Many parents enjoy making an annual gift of $24,000 to each of their adult children because of the personal satisfaction it brings to see them enjoy it. The children have the opportunity to be thankful year after year and are able to enjoy a lifestyle that would not be possible without the annual gift.
However, when an estate planner suggests that a client create an irrevocable life insurance trust to pay estate taxes, there is often a concern about how to pay the life insurance premium. Since premium payments burden cash flow, they can make it difficult to continue annual gifts to the kids.
A high net worth does not necessarily equate to a large amount of cash on hand. Many of our clients own land, closely held stock or other significant, appreciating assets. So how can clients continue to make annual gifts to the children while they are alive and still have the funds available to fund the ILIT? Is an ILIT still an effective technique?
The usefulness of an ILIT has long been understood. Clients like to know with great certainty that the precious stock, land or other property asset will not be forced into a sale for the purpose of paying Uncle Sam when they die. This is where having life insurance in force to pay the estate tax becomes helpful. The size of the estate, of course, determines how large a policy is needed.
Next, a determination needs to be made regarding whether the life insurance premium will cause a gift tax problem. With the lifetime exclusion for gifting purposes at $1 million for each spouse, ILITs can still be a useful tool.
However, for the largest of estates, it may not be enough. The annual premiums needed to fund the ILIT may be so large that (gift tax rules aside) it may make more sense to finance the cost of the life insurance through a reputable bank.
A grantor retained annuity trust, used with financed premiums to fund an ILIT, may help solve that problem. A GRAT allows an individual–the grantor–to transfer property to the beneficiary (the ILIT) at a reduced gift tax cost. The property for which this is most effective is an asset that is expected to appreciate, such as stock that will go public, land that is rising in value or perhaps a closely held business.
An irrevocable trust holds this property for a specified number of years. The grantor gets to retain an interest in the trust property through an annuity, whether as a fixed percentage or fixed dollar amount. The grantor’s gift to the trust is the fair market value of the property transferred, less the present value of the retained annuity payments.
At the end of the trust’s term, the remaining property passes to the remainder beneficiary (the ILIT) without additional gift tax. Assuming the grantor survives the trust term, a GRAT is an effective estate “freeze” technique.
After the GRAT is created, the appreciation of the property’s value above the assumed discount rate passes to the ILIT without gift tax, thereby freezing the value. The value included in the grantor’s estate is the value of the annuity payments.
If designed correctly, these annuity payments will help cover a portion of the annual interest payment to the bank that loaned the grantor the money to fund the ILIT. Also, the value of the interest payments made to the bank by the grantor is considered a gift for gift tax purposes. If the payment is greater than the $12,000 annual gift tax exclusion, then the excess counts toward the $1 million lifetime gift tax exclusion.
If the grantor dies during the term of the trust, then the trust assets will revert back to his estate. It would make him no worse off than if the GRAT technique had not been used.
Consider this example
A 61 year-old affluent individual creates a 10-year GRAT with an annuity payout of 13.33%.
–The individual’s property, valued at $2,297,320, is gifted to the GRAT. (The example works with property valued either at this amount or with a greater value that is reduced to $2,297,320 after the available discounts are taken.)
–The property earns an annual income of 3%.
–The property’s value grows at a rate of 10.18%
–The IRC Section 7520 discount rate is 5.6%.
–The individual has an estate tax liability of $20 million.
–The individual’s ILIT holds a $20 million last-to-die joint life insurance policy to pay estate taxes.
Taking into consideration the 13.33% annuity payout rate and the 5.6% government discount rate on the initial value of the property, the goal is to have a “zeroed out” GRAT (meaning the grantor will not owe any gift tax.) Factoring in the growth rate and the income rate on the property within the GRAT helps to achieve the second goal: Having enough left at the end of the trust to pay off the balance of the loan.
Assuming from Table 1, aside from a total premium to the ILIT of $2,297,320 and the gifted interest of $1,010,821, the only gift tax the individual pays is the amount in excess of the lifetime exclusion.
Most people gladly choose to pay $2,297,320 in premiums rather than the full $20 million in estate tax.
In Table 2, we illustrate a $20 million joint life last-to-die policy with an annual premium of $229,732. The annual interest due if the premium is financed appears in column 3. The cumulative interest paid over the 10 years would be a little over $1 million, as illustrated in column 4.
The interest that is paid by the grantor would be a gift and would count against the grantor’s lifetime exclusion. If the grantor had not used that lifetime exclusion, there would effectively be no gift taxes paid on the interest charges. The money to pay the interest could be taken out of the $306,244 annuity payment that is coming from the GRAT. The GRAT payments should also be sufficient to cover income taxes due on those proceeds.
Assuming the assumptions we made before hold true, the remainder interest in the GRAT would be $2,298,275. That amount would be enough to pay off the bank loan and the trust would have a policy, assuming dividends were paid as illustrated, that had no future premiums due.
The grantor would need to establish a GRAT with an amount equal to the 10-year premium of the policy. If the other assumptions we mentioned hold true, the GRAT would be considered “zeroed out” for gift tax purposes.
There are opportunities to include property in a GRAT that could be discounted for valuation purposes. Of course, the grantor would have to consult with tax council and a certified appraiser for those discounts.
Michael W. Halloran, AEP, CLU, ChFC, CFP, and Michelle Wordell, CFP, are financial advisors with Northwestern Mutual Financial Network in Jacksonville, Fla. Halloran is on the board of the SFSP and Wordell is a Society member. They can be reached at and , respectively.