Life insurance distributors increasingly are taking a closer look at the survivorship stand-by trust (SST) as a flexible alternative to standard estate planning techniques in the current climate of estate tax uncertainty.
This new-found interest in survivorship stand-by trusts is being driven by clients with significant taxable estates who are demanding flexibility to respond to the tax law changes.
In the post-EGTRRA world of quasi-estate-tax repeal, prospects are more reluctant to commit to irrevocable plans that may not make quite as much sense in a future world without federal estate taxes. EGTRRA–the Economic Growth and Taxpayer Relief Reconciliation Act of 2001–left many high-net-worth individuals in limbo about their estate planning.
These clients may have legitimate concerns about generating income sufficient to support their lifestyles. Or they may be concerned about the potential burden of federal estate and income taxes. They may be hesitant about locking up assets in an irrevocable trust due to the concomitant loss of control.
Into this quandary leaps the advisor, whose desire is to give clients what they want–lifetime income, estate liquidity, and tax relief–while retaining complete control of their estate. Some are discovering that the survivorship stand-by trust can play an important role in accomplishing their estate planing goals.
Designing and building a comprehensive estate plan that meets all the clients’ needs has always been both an art and a science. Clients often have estate planning goals that are fundamentally in conflict, and reconciling those goals is at the heart of an effective estate plan.
One of the first techniques that financial professionals frequently turn to for estate tax reduction and liquidity is the irrevocable life insurance trust, or ILIT, funded with a survivorship policy on husband and wife.
The clients make tax-free gifts to an irrevocable trust, which then purchases life insurance on the joint lives of the clients. The structure is familiar. The ILIT is named owner and beneficiary of the policy. Following the death of the insureds, the ILIT receives the death benefit. The ILIT may then lend money to the estate to pay death taxes and administration costs, thus solving the liquidity problem.
Alternatively, the ILIT may use the death benefit to purchase assets from the estate. If the estate needs no additional liquidity, the death benefit can be paid out directly to the trust beneficiaries or retained by the ILIT to finance long-term benefits for the deceased couple’s heirs.
While trust-owned life insurance fulfills the dual objectives of estate liquidity and tax relief, such benefits are not without their cost. The price of the creation of this multipurpose estate-tax-free fund is loss of income from the fund during life and loss of control at all times after its formation. Let’s look at how the ILIT keeps assets out of an estate and why it could create difficulties for our hypothetical clients.
To assure that trust-owned life insurance will remain outside the taxable estate of the grantors, all aspects of control over the policy and the trust must be in the hands of a third party trustee. The grantor/insureds must have no “incidents of ownership” in the policy, either as individuals or as fiduciaries of the trust (IRC Sec. 2042).
Generally the insureds will not possess any rights to income from the policy or the trust. Nor can they have the right to change beneficiaries. The benefits of the ILIT–estate liquidity and estate tax relief–are secured at the expense of access to trust values and control over trust assets.
Considering the Alternatives: Outright Ownership, or the SST
The insureds could jointly own the policy outright with rights of survivorship. During their lives they would have complete control over the policy values and could change ownership and beneficiaries at any time prior to the second death. At the second death, the policy would be fully includable in the surviving spouse’s estate and subject to estate taxes, an unhappy result.
The survivorship stand-by trust (SST) has far greater flexibility than an ILIT or outright ownership. The SST gives the clients control over the policy during the policyowner/insured’s lifetime that cannot be achieved with the ILIT, including access to cash values and control over beneficiary designations. With an SST, the policyowner retains the unfettered right to income-tax-free access to policy values during his life.
At the same time, the SST is designed to keep the ultimate death benefit in excess of the cash value out of the surviving spouse’s estate. Finally, no gift taxes are due on premium payments made during the policyowner’s life.
It’s important to note, however, that withdrawals and loans will reduce policy values and the death benefit and may have tax consequences. A reduction in the death benefit may cause the policy to become a Modified Endowment Contract (MEC). Distributions, including loans, from a MEC receive less favorable tax treatment than policies that are not classified as MECs. This also applies to distributions made within two years prior to the policy becoming a MEC.
How the SST Works
The survivorship stand-by trust is built by addressing the following issues: Policy Ownership and Benefi- ciary Designations. The SST begins with the purchase of a survivorship life insurance policy on husband and wife. The spouse with the shorter anticipated life expectancy–based on age, gender, and health concerns–is the applicant and initial owner of the policy. (For the purposes of this article we will assume that the husband predeceases the wife.)
The survivorship stand-by trust is named the primary beneficiary and contingent owner. Until the death of the husband (the policy owner), the SST stands by, waiting to receive the policy. At the husband’s death, the policy will pass by terms of policy contract to the contingent owner, the SST. The value of the policy included in the husband’s estate is limited to its cash surrender value.
Premium Payments. The policyowner/ husband must make all premium payments from his own separate property. In community property states, this can be accomplished with a community property waiver. It is important that his wife should not be considered a grantor of the trust. If she contributes property to the trust, and later receives income from the trust, all or a portion of the trust could be included in her taxable estate (IRC Sec. 2036).
It is therefore important to plan for the possibility that the husband may no longer be able to make gifts to the SST, such as in the case of his premature death. It may be advisable to include a term policy on the husband’s life in the SST. If that option is selected, it is advisable to establish the SST during the husband’s life to hold the term policy outside his taxable estate. Another option is to select a survivorship policy that requires no further premiums following the death of the first insured.
The Survivorship Stand-by Trust. The SST in most cases is created in the will or living trust of the policyowner/insured, and therefore can be changed during his lifetime. This feature adds to the flexibility of the concept. The two major purposes of the SST are to keep the trust principal out of both spouses’ estates and to pass assets to children and grandchildren.
In other words, this SST acts as a credit shelter trust.
In the most common SST design, the beneficiaries of the trust are limited to children and grandchildren. As an insured under a policy held in trust, the surviving spouse must have no incidents of ownership in the policy to avoid inclusion in her estate under IRC Sec. 2042.
Consequently, the surviving spouse should not be named sole trustee of the SST. Nor should she have the right to demand income from the trust.
In many cases this would not be a problem because the surviving spouse would normally look to the assets of the marital trust for her support; however, it could become necessary to access the bypass trust if the marital trust assets are depleted. If there is any thought that this may be a concern, an independent trustee could be given the discretionary right to distribute trust income to the surviving spouse. This potential problem should be anticipated when the SST is originally drafted.
At the death of the surviving spouse, the death benefit is paid to the SST. Trust assets can then be distributed to the children and grandchildren, or continue to be held in trust for their benefit. Funds could also be loaned to the estate, or the SST could purchase assets from the estate if the estate needs cash to pay estate taxes.
Estate Tax Consequences. At the husband’s death, the cash surrender value of the policy will be included in his estate. As long as this value is less than the estate tax applicable exclusion amount, it will be sheltered from estate tax.
If the cash surrender value coupled with any other assets that do not qualify for the marital deduction exceed the available applicable exclusion amount, estate tax will be due and payable on the excess within nine months of his death. At the death of the surviving spouse, no estate tax is due on the policy because it was never owned by the wife. Moreover, if structured properly, she also never held any incidents of ownership that would have caused inclusion in her estate.
Gift Tax Consequences. During the husband’s life he owned the policy, so any premium payments made by him from his separate property are not gifts. The wife should avoid making gifts to the SST to avoid any inclusion in her estate as described above.
Planning for an Unexpected Order of Death
The effective use of the SST as described above is based on the assumption that the husband will die first. While this may be actuarially sound, in a number of cases it will be the wrong assumption. What happens if the wife dies first, and how do we plan for it?
Wife Predeceases Husband–Estate Tax Treatment If the wife predeceases her husband, no portion of the policy will be included in her estate. She never owned it, nor are any incidents of ownership attributed to her under IRC Sec. 2042.
If the husband then dies while owning the policy, the entire death benefit will be included in his estate. To avoid this problem, he should gift the policy to the SST as soon as possible. If he lives for three years following the gift to the SST the policy will be removed from his taxable estate. If he dies within the three-year period, the entire death benefit will be included in his taxable estate (see IRC Sec 2035). It is this risk of the husband’s death within three years following the death of the wife that clients must be made aware of when considering an SST.
Wife Predeceases Husband–Gift Tax Treatment Following her death, the husband gifts the policy to the SST, which must now be funded if that has not previously occurred. The husband’s taxable gift is equal to the value of the policy.
The gift can be sheltered from gift tax by using gift tax annual exclusions or a portion of his gift tax applicable exclusion amount.
Simultaneous Death If the insureds die simultaneously, or in such circumstances where it is not possible to discern which spouse dies first, it’s important to know what the life insurance policy provides as the order of death. You will want to make sure that in the event of simultaneous deaths the SST receives the proceeds.
Flexibility has always been an important element of an estate plan. It is difficult, if not impossible, to anticipate the many changes that could and do occur in any family’s overall financial picture, its tax status, or even the identity of all the family members over the course of many years.
An irrevocable life insurance trust can be an important element of an estate plan, but it may make some sense to consider other ways to provide the flexibility that clients rightly seek.
The SST works best if the spouses die in the anticipated order; however, it is possible to plan for the alternative. While there is some risk associated with the plan, the survivorship stand-by trust offers a combination of access to lifetime income, estate liquidity, tax relief, and the ability to control assets during the policyowner’s life that cannot be achieved by an ILIT or outright ownership of life insurance.