Leveraging The Multiple Tax Advantaged Trust

In 2001, the U.S. Congress passed the Economic Growth Tax Reconciliation and Recovery Act, which contained provisions to eliminate the federal estate tax code and replace it with a modified capital gains tax system. With the passage of this act, many people in our industry said that estate tax planning was dead.

How things change!

Recent circumstances have changed the outlook, not only with federal estate taxes but federal taxation in general.

The rosy economic situation of the decade preceding the passage of EGTRRA 2001 changed noticeably in 2001 and 2002, when the stock market plunged. A large and growing national debt replaced the projected 2001 government surpluses. Indeed, the national debt is approaching $9 trillion and the U.S. Congress has had to increase the debt ceiling for 4 of the last 6 years to accommodate the growing burden.

Add to this the baby boomers who are now between the ages of 43 and 62. This group, which comprises nearly 30% of the U.S. population and which supplies the U.S. government with significant income tax and Social Security tax revenue, is now entering into retirement in growing numbers. They are going from earned income that supplies the federal government with Social Security and income taxes to retirement income (some tax-free or tax preferred) and drawing on the federal government’s Social Security fund. Add, too, the war on terror that–by some estimates–cost the U.S. government $12 billion per month, and we have a future situation that strongly suggests Congress will need to boost tax revenues through increased tax rates.

If so, where might the taxes rise? We know the trifecta tax terrors of income tax, capital gains tax and transfer taxes (gift and estate taxation), but which one will likely increase? Could 2 or all 3 areas increase in the future?

Current taxes are lower than in times past. The highest current income tax rate is 35%, the capital gains tax rate is 15% and the current gift and federal estate tax rate at the highest marginal rate is 45%. The federal income tax rate in the past was as high as 70%, capital gains tax was as high as 20%, and the federal estate tax rate was at 55%.

In polling advisors around the country, nearly all of them agree that the current circumstances suggest tax rates will rise in 1, 2 or all 3 ‘tax terror’ areas in the future.

Is there a strategy that can eliminate all 3 tax terror areas today? The answer is yes! Lawyers call it the irrevocable life insurance trust, but considering all of the ILIT’s tax benefits, the vehicle should be renamed the multiple tax advantaged trust.

The MTAT is so often viewed as merely a means to have life insurance escape federal estate taxation that the true–and rather incredible–tax advantage power of this tool is frequently overlooked. This article will examine the multiple tax-avoidance power of this estate-planning tool.

Federal estate taxes

The general rule involving personal life insurance owned by an individual is that the proceeds of the life insurance policy are fully included in their estate for estate tax purposes. For some, this can mean that their personally owned life insurance portfolio may shrink by as much as 45% due to federal estate taxation.

One way to avoid estate taxation on life insurance is for a MTAT to be the owner and beneficiary of the life insurance policy on Grantor from the policy’s inception. By never having any “incidents of ownership” in the policy by the insured, the entire proceeds of the policy will escape federal estate taxation on the insured’s death. This represents potential savings of as much as 45% of the face amount of the policy.

In addition to the federal estate taxation savings, the life policy provides cash that can be used by an estate. Frequently, the MTAT is structured to permit loans to the estate or the MTAT purchases illiquid asset from the estate in an amount that will allow the estate to pay the estate clearance costs. By using the MTAT, the estate clearance costs are offset by the face amount to preserve an estate and pass it intact, and the cash from the life policy assists in preventing fire sales of illiquid assets. All of this can be accomplished without the life insurance being a part of the estate tax problem.

This part of the MTAT strategy is well known and accepted. But how this strategy impacts other taxes is also important.

Federal gift taxes

The payment of the premiums on the life insurance policy in the MTAT represents a gift of the premiums to the ultimate beneficiaries of the trust. The Internal Revenue Service attacked these premium gifts as gifts of future interest, arguing that the trust was irrevocable and would not distribute the proceeds until the death of the grantor or grantor and grantor’s spouse. By claiming that the premium gift was a gift of a future interest, the IRS attempted to prevent these gifts from being considered part of the grantor’s annual gift tax exclusions, subjecting the premium transfer to gift taxation in the year of the gift.

In the now famous case of Crummey v. Commissioner, a strategy was devised, which is now accepted, to allow the annual gift tax exclusions to be applied against the premium dollars to escape federal gift taxation on the amounts covered by this gift exclusion. Under the Cristofani case, this gift tax-avoidance strategy was expanded to include gifts to bona fide contingent beneficiaries of the MTAT. By including grantor’s children, the children’s spouses and the grandchildren in this gifting technique, in many cases, the entire premium amount is able to avoid gift taxation. Thus, the MTAT frequently avoids gift taxation on the premium.

Since the MTAT owns the life policy on the insured from the policy’s inception, upon death, the beneficiaries of the trust receive the proceeds free of gift taxes as well. So, in addition to gift tax protected premiums, the beneficiaries are also protected from gift tax on the proceeds. When the premium amount transferred to the MTAT to fund the policy can be covered by the collective annual gift tax exclusions of the beneficiaries, then the transfer is free of federal gift taxation.