished the objectives of her advisors by avoiding current gift tax liability.

, J.D., CPA, is senior counsel, director of advanced markets and small-business insurance, Manulife Financial, Boston. He can be reached via e-mail at Randy_Zipse@manulife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 29, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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