Flexibility in the tax planning of high net worth individuals is extremely important. When engaged in personal estate planning, these individuals express reluctance to tie assets up in an irrevocable trust despite the estate tax planning benefits of doing so. Having easy access to their assets is also a recurring theme.
The ability to tap into assets targeted for estate tax planning, for instance a life insurance policy, is important for emergencies or opportunities that occur during the individual’s life. Typically, this access is precluded once the policy is put into an irrevocable trust. In addition, due to perceived estate tax uncertainty, many high net worth individuals are adverse to losing control over their life insurance policy by parking it in an irrevocable trust when the policy may not have to be removed from the estate if estate taxes are substantially reduced or eliminated.
The solution is to create a mechanism that provides the high net worth individual with lifetime access to the life insurance policy purchased for estate planning, while maintaining the flexibility to remove the policy death benefit from the individual’s estate at death.
Life Swap Concept
The life swap concept accomplishes both goals. It allows for policy access and the ability to remove the policy death benefit from the taxable estate. With life swap, the individual creates an irrevocable defective grantor trust and funds it with an asset to which the individual does not currently need access. Concurrently, the individual purchases a life insurance policy sufficient to meet the potential future estate tax need.
During the insured’s life, he or she can access policy values because the policy is owned directly by the insured. This provides a ready cash reserve that is accessible on a tax-advantaged basis. Cash withdrawals from a life insurance policy are considered a return of premium and, therefore, are not subject to income tax (limited by the insured’s investment or “basis” in the policy).
Loans may be taken against policy values after the insured has withdrawn the basis amount. This cash reserve may be used by the insured as a financial stop-gap during his or her life. Meanwhile, the asset(s) in the irrevocable trust is appreciating outside the insured’s taxable estate.
If, prior to the insured’s death, it is determined that the policy death benefit should be removed from the insured’s estate, the policy owned by the insured may be “swapped” for the asset(s) held in the irrevocable trust. Although the value of the asset received by the insured in the swap is included in the insured’s taxable estate, the larger death benefit of the life insurance policy escapes estate inclusion once it is swapped into the irrevocable trust. This flexibility, however, is attained at the price of timing volatility. If the insured dies before the swap is conducted, the full death benefit remains in the insured’s taxable estate.
Properly structured and timed, life swap may be accomplished with no adverse tax consequences. And the insured’s goals of access to the policy values during life while removing the death benefit from the insured’s estate, if desired in the future, are accomplished.
Defective Grantor Trusts
The first step in structuring the life swap is to make the irrevocable trust defective for income tax purposes. The defective grantor trust rule to be used for life swap is found in Code Section 675(4)(C). By adding the language found in this code section to the irrevocable trust, the grantor gains the ability to “swap” property held by the trust with property of similar value held outside the trust.
Because the properties being swapped are of similar value, the transfers should not be subject to income or gift taxation. Note that the valuation used for both the life insurance policy and for the asset received from the trust must be fair market value to avoid gift tax issues.
Three Year Rule
Generally, the transfer of a life insurance policy into an irrevocable trust within three years of the insured’s death causes the death proceeds to come back into and be taxed as part of the insured’s estate. The three-year rule of IRC 2035 only applies to transfers by gift. An exception to the rule is a transfer by sale. The life swap avoids the rule because the policy being transferred to the trust is “sold” for the value of the assets being received from the trust in exchange for the policy.
Transfer for Value Rule
The transfer for value rule of code section 101 provides that when a policy is sold or otherwise transferred (swapped) for a valuable consideration, the life insurance death proceeds, above the consideration paid for the transfer of the policy plus the net premiums paid by the purchaser, are taxable as ordinary income.
The only way to avoid a transfer for value when selling a life insurance policy is to sell it to a buyer who is an exempt recipient under the rule. For life swap, the most important exempt recipient is the insured. The sale of the policy to the insured is exempted from the rule so the negative tax consequences of the rule are avoided.
Remember that the transfer for value rule is an income tax rule. The irrevocable trust created in the life swap plan is a defective grantor trust for income tax purposes, so the transfer of the policy into the trust is considered a transfer of the policy to the insured and, therefore, the transfer for value rule does not apply.
By allowing the asset(s) to grow in the trust and then swapping it out for the life insurance policy prior to death, one removes the larger death proceeds from the insured’s estate for the lower value of the policy at the time of the transfer (the swap is based upon the policy’s cash value, not the full value of the death proceeds). The asset received from the trust also enjoys a step up in basis because it will be included in the insured’s taxable estate at death.
Moreover, if the asset(s) growing in the trust appreciate beyond the value needed for the swap, that additional growth will remain in the trust after the swap and out of the insured’s taxable estate. Of course, after the swap, the life insurance death proceeds will be received by the irrevocable trust income tax free and will be available to meet the insured’s estate tax liability.
With life swap, timing is everything. What happens if the individual dies before the swap is conducted? If the individual’s spouse is alive, the assets, including the life insurance death proceeds, may be passed to the spouse without estate tax inclusion under the unlimited estate tax marital deduction. The policy proceeds may then be used for the spouse’s planning. Alternatively, although the life insurance death proceeds will be taxed in the insured’s estate, the estate can use the life insurance to meet the estate tax liability.
Life swap builds the desired flexibility into the high net worth individual’s planning. It achieves the goal of retention of access to the life insurance policy values during the insured’s life for emergencies or opportunities while allowing the larger death benefit to be removed from the insured’s taxable estate.
Life swap also brings the ability to position the life insurance appropriately based upon the state of the estate tax in the future, at a time closer to the individual’s death. This allows the insured to purchase the life insurance for planning purposes while still healthy, yet it provides the ability to remove the policy death proceeds from the estate if estate taxes are still a concern.