Alternatives to funding life insurance premiums.

Clients facing the estate tax are often confused by advanced approaches to estate planning. Gifting techniques can be daunting and intimidating, even to the most sophisticated taxpayers. For many, life insurance continues to be the easiest and cleanest way to pay estate tax without risking premature death and IRS scrutiny. In essence, this allows prepayment of the estate tax from current assets, for the cost of a life insurance premium. Unless clients self-insure by continuing to pay premiums beyond their life expectancy in an aggregate amount equal to the death benefit, their heirs will receive a windfall (especially if the insured dies prematurely).

Whether clients purchase single-life or survivorship life insurance policies, to the extent that an irrevocable mast is the policy owner and beneficiary, the proceeds will pass estate tax free to their trust beneficiaries. The beneficiaries will then loan the proceeds to the executor, who will use it to pay the estate tax.

Problem

The most common obstacle encountered when coordinating life insurance in an estate plan is determining whether the premium payments fit within the Crummey powers in the irrevocable mist. Ordinarily, life insurance premiums paid to such a trust are deemed gifts, because the proceeds Hill ultimately benefit the trust beneficiaries after the insured dies. This type of gift will exhaust a portion of the donor's $1 million lifetime gift tax exemption. The more preferable option is to qualify the premiums for the annual gift tax exclusion, currently $11,000 per year per donee ($22,000 if the spouse consents to the gift). To do so, this gift must be of a present interest, which means that it must be enjoyed immediately. This is accomplished by giving each trust beneficiary a Crummey power or withdrawal power. The problem is, even when using "hanging" powers, because permanent life insurance products (such as whole-life and variable life) are frequently purchased to satisfy the estate tax problem, the premiums often exceed the $11,000 (or $22,000) per-beneficiary Crummey withdrawal powers.

Solution

One possible solution is to have the irrevocable trust own an asset that produces sufficient income to pay the life insurance premiums without requiring additional contributions.

Example: H and W are married; they have two adult children and no grandchildren. H Owns 100% of O, a manufacturing company. He also owns, in his sole name, the building in which O is located. H is concerned about his ever-growing estate tax liability and purchases a $5 million life insurance policy for a $75,000 annual premium. The policy will also provide income replacement for W and their children. H creates an irrevocable trust with W and his friend X as trustees to be the policy's applicants, owners and beneficiaries. The trust will "sprinkle" income and principal to W and her issue; on W's death, it will be divided into shares for the children, with distribution of the trust principal in installments at ages 30 and 35. Besides permitting the life insurance proceeds to pass to the children free from estate tax, the trust is drafted as a "defective" grantor trust for income tax purposes under Sec. 677(a)(2). Thus, during H's life, to the extent the trust holds assets subject to income tax (such as real estate or marketable securities), he will be responsible for paying that tax, even though he does not receive any trust income or principal.

The building is worth $4 million but, because it was recently refinanced, there is only $44,000 equity. H first transfers it to a manager-managed limited liability company (LLC), N. H and W each own a 1% membership interest in N and serve as the managers. H gifts the remaining 98% of the membership interests he owns to the irrevocable trust. The transfer of N interests is a gift for gift tax purposes, but it is only a gift of $43,120 (or less, taking into account lack of marketability and minority interest discounts), which will exhaust most of the gift tax annual exclusions.

O is the tenant and pays N as the landlord, $30,000 rent each month (determined to be fair market rent by an appraisal) pursuant to a "triple net lease" ($360,000 per year).The rent check is deposited into a bank account in N's name. N will make mortgage payments totaling $160,000 per year, leaving $200,000 in the N bank account.

At the end of the year, N Hill make a pro-rata distribution to its members; H will receive $2,000,W will receive $2,000 and the irrevocable trust will receive $196,000. The irrevocable trust will use this distribution to pay the $75,000 life insurance premium. The extra $121,000 of income will stay in the trust.

All three members will receive a K-1 from N, reflecting their pro-rata share of N's income and distributions. H and W will each report their share of the income on their joint Form 1040. Because the irrevocable trust is a defective grantor trust, H and W must also report the trust's share of income on their Form 1040, even though $121,000 of it remains in the trust.

Benefits

The advantages of this technique are that H and W have found a source to pay for the life insurance premiums without having to worry about the annual gift tax limit described above. Another benefit is that the building, which is an appreciating asset, was removed from the taxable estate. The only gift was the initial transfer of the 98% membership interest in N to the irrevocable trust, which was covered by the gift tax annual exclusion. Also, the $121,000 remaining after paying the $75,000 life insurance premium (including its subsequent appreciation), will eventually pass to the children estate tax free. Further, because H is paying the income tax out of his own pocket, in effect the $121,000 is growing income tax free as well, similar to a qualified pension or profit-sharing plan. This is helpful estate planning, in that H is reducing his taxable estate by the income tax paid, without that payment being deemed a gift.

By comparison, if H and W, or their LLC, owned the building, they would receive all the rent, pay income tax on it, pay the life insurance premiums (subject to the gift tax limit stated above) and keep the excess, which would be included in their estates to the extent not spent. By integrating the LLC into the life insurance planning, H and W will continue to pay all of the income tax on the rent received by them or the irrevocable trust, but the life insurance premiums will be paid from this distribution, so that they do not have to be concerned with the $44,000 per-year gift tax limit. Also, to the extent they do not need the excess $121,000 of rent, it will pass to the children free from estate tax.

FROM MICHAEL MARKOFF, ESQ., DANZIGER & MARKOFF LLP, WHITE PLAINS, NY (NOT AFFILIATED WITH BAKER TILLEY INTERNATIONAL)