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Establishing Spousal Access Trusts With Variable Universal Life

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An Irrevocable Life Insurance Trust is used by estate planners to protect their client’s wealth. If the ILIT is properly drafted, the life insurance death benefits can be received income and estate tax-free. An ILIT is created for a variety of reasons, which may include a desire to equalize inheritances among children, to pay estate taxes and to replace income in the event of the untimely death of the insured(s).

However, a common concern about an ILIT, especially among married couples, is that both spouses lose their ability to access the policy’s cash value during the insured(s) lifetime. Two types of ILITs can provide access to the cash value without causing estate inclusion of the death benefits in the insured(s) estate. These are the spousal access trust and the survivorship spousal access trust.

Spousal access trust

A spousal access trust is a single life ILIT that allows one spouse (the non-grantor spouse) to receive distributions from the trust during his or her lifetime. The non-grantor spouse is also the trust’s non-insured spouse, who has access to the ILIT assets, including the cash value of the life insurance policy. The non-insured spouse can also be named the trustee of the trust. The trustee can make distributions as well to other family members (such as children) for their health, education, maintenance and support.

(Note: Certain states may prohibit a trustee-beneficiary from exercising distribution powers, even for health, education, maintenance and support, requiring the appointment of a non-beneficiary co-trustee.)

The trustee/spouse can make this distribution during his or her lifetime. Thus, the trustee need not wait until the insured’s death to make distributions from the ILIT. Upon the insured’s death, the ILIT will receive the death benefits income- and estate-tax-free. The spouse may receive benefits until her or his death and the children may receive the remaining benefits. Or the trust may be structured for multiple generations as a dynasty trust.

Consider a hypothetical client, Bob, age 45, who is married with 3 children. Bob is a preferred non-smoker living with his family in Pennsylvania. He is concerned about estate taxes in the future. The primary need of Bob and his family is to have a policy available as a source of supplemental retirement income.

Bob creates an ILIT, which then buys a $2.3 million variable universal life (VUL) policy on Bob’s life. The policy cash value is assumed to grow at an 8% gross rate of return. Bob will use his three annual exclusions of $36,000 to make gifts to the trust for 20 years. Bob’s wife, Ann, is the trustee. As a trustee, she may make distributions from the policy to herself or to the other beneficiaries for health, education, maintenance and support. Beginning in the 21st year, $100,000 is distributed annually to the trust’s beneficiaries for the next 15 years. The total amount distributed to the trust beneficiaries is $1.5 million. In addition, the trust will have a remaining net death benefit. (See Table 1.)

Survivorship spousal access trust

The survivorship spousal access trust is effective in second-to-die cases because survivorship life insurance is ordinarily less expensive than single life coverage and because most couples will owe no estate tax until the death of the surviving spouse. In a survivorship spousal trust, only one spouse (the donor spouse) will be the grantor; the other spouse will be the beneficiary, along with children and other family members.

Neither spouse should be designated a trustee. Rather, an independent trustee should be appointed with authority to make distributions to the non-grantor spouse as well as other trust beneficiaries.

By using the survivorship spousal access trust, one of the spouses can continue to have access to the cash value during her or his lifetime without estate tax inclusion issues. Furthermore, the survivorship access trust (like the spousal access trust) may be structured as a dynasty trust.

For example, assume Barry & Sarah Burns are 50 years of age. Their estate plan takes advantage of a credit shelter trust, the balance of which is transferred using the unlimited marital deduction. Therefore, there will be no estate tax at the death of the first spouse.

However, there is a need for approximately $5 million upon the surviving spouse’s death (at life expectancy) to pay the estimated estate tax due. Barry (the grantor) creates the ILIT using his separate property. The ILIT owns a survivorship policy on Barry and Sarah. An independent trustee (child or trusted advisor) can be the trustee.

The trustee has the power to make discretionary distributions to Sarah and the other family members during their lives. The trustee buys a $6.7 million survivorship variable universal life (SVUL) policy on Barry and Sarah, both of whom are preferred non-smokers residents in Pennsylvania and have 3 children.

The insurance policy is illustrated to grow at an 8% gross rate of return. Barry and Sarah “gift split,” causing all the premiums to be covered by the annual exclusions. Beginning in the 16th year, $100,000 is distributed annually to the trust’s beneficiaries for the next 15 years. The total amount distributed to the trust beneficiaries is $1.5 million. In addition, the trust will have a remaining net death benefit. (See Table 2.)

In a survivorship spousal access trust, it is essential to plan for the possibility that the grantor may die first before the premiums are paid. If Barry predeceases Sarah, his separate will or revocable trust may leave the unused exemption equivalent amount ($2 million in 2006-2008) to the ILIT. Alternatively, Barry’s estate or Sarah may lend funds to the trust. Another option allows the ILIT to purchase a term policy on Barry’s life to cover the premium payments.

Dynamic duo

The spousal access trust incorporates the dynamic duo of VUL with a flexible irrevocable trust, which may allow a married couple to maintain access to the policy cash value during their lifetime and exclude the values in the policy from income, estate and possibly GST taxes at their death.

Morry J. Zygman, JD, CLU, ChFC, is an associate counsel in advanced markets at John Hancock Life Insurance, Boston, Mass. You may e-mail him at [email protected]