Survivorship Life For the Squeamish

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).