Whether or not permanent repeal of the estate tax becomes reality, the use of trusts for estate planning purposes will still enjoy broad support among high-net-worth clients and business owners, according to a panel at LIMRA International’s Advanced Sales Forum, held here last month.
Additionally, the speakers noted, certain techniques should be explored aggressively in the current tax environment, including “trust-stuffing,” generation-skipping dynasty trusts, 419(e) plans and standby trusts.
“There are three predators of wealth: the IRS, creditors and spouses or ex-spouses,” said Thomas Commito, vice president of business and industry development at Lincoln Financial Distributors, Philadelphia, Pa. “Most people are better off putting their property in trust rather than transferring their property outright because of the asset protection [afforded by the trust].”
One way to maximize that protection, Commito suggested, is by “stuffing” the trust, i.e., leveraging a combination of estate planning vehicles that permit the client to put the most amount of money into trust without using the gift tax exemption.
The technique’s principal steps include funding a grantor trust in the form of an Irrevocable Life Insurance Trust using annual exclusion gifts and premium financing of an interest-only note; the ILIT’s establishment of a “reverse” grantor-retained annuity trust; the grantor’s buyback of the note at a discounted basis; and the purchase of additional life insurance.
Commito illustrated the technique’s power using the example of premium-financed $1 million cash loan and $44,000 in annual exclusion gifts ($11,000 for each of four Crummy beneficiaries) to the trust in exchange for a long-term, interest-only promissory note or “balloon note.” Using an applicable federal rate (AFR) of 4.28%, the note matures after a term of years, typically 10 to 20 years beyond the life expectancy of the grantor.
“The reason for going beyond,” said Commito, “is because if [the grantor] has to pay the principal on the note, he’ll want to use the policy’s death proceeds for that purpose. If however, the grantor dies before the term of the note, a provision in the note may permit the trustee to prepay the principal without penalty.”
The trust then establishes a “reverse GRAT,” so named because the GRAT accelerates annuity payments using “commutation” (prepayment) power, thereby disqualifying the GRAT for tax purposes. But because the trust can sell the remainder interest to the grantor at fair market value ($1 million), though the annuity or tax value is zero (because of the IRS disqualification), the reverse GRAT doubles the value of remainder assets to $2 million.
The grantor in Commito’s example then uses this amount to buy a second-to-die universal life policy. At the death of the second spouse, the policy yields a death benefit of $18.3 million.
Avoidance of gift tax costs within the context of dynastic planning was also the focus of a presentation by Deborah O’Neil, vice president of Paramount Planning Group, a New York-based division of AXA Financial. O’Neil cited several techniques–the grandchild’s trust, “blended ILIT,” non-taxable gifts trust, a solution that pairs an ILIT with the non-taxable gifts trust and the “HEET” trust–that enable clients to avoid the gift tax and the generation-skipping transfer (GST) tax.
The first method, which is for the benefit of a single grandchild, funds the trust with annual exclusion gifts that qualify as direct skips (a skip person being two or more generations below the donor or 37 1/2 years younger if not related to the donor).
The gifts purchase insurance on the grandparent’s or grandchild’s life. The trustee manages principal distributions and income payments to the grandchild beneficiary. Because the grandchild has a demand right (or Crummy power) over the trust asset, he or she can withdraw trust funds without incurring a gift tax.
The vehicle, said O’Neil, protects the grandchild from claims by “future creditors, predators and spouses” and, using insurance, the assets grow tax-deferred. But she observed that other solutions are needed if the assets are to pass to multiple generations, ad infinitum.
To that end, an ILIT may be used. In O’Neil’s example, each of two spouses makes gifts to the ILIT using their annual gift tax exclusion amount ($11,000 per donee). Then, tapping their combined $3 million GST tax exemption, they make additional gifts to purchase life insurance for both skip and non-skip beneficiaries.
A third option, the Health Education Exclusion Trust, or HEET trust, lets individuals create a trust to pay beneficiaries’ health and education expenses that qualify under IRC section 2503(e). The trust, O’Neil observed, can continue for multiple generations without invoking the GST.
But because the HEET trust would violate the rule against perpetuities for distributions that don’t qualify under 2503(e), O’Neil advised creating a second trust to cover expenses not related to health and education, thereby maximizing leverage of the GST exemption.
“The best [solution] is to try a blend of trusts, taking advantage of the GST exemption only where necessary,” said O’Neil. “That way, no out-of-pocket gift taxes are paid.”
Another tax-advantaged vehicle for covering post-retirement medical expenses is the single-employer 419(e) plan. Debra Repya, director of advanced markets at Securian Advisor Services, St. Paul, Minn., said the plan affords employers a current income tax deduction.
Employee participants enjoy tax-deferred growth on assets held in trust. In addition to covering post-retirement health costs (including long term care), the plans provide a pre-retirement death benefit.
“A 419(e) plan would be a great addition to the 412(i) plan for a small, cash-rich employer who is willing to fund a benefit for employees,” said Repya. “But advisors need to understand that 419(e) plans are not listed transactions. And they’re not multi-employer, deferred comp plans.”
Repya also endorsed the survivor standby trust, which delays putting a life insurance policy into the testamentary trust until the first death of a spouse. Before death, the policyholder enjoys full access to cash values, pays no administration expenses and makes no irrevocable gifts. Upon the second death, insurance proceeds are distributed estate tax-free.
‘The best [solution] is to try a blend of trusts, taking advantage of the GST exemption only where necessary….That way, no out-of-pocket gift taxes are paid’