Ideas For Managing Wealth

In B Trusts With Life Insurance

Estate planning with life insurance today is focused on managing wealth and risk as much as it is on saving estate taxes. One idea gaining popularity is the idea of using life insurance to manage wealth in exemption equivalent trusts. Financial advisors can play an important role by providing information to the trustee and legal advisors about variable life insurance products.

Under current law, a person can pass any size estate to his or her spouse without federal estate and gift taxes because of the unlimited marital deduction. In addition, each taxpayer also has a nonrefundable credit against federal estate and gift taxes. In 2004 and 2005, at death, assuming no lifetime gifts have been made, a person may pass $1.5 million free from federal estate taxes. The amount protected is now commonly referred to as the “exemption equivalent amount.”

We know that inadequate estate planning can result in wasting a clients credit. For example, a couples estate plan may exist entirely of jointly held assets or a simple will leaving all assets to the surviving spouse. When the first spouse dies, all assets are transferred to the surviving spouse via the marital deduction and, therefore, estate taxes at the first death are avoided.

However, when the surviving spouse later dies and passes the combined estate to his or her heirs, the federal estate and gift tax will be imposed on the transfer of assets. At that time, only the second spouses federal estate and gift tax credit will be applied to reduce estate taxes. The first spouses credit was wasted.

A common estate planning technique used to ensure that each spouse fully utilizes his or her credit is the credit shelter trust (now often referred to as the exemption equivalent trust or “B Trust”). In a typical planning scenario, when the first spouse dies, the exemption equivalent is placed into the B trust. The balance of the estate usually passes to the surviving spouse via the unlimited marital deduction, perhaps to a marital trust (“A Trust”) for the benefit of the surviving spouse.

Under typical B trust arrangements, the surviving spouse is entitled to all income from the trust for life. Usually, the surviving spouse will not be entitled to any of the principal of the trust. In some situations, some flexibility may be drafted into the trust, allowing the trustee to distribute principal to the surviving spouse for health, support, maintenance or education.

Upon the death of the surviving spouse, the trusts principal and the appreciation in those assets will pass to the principal beneficiaries free from federal estate tax.

The life insurance planning opportunity often discussed arises at the first death, when the first spouses B trust is funded. The primary issue for the trustee is how to manage the assets in the B trust. In general, the trustee has a fiduciary duty to balance the needs of the surviving spouse with the duty to preserve principal for the remainder beneficiaries. In many cases, the trustee may invest in a mix of stocks and bonds to generate income for the surviving spouse while seeking to preserve the inflation-adjusted value of the principal.

Trustees should consider purchasing life insurance as an asset for B trusts where the trust language permits and especially where the surviving spouses income needs are met by other sources of income. Typically, the insured will be the surviving spouse. In all cases, the trustee will want to consult with legal counsel on whether and when to purchase life insurance in exemption equivalent trusts, and, if so, the trustee will need legal counsel and financial advice with respect to the amount of premium, face amount and type of policy that should be used.

Life insurance generally will be used to create leverage with respect to the exemption equivalent amount, or some portion of it, with the death benefit generated by the premium used to buy the insurance in trust. Also, life insurance generally will be used to help minimize the income tax liability to the trust. Trusts are subject to high income tax rates. Life insurance, with tax deferral on cash values, provides a method of managing the trusts income tax burden (see box for example).

In some cases, especially with regard to a younger insured, the trustee may want to direct the investment of the cash value in the life insurance. Moreover, the trustee seeks to minimize the tax burden to the trust with respect to any gains. In such a case, the trustee may seek to invest in variable universal life insurance. Variable universal life would allow for potential cash accumulation with tax-deferral inside the trust.

As is the case with all cash value life insurance, the accumulated cash value may be withdrawn or borrowed by the trustee. Assuming that the policy qualifies as life insurance under the Internal Revenue Code and is not a modified endowment contract, the trust will not be subject to income tax on any distributions not in excess of premiums paid, or on any loans from the contract, unless the policy lapses or is surrendered.

After making the withdrawal and/or loan from the policy, the trustee may distribute such funds to the surviving spouse pursuant to the distribution terms of the trust. Ultimately, the death benefit will be paid free of estate and income taxes because the asset is in the “B” trust.

The Role of the Financial Advisor

Financial advisors can and should play an important part in providing information to the trustee and legal advisors about variable life insurance products. Financial advisors must emphasize the risk of market declines as well as the potential rewards of market gains when using variable products. This creates an opportunity for the financial advisor to showcase his or her wealth management knowledge and skill in managing product selection and ongoing management of the underlying subaccounts to help maximize potential returns and to minimize the risk presented by potential market declines.

Regardless of the type of cash value life insurance selected, the “B” trust life insurance planning must be coordinated with the rest of the surviving spouses estate plan. Overall, the “B” trust planning opportunity can be one of the most powerful examples for the tax deferral, and estate and income tax-free death benefits life insurance may provide in estate planning today.

Brett W. Berg, JD, LLM, CLU, ChFC, is director of advanced sales for Nationwide Financial in Columbus, Ohio. He may be reached at bergb@nationwide.com


Reproduced from National Underwriter Edition, May 14, 2004. Copyright 2004 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.