The B trust (also known as a credit shelter trust or bypass trust) is a basic component of estate planning. The vehicle is most often used by married couples to optimize the amount that can be excluded from estate taxes when the first spouse dies.
However, for clients who may be facing estate tax issues, promoting funding a trust before death may enhance your reputation as an expert in your client’s mind. The advantage of funding an irrevocable trust during life is that any growth of the trust’s assets during the grantor’s lifetime will be excluded from estate tax as well.
Case in point
For example, suppose a 60-year-old grantor funded a $1 million B trust today, (using the 2008 exclusion), and assume it earns a relatively conservative 6% on the trust’s assets. Over 12 years, the account could grow to $2 million. Over 24 years, it could double again, to $4 million. At death of the grantor, an additional $1 million can be added based on the current (2008) exclusion. The grantor’s estate has effectively shielded $5 million from estate taxes instead of $2 million had the trust been funded at death.
After the death of the grantor, the surviving spouse may need income from the trust. To ensure that the survivor is not “disinherited,” the trust can usually pay for the health, education, maintenance and support of the surviving spouse during his or her lifetime. After the surviving spouse dies, the beneficiaries may then receive the proceeds from the trust. This fulfills the primary goal of the B trust, which is to leave a legacy to beneficiaries that is untouched, to the extent possible, by estate taxes.
A couple of obstacles to this scenario may exist, but careful advanced planning can mitigate them. First, since the trust is irrevocable, the issue of the effect of taxes on any growth in the trust is important to consider. If growth occurs inside an income-generating program, the irrevocable trust may be required to pay income tax at the highest individual rate if the income is not distributed to the income beneficiary.
While life insurance is certainly a viable option if the clients are insurable and agreeable to purchasing more life insurance, another strategy could be for the trustee to purchase a deferred variable annuity. In this way, the trust may be able to avoid paying income tax on any gains within the annuity until it is distributed.
Secondly, if an annuity is used as a funding product, is it tax-deferred? According to Section 72(u) of the Internal Revenue Code, an annuity owned by a non-natural person cannot receive tax deferral through a deferred annuity. However, Section 72(u)(1) of the code provides an exception for an annuity owned by a trust or other entity holding an annuity as an “agent for a natural person.”
Whether or not the trust qualifies for the exception needs to be determined by a professional advisor who is familiar with both the trust and applicable tax law.
Assuming the above criteria are met and it is determined that a deferred variable annuity is appropriate, the structuring of the annuity contract can be varied to meet the clients’ objectives concerning the distribution of assets after death. Let’s review a couple of options:
In the first option, the trust owns the contract, and the grantor of the trust or the spouse of the grantor is named as the annuitant while the trust is named as the beneficiary. When the annuitant dies, the annuity contract will pay a death benefit to the trust, usually within 1 to 5 years. The trust provisions then determine how the individual trust beneficiaries will receive the trust assets.
A second and less traditional approach is to name the beneficiary of the trust as the annuitant on the contract. If there are multiple beneficiaries, multiple contracts can be established. Under this scenario, when the surviving spouse passes away, and the provisions of the trust dictate that the beneficiaries receive distributions from the trust, the beneficiary may be able to receive the contract rather than the death benefit payout.
If this option were available, instead of receiving a taxable distribution, the beneficiary would receive an annuity contract on which he is named the new owner without incurring a tax on the gain. The tax deferral, as well as the benefits of the annuity, will continue (subject to the annuity provider’s terms). Because this option is based on PLR 19905015, it applied only to the person to whom the letter was addressed. Nevertheless, a qualified attorney should be able to offer guidance.
Focusing on common goals
Estate planning is complicated. Trusts can be complicated. Annuity contracts and their benefits and structuring variables can be complicated. Because each situation requires individual attention, there are no hard and fast rules that will cover every eventuality.
There may, however, be common goals that can be achieved when a B trust is part of an estate plan. Using an annuity as a possible investment product within the trust may provide estate planners, attorneys and financial advisors with a unique opportunity.
Kelly LaVigne, JD, is vice president, advanced markets, at AXA Equitable, Life Insurance Co., New York, N.Y. You can e-mail him at .