Bailouts, tax uncertainties, bank credit concerns, promised income and capital gains tax increases by President Obama, and retention of the federal estate tax! Oh my! In today’s financial and tax environment you may have lots of clients who just want to crawl into a shell and do nothing.
That might be a big mistake. What if there is a way to help those same clients navigate through these uncertainties?
By combining the benefits and features of current financial products and services with the existing income, capital gains tax and transfer tax opportunities contained in the IRS code, high net worth clients can secure a multiple tax-advantaged pool of wealth. They can also create funds to benefit them and their heirs, thereby easing the bank credit-freezing concerns that might limit access to monies. I call it the DynNo Tax Trust Strategy.
How it works
To illustrate, consider a wealthy couple, both age 55, who have a combined net worth of $20 million. They are aware that under President Obama, estate taxes are likely to continue and that income and capital gains tax might even increase in coming years. They also foresee a credit crunch with the banking industry. They want to accomplish the following:
? With the expected retention of federal estate taxes, they want to purchase a life policy that could provide funds and assets at death, outside of their taxable estate for federal estate tax purposes, while tax-efficiently offsetting their estate clearance costs. These funds would grow income- and capital gains-tax free and be free of federal estate taxation.
? Since there is a real concern about increased federal income and capital gains taxation, the clients want to have supplemental retirement income that is insulated from Social Security tax plus federal, state, local and income taxes and future income tax increases.
Given the bank credit crunch, they want to be able to create–using their estate–an accessible pool of funds for themselves and their children, on a loan basis should there be a future need.
Can this be done?
The DynNo Tax Trust Strategy: Defective Irrevocable Life Insurance Trust with Grantor Loan Provisions
A technique that is becoming increasingly popular is the “defective” irrevocable life insurance trust. The trust is set up to be “effective” for federal estate tax purposes, while being “defective” as a grantor trust for income tax purposes. The latter means the trust and its assets are viewed as if they are owned by the grantor/client and taxed for income tax purposes, accordingly. Because the trust owns only life insurance, the life insurance income tax benefits will be treated as belonging to the client/grantor for income tax purposes. A recent IRS Revenue Ruling 2008-22 has added favorable fuel to the fire of this strategy.
This strategy is implemented, frequently, as follows:
? An ILIT is established that lets the grantor/client exchange assets with the independent trustee using an asset of equivalent value (in this case, a collateralized demand loan arrangement for the trust’s cash value).
? The trustee purchases an equity-based variable survivor life policy on the couple. The life insurance protection element of the policy (a non-modified endowment contract) is set up to be the lowest amount of face coverage relative to the premium paid for the policy.
? This set up will permit a tax-favored build up of cash value, income- and capital gains-tax free. The arrangement will also allow the trustee to access the policy’s cash values on a tax-deferred basis. (At death with an in-force policy, the death benefit is distributed income- and capital gains-tax free to the trust).
Because the grantor can exchange an equivalent asset for a trust asset, the IRS treats the DynNo trust assets as if they were owned by the grantor for income tax purposes. There is, therefore, no income tax because the exchange is treated as if the grantor made an exchange of property with him or herself. Under Revenue Ruling 2008-22, this right does not invalidate the trust under IRC 2036 or 2038 for federal estate tax purposes. This would mean that the trust is “effective” for federal estate tax purposes.
The policy in this example might be a flexible premium variable survivor life policy, starting with a minimum death benefit that still allows for a non-modified endowment policy with a broad range of equity subaccounts. The policy would be super-funded relative to the face amount to strive to grow the cash values over time.
How does this accomplish the client’s desires?
A properly arranged defective ILIT will remove the death benefit of the ILIT-owned policy from the grantor’s estate for federal estate tax, as well as federal income tax and capital gains under current law.
Supplemental retirement income option with income tax insulated income
In this example, the grantor, with proper collateralization and for an acceptable prevailing interest rate charged, will likely make the loan a substituted property of equivalent value. This means the cash value pool of assets can be available to the grantor on a loan basis, much like a personal bank.
And, much like a reverse mortgage, the grantor can get loan income from the trust to use as supplemental retirement income free of federal, state and local income tax, as well as Social Security and capital gains tax. Although the grantor must make interest payments to the trust, such payments would be treated as if they were made to himself, and therefore would not be taxable.
It is important to note that the terms of the loan should be reasonable and should be honored (i.e., required repayments should be made).
Upon the death of both spouses, the loan is paid off with interest from the grantor’s taxable estate and becomes deductible for federal estate tax purposes. Both the loan pay-off and the death benefit will go into the trust and be distributed to heirs estate tax-free.
A source of funds for the family
With the collateralized demand note arrangement in the trust, the grantor has a pool of assets in the policy cash value that are “loanable” to himself or herself. The grantor can access this pool for himself or herself or the family. If both spouses die with the policy in force, the trust will receive the death benefit. The trust can continue for the children if the grantor so desires to provide personal bank-type services to them.
Concerns about future tax code changes
There are no guarantees, but tax code changes that have unfavorably impacted insurance products, such that they result in deprivation of property rights, have a long history of being grandfathered when new tax law changes occur, meaning that the tax consequences of the grandfathered transaction would not be altered by the changes in the law.
Constitutionally, citizens cannot be deprived of property without due process of law. This means, generally, that tax law changes that deprive people of property are frequently grandfathered to protect a client’s action that was legally sound at the time of implementation.
This aggressive tax strategy is not for the faint of heart. The revenue ruling details requirements that must be followed to come under its purview. And the ruling does not address collateralized demand loan arrangements as “equivalent” property.
As your clients’ personal situations change (i.e., marriage, birth of a child or job promotion), so will their life insurance needs. Care should be taken to ensure these strategies and products are suitable for long-term life insurance needs. You should weigh your clients’ objectives, time horizon and risk tolerance as well as associated costs before investing.
Also, be aware that loans from a policy and market volatility can lead to the need for additional premium payments. Variable life insurance includes costs of insurance that vary with the insured’s gender, health and age, underlying fund charges and expenses; and with additional charges for riders that customize a policy to fit the clients’ needs.
Using a defective irrevocable life insurance trust may make a lot of sense for wealthy clients who need to address changes to the federal estate and income taxes, capital gains, and the potential difficulty in securing credit lines from troubled banks. Revenue Ruling 2008-22 does fan the flames of this hot idea. With the likelihood of grandfathering of past strategies involving insurance products, the time to act may be now!
Donald G. Schreiber, J.D., CLU, ChFC, is a senior advanced sales consultant for Nationwide Financial Services, Inc. He can be reached at [email protected]