"Wait and see" GST tax planning.

If an irrevocable life insurance trust (ILIT) holds only term insurance (i.e., with no cash surrender value (CSV)), it is possible (and often recommended) not to allocate any generation-skipping transfer (GST) tax exemption to the trust until after the insured dies. Although this technique is extremely effective if a client is "cooperative enough" to the relatively suddenly, this plan can be a trap if the client develops health problems in the calendar year before death.

Background

Generally, the overall goal is for the ILIT to be fully exempt from the GST tax, while using as little as possible of the donor's lifetime GST exemption. There are two ways to make the trust fully exempt. One method is relatively simple, but ultimately uses more of the exemption. The other requires more planning, but can achieve a zero inclusion ratio without using as much of the GST exemption.

The two methods involve allocating a GST exemption either (1) to the trust on an annual basis equal to each trust contribution or (2) against the trust's fair market value (FMV) at the time of the allocation. If the latter is used, then after a GST allocation is made against the net value (which has the effect of "catching up" for prior years in which no exemption was allocated against the premiums), the GST exemption needs to be allocated (dollar-for-dollar) against all subsequent trust contributions to maintain the trust's exempt status.

For most ILITs that hold either whole life or universal life policies, the policy's FMV will be smaller than the premiums paid during the first few policy years. Thus, the best way to achieve exempt status while using the least amount of GST exemption is to not allocate any GST exemption against the premiums when they are contributed to the trust, but rather to allocate an exemption at a later date against the (then-lower) value of the trust at that time. Before the allocation date, the trust would be fully subject to the GST tax; once the GST exemption is allocated against the current FMV, the trust would become exempt.

Example 1: An ILIT holding a whole life insurance policy receives a $10,000 premium each year, but the CSV at the beginning of year 10 is only $30,000. If $10,000 of GST exemption had been allocated against the trust each year, the $100,000 total would have made the trust fully exempt at all times. Alternatively, exempt status can be achieved by waiting until year 10 to make a "late allocation" of $40,000 of GST exemption to the trust. The benefit is that this makes the trust exempt, but requires only enough exemption to cover the current FMV ($30,000), plus the current premium ($10,000). Thus, the donor saves $60,000 of exemption, which is then available to offset other GST tax transfers (if any).

Example 2: The facts are the same as in Example 1. If the GST allocation for year 10 (made while the insured is still alive) had been for only the $10,000 current premium, but did not cover the $30,000 of prior FMV, the trust would become only one-fourth exempt ($10,000 allocation/($30,000 prior FMV + $10,000 addition)). Thus, 75% of any amount ultimately paid to the grandchildren would be subject to GST tax when paid.

Crucial to understanding the potential benefit of waiting to make the GST allocation is a thorough grasp of how timely allocations of GST exemption are treated. Essentially, regardless of when premiums are paid during the year, Sec. 2642(b)(1) treats the GST exemption as allocated to the trust as of the gift date, as long as (1) the donor files a gift tax return before the extended due date for that year or (2) there is an "automatic" exemption allocation under Sec. 2632(b)(1) or (c)(1).

In contrast, Regs. Sec. 26.2642-2(a)(2) provides that a donor must make any "late allocation" against current FMV by actually filing the return in the month the allocation is to be effective. For example, to allocate against the CSV as of July 1, 2004, the donor must file a return in July 2004.

Example 3: The facts are the same as in Example 1; the CSV is $30,000 as of July 1, 2004. No GST exemption has been allocated to the trust. The $10,000 annual premium is paid in July 2004, but the donor dies in August 2004, before he files a gift tax return showing the $30,000 allocation.

In Example 3, even though the executor can make the trust one-fourth exempt by timely filing the 2004 gift tax return before April 15, 2005, the only way to make the trust fully exempt would be to allocate GST exemption (if available) on the Federal estate return equal to 75% of the insurance proceeds, under Sec. 2642(b)(2). If the policy's face amount exceeds $1.5 million, however, there may not be sufficient GST exemption available to make the trust fully exempt.

Special Technique for Term Insurance

Based on the above rules, there appears to be a potential benefit for term insurance. If an ILIT holds only a term life insurance policy that pays premiums monthly, the policy's value (and, thus, the trust's value) is arguably zero at the end of each month (when a premium becomes due again). As long as the trust's FMV is zero as of the date of the gift(s) to the trust each year, one could wait (almost indefinitely) to make the allocation, because a timely allocation (even after the insured's death) should still result in a fully exempt trust.

This is because the "timely allocation" against the current-year premiums would equal 100% of the combination of (1) the policy's value immediately before the gift (which is zero), plus (2) $10,000, the current-year gift(s). If multiple gifts are made to the trust during the year (for instance, monthly premium payments), a timely allocation against that first premium for the year would produce a zero inclusion ratio, as long as the policy's FMV was zero immediately before that gift. Exempt status would then be maintained via the "timely allocations" to the other subsequent gifts to the trust during the year.

This plan's main flaw would occur if the FMV of the trust's policy is something other than zero by the time the first premium is contributed to the trust for the year. One example would be if the insured dies before the first premium is paid for the year. A less obvious example, however, is that a term insurance policy's FMV will be greater than zero if the insured is diagnosed with a serious illness or other health problem that makes iron or her uninsurable or highly rated, even though the policy has no CSV with the insurance company. In fact, if the insured is diagnosed with a terminal illness, the policy's FMV to a "viatical settlement" company might actually be close to its face value, even though the insured is still alive.

Example 4: An ILIT holds a term insurance policy with no CSV. X, the insured, had a heart attack in 2002 and is now "rated" for any new insurance. As a result, the policy's FMV (immediately before a $10,000 contribution to the trust in July 2003) is $5,000, instead of zero. X died in an auto accident in August 2003.

In Example 4, a $10,000 "timely allocation" against the July 2003 gift makes the trust only two-thirds exempt from GST tax ($10,000/($5,000 prior FMV + $10,000 current-year gifts)). Thus, one-third of all payments to X's grandchildren in the future will be subject to the flat-rate GST tax, unless either (1) X files a gift tax return in July 2003 to make a "late allocation" to the $5,000 CSV at that time or (2) after X's death, the executor makes an additional allocation of one-third of the insurance death benefits.

Reasons to Delay an Allocation

On the one hand, some taxpayers may prefer the simplicity of doing nothing and relying on the Sec. 2642(c)(1) automatic allocation rules to use a portion of their exemption equal to current-year gifts (particularly if the taxpayer has no plans to use any remaining GST exemption at death). However, several masons could compel the taxpayer to at least consider not having any GST exemption allocated annually (which would require the filing of at least a gift return to elect out of automatic allocations).

First, because term insurance premiums become very expensive as an insured gets older, most policies actually lapse before the insured dies. Thus, if the insured has allocated GST exemption against the premiums but the term policy never pays anything to the grandchildren, he or she would have wasted GST exemption that could have been saved for other purposes.

Second, once the insured starts allocating GST exemption to a trust, he or she will want to continue to do so each year, to maintain the trust's fully exempt status. If the insured makes those allocations via the automatic-allocation rules, he or she must maintain records showing how much exemption was used each year. Although the best way to maintain records is to prepare a gift tax return, this would require preparation fees.

Third, and most importantly, the trust can still achieve fully exempt status in the future, without the insured allocating GST exemption currently. As long as the FMV of the term insurance policy continues to be zero at the time of the first gift to the trust each year, the insured can wait indefinitely to allocate GST exemption to the trust, and simply let the executor file a "timely allocation" against the premiums paid during the year of death. This will result in less GST exemption being reed them if an allocation were made against each and every premium. However, if the insured develops health problems or an illness that causes the policy's FMV to be greater than zero, he or she should timely file a gift return and allocate exemption against that year's premiums and begin filing gift returns annually thereafter.

Summary

Because term insurance has no CSV, an insured can achieve a zero inclusion ratio for an ILIT by not allocating any GST exemption until a "timely" allocation is made in the year of his or her death.

This plan allows a trust to completely avoid GST tax, while using less GST exemption than would otherwise be required. However, this method can be a trap if a client develops health problems or an illness that causes the term insurance to have a FMV, even though it does not have a CSV.

Vital to using this method is maintaining good communication with the client, to ensure proper allocation of the GST exemption if the client develops health problems. This can be achieved by either (1) starting "timely" allocations or (2) making a "late" allocation, depending on the situation.

FROM MARVIN D. HILLS, CPA/PFS, CLU, CHFC, SOUTH BEND, IN