Estate planning can be viewed as 2 distinct but related disciplines: 1) estate distribution planning and 2) estate tax planning. Estate distribution planning–who gets what, how and when–pertains to every estate, while estate tax planning applies particularly to estates that exceed the applicable exemption amounts ($2 million per person or $4 million per married couple, 2007-2008).
As exemptions and exclusions increase and transfer tax rates decrease, fewer estates may be taxable, but those that are will be larger (over $4 million in 2007 and 2008; over $7 million in 2009). Also, the traditional planning techniques–gift and estate tax exemptions, credit shelter trust planning, annual exclusion gifts and irrevocable life insurance trusts–may not be sufficient to meet these estate owners’ planning objectives. To be sure, these clients may want to transfer more of their estates to their heirs tax-free but don’t know how.
Your wealthy clients, Mr. and Mrs. Diedrich (died o rich) have a taxable estate exceeding $4 million. Their estate plan already takes advantage of the gift and estate tax exemptions and annual exclusions, but the Diedrichs would like to transfer more to their heirs without incurring gift taxes.
A portion of their portfolio is invested in low-risk, “lazy” assets such as CDs, money market funds and municipal bonds. Although they don’t need the principal, which they have earmarked to go to their heirs at their deaths, they would like to retain the modest 4% interest they receive from these investments.
Mr. and Mrs. Diedrich (both age 65) create an irrevocable trust to hold assets for the benefit of their heirs and lend the trust $1 million worth of these “lazy” investments. Since these funds are loaned to the trust and not gifted, (1) the Diedrichs will incur no gift taxation on the transfer and (2) the trust will be required to pay annual interest to the Diedrichs on the note at the prevailing long term applicable federal rate (AFR). We’ll use a 5% rate and $50,000 interest payment ($1 million x .05) for our case study.
To meet the $50,000 annual obligation on the note, the trustee decides to purchase a joint, single premium immediate annuity with the $1 million loan. The annuity pays $70,000 annually, or $20,000 in excess of what the trust needs to make its interest payments to the grantors. Since the Diedrichs made clear they are interested in passing as much to their heirs as possible without incurring gift taxes, you show them how they can use the $20,000 “excess” annuity payout to purchase a $1,300,000 survivorship life insurance policy.
The Diedrichs’ irrevocable trust will be structured as a grantor trust (sometimes referred to as an intentionally defective grantor or income trust), which means items of income owned by the trust will be taxable to the grantor(s) and not the trust. As such, distributions from the annuity owned by the grantor trust will be income taxable to the Diedrichs.
However, because of the annuity exclusion ratio, only that portion of the annuity payment representing gain is income taxable to the Diedrichs (the portion representing return of basis is not). It is true that the Diedrichs are paying income taxes on an annuity they do not own, but they will be receiving an annual interest payment from the trust in the amount of $50,000, which is not taxable to them (nor deductible by the trust) because of the grantor trust rules. Because the grantor and grantor trust (IDGT) are considered one taxpayer for all aspects of income taxation, the grantor will not recognize income when the interest on the note is received.
A properly drafted trust, which is “defective” for income tax purposes, will be “effective” for estate tax purposes. So assets transferred to the trust will pass free of estate taxation at the grantors’ deaths.
Survivorship life insurance premium payments are paid from annuity distributions until the second death. At that time, the death benefit from the second-to-die life insurance policy ($1,300,000) is paid to the trust, income tax free and outside of the Diedrichs’ estate. Since the grantor trust was paying interest-only on the loan during the Diedrichs’ lives, the principal sum of $1 million is now due and is paid from the death benefit, with the balance of $300,000 retained in trust for the benefit of heirs pursuant to the terms of the trust.
The Diedrichs wanted to transfer additional assets to their children without incurring gift taxes–they did: $300,000 from the survivorship life death benefit. They were willing to transfer some of their “lazy” assets but wanted to retain an income interest during their lifetimes–they did: They actually received more after taxes because of the annuity taxation rules.