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Today’s life insurance planning environment provides sophisticated techniques to help clients create, retain, and transfer their wealth. Many of these concepts initially offer great tax advantages, such as reduced gift taxes, but these advantages decrease over time.
Examples: premium financing and split-dollar plans, which provide substantial tax benefits and leverage of available funds at plan inception, but become more costly to the client with each passing year. An exit strategy for such plans is therefore a must.
However, using policy cash values for this purpose in the current low interest rate environment is difficult; and other rollout approaches may lead to substantial gift taxes.
What other options are available to clients? For the charitably inclined, the same low interest rate environment that suppresses policy cash values can make a charitable lead trust a great, if often overlooked, exit strategy.
A donor makes a contribution to the charitable lead trust (CLT) and the designated charity receives a payout from that trust for a period of time. The payout could either be specified, as in an annuity trust, or vary with the value of the trust assets, as with a “unitrust.”
The duration of the CLT can be for a term of years or for the donor’s lifetime. At the end of the payout period, the remainder value of the trust passes to the remainder beneficiary, which could, if desired, be an irrevocable life insurance trust (ILIT).
When the CLT is created, the donor receives a potential income tax deduction based on a complicated IRS calculation and the current ?7520 rate (an explanation of this calculation is beyond the scope of this article). The donor also is deemed to have made a taxable gift to the remainder beneficiaries. The gift amount will generally equal the fair market value of the asset contributed to the trust less the potential income tax deduction.
When a CLT is funded with a highly appreciating asset, the taxable gift can end up being significantly less than the ultimate value passed to the remainder beneficiaries. As a result, the CLT can be a very gift-tax efficient way to transfer wealth. In some cases, the plan can be structured so that the taxable value of the gift is zero, though the actual remainder value of the trust is projected to be much higher.
To illustrate, consider Ellen Ripley, who is 50 years old and recently widowed. She and her husband had built a successful salvage business that is now worth about $20 million. She needs at least $10 million of life insurance, but cash flow is tight due to her husband’s death.
Ellen has heard of premium financing, but is concerned about interest rate fluctuations. She realizes she needs a way to get out of any financing arrangement should interest rates rise dramatically. Ellen also wants to minimize gift taxes. Her college-aged daughter, Rebecca, has an interest in eventually joining the business, so Ellen would like to preserve her gift tax exemption to make planning for this transfer easier when the time is right.
Fortunately, Ellen’s planner Dwayne Hicks has an idea. He knows that since her husband’s death, Ellen has become a strong supporter of the American Cancer Society. Therefore, he suggests combining premium financing with a CLT.
Ellen will create an ILIT that will borrow $135,629 annually from a third-party lender to purchase a $10 million life insurance policy. Ellen will gift the loan interest to the ILIT each year at an initial rate of 6%, or $8,137 for the first year.
However, every year the interest cost will increase, as more premiums are borrowed or if interest rates go up. This is where the CLT comes into play. The term of the CLT can be designed to coincide with the projected year of the loan repayment so that assets are available to pay the loan and terminate the financing arrangement.
Dwayne recommends that Ellen put $1.9 million into a CLT, which will pay the American Cancer Society $183,049 for 15 years, and name her ILIT as the remainder beneficiary. Based on the payment of $183,049 and the November 2005 ?7520 rate of 5%, the IRS calculation indicates that Ellen will have a potential tax deduction of $1.9 million and no taxable gift for the remainder that passes to the ILIT.
In many CLTs, the value of the potential deduction is less than the value of the asset transferred to the CLT; and the remainder that passes to the ILIT is a taxable gift. However, Dwayne recommended this payment level to the charity to maximize the tax deduction and reduce the gift tax cost.
Ellen has stock that has been appreciating rapidly, so Dwayne recommends that she use this to fund the CLT. Assuming the specified payout to the charity and a growth rate of 10%, the remainder value that passes to the ILIT in year 16 will be $2,120,831.
The total premiums borrowed will be $2,034,435, so the trust will have enough money to pay off the premium financing loan. At Ellen’s death, the ILIT will receive the policy death benefit, which may be used to help pay the estate taxes and protect the business for her children.
The charitable lead trust is a flexible and powerful planning tool to help transfer wealth in a socially responsible and tax-efficient manner. A CLT can even be created and used as an exit strategy for an existing plan.
If your clients have already entered into a split-dollar or premium financing arrangement with no strategy for roll-out, they could set up a CLT after the fact and use the remainder value as their exit strategy. Don’t overlook the charitable lead trust when helping your clients in their wealth transfer planning!
Cynthia Crino, CLU, is AVP for operations, advanced markets, at John Hancock Financial Services, Boston, Mass. You may e-mail her at firstname.lastname@example.org.
‘The charitable lead trust is a flexible and powerful planning tool to help transfer wealth in a socially responsible and tax-efficient manner.’