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Estate planning with life insurance.

One of the biggest challenges facing advisers in estate planning today is giving clients effective advice and wealth transfer ideas under the current, uncertain transfer tax system. The estate and gift tax systems have been decoupled, creating a situation in which the lifetime gift tax exclusion is $1 million per person, while the estate tax equivalent exemption is $1.5 million per person. Further, the estate tax exemption will increase through 2009, disappear entirely in 2010 and, barring further legislation, reappear in 2011. The question for tax advisers is how best to proceed under the present tax structure to protect clients' wealth against an uncertain future.

Even though the future is somewhat vague, a "do nothing" approach is clearly not a solution. This column explores creative exclusion planning to generate additional wealth for clients.

One area not addressed in depth in this column is the annual gift tax exclusion. However, no discussion would be complete without mentioning this powerful wealth transfer tool. Even in today's tentative legislative environment, an actively managed gifting program, coupled with a trust for the benefit of children and/or grandchildren, allows an individual to make substantial gifts that could ultimately be exempt from estate and generation-skipping transfer taxes.

For example, a wealthy couple with six heirs could transfer $132,000 per year to a trust without affecting their lifetime credits or being concerned about the future of transfer tax legislation. The trust proceeds could be invested in marketable securities or leveraged to purchase life insurance. In any case, the annual gift tax exclusion is a great way to remove wealth and asset appreciation from an estate; it should not be forgotten amidst the more advanced planning techniques discussed below.

Leveraging the Gift Tax Exemption

The $1 million lifetime exemption available to individuals ($2 million for married couples) will remain even after the current law sunsets on Dec. 31,2010. Accordingly, tax advisers can reasonably rely on this exemption and focus on the best way to use it.

Several estate planning strategies can reduce a client's taxable estate. One of these combines three planning vehicles--a family limited partnership (FLP), a grantor retained annuity trust (GRAT) and an irrevocable life insurance trust (ILIT). This strategy is not overly complicated, and the results can be substantial.

FLPs: Recent litigation and case law on FLPs offer guidance on how to structure partnerships and make appropriate investments. The specifics are beyond this column's scope, but if the rules are followed diligently, a FLP is a viable wealth transfer tool. (For more information on FLPs, see Schlueter, Tax Clinic, "Discounting FLP Interests," TTA, February 2004, p. 74; Satchit, "FLP Administration Issues," TTA, June 2004, p. 352; and Eyberg and Raasch, "FLP Planning after Strangi, Kimbell and Thompson," TTA, December 2004, p. 750.)

GRATs: A GRAT is a very useful device in today's low-interest-rate environment. For example, Sec. 7520, which governs the assumed rate of return that the IRS believes investors will earn on their money, is currently very low. GRATs are potent in this setting: a trust may earn well in excess of the prescribed Sec. 7520 rate, and a GRAT annuity payment can be structured so that property contributed to the GRAT receives a substantial discount. Further, because the discount is a numerical calculation, it offers certainty against audit risk.

ILITs: Finally, an ILIT continues to be a great way to house the ownership of life insurance policies and to protect the proceeds from being included in an insured's estate, thus avoiding estate taxation.

The Strategy

Tax advisers are challenged to find the best way to use gift tax exemptions, and a combination of a FLP, GRAT and an ILIT can offer significant leverage. The strategy is two-pronged: the client simultaneously establishes and funds an ILIT and makes gifts of FLP units to a GRAT. From a gift tax and overall economic standpoint, this is a less expensive way to purchase life insurance.

Funds transferred directly to an ILIT are gift tax dollars valued at "face." If the money is then used to buy life insurance, the leverage and wealth created are measured simply by the (1) insured's lifespan, (2) aggregate premiums paid and (3) death benefit received. If an insured dies before his or her life expectancy, the insurance increases family wealth. On the other hand, if he or she lives past life expectancy, the funds in the trust might have generated more wealth had they been used to purchase investments rather than insurance. The strategy, however, allows life insurance to be purchased with discounted dollars, which substantially leverages wealth creation, regardless of how long the insured lives.

In regard to FLPs, there are two layers of discounts--those for minority interest and lack of marketability of the LP units. In addition, there is a mathematically calculated discount attributable to the GRAT. As indicated above, the two-prong strategy simultaneously establishes and funds an ILIT and makes gifts of FLP units to a GRAT. The ILIT is funded with the minimum needed to purchase a death benefit through the end of the GRAT's term. When the GRAT terminates, the remainder interest is transferred to the ILIT.

Example 1: Client R establishes a 10-year GRAT. His life insurance policy is structured so that a premium is paid in year 1, and the next payment is made in year 10. The first payment equals the minimum needed to fund the policy's death benefit throughout the GRAT's term; the payments in years 10 and beyond are structured to sustain the policy through the remainder of the insured's life.

The benefit of this approach is its postponement, until after year 10, of the need for most of the funds to carry the policy, at which time the GRAT proceeds can ultimately pay the premiums. Obviously, the GRAT must be carefully structured to ensure that the funds are available in year 10, but, once done, the funds sustaining the policy will have been deeply discounted for estate and gift tax purposes. This strategy allows for use of the gift tax exemptions, and provides significant leverage for creating wealth.

Finally, there is an ancillary benefit. The life insurance is in force from the outset; thus, if the grantor dies during the GRAT's term, the insurance will be available in trust for the ILIT's beneficiaries. Because the GRAT's value is included in R's estate, the ILIT offers protection against the potential estate tax liability from that inclusion. The technique is illustrated in Exhibit 1 below.


Alternative Uses of Insurance

The discussion above focused on minimizing transfer taxes and creating wealth by leveraging gift tax exclusions and discounts. In today's legislative environment, however, tax advisers are challenged to devise other strategies that will allow clients to prosper without incurring a current tax liability. One option is insurance, which can be used not only to offset shrinkage from estate tax or to provide family liquidity, but also to invest.

Tax advisers are already familiar with the use of variable life insurance policies, which allow policyowners to invest the policy's cash value in various mutual funds. The assets can grow income-tax deferred, because the investments are tied to a life insurance contract. However, besides variable life policies, there are other ways tax advisers can use life insurance to create wealth.

Insurance arbitrage: This strategy involves two insurance products--a single premium immediate annuity (SPIA) and a universal life (UL) policy. The SPIA is a contract under which a client establishes a lifetime income stream by giving an insurance company a single lump-sum premium. In exchange, the insurance company agrees to pay an income stream for the insured's life. However, premature mortality is an associated risk--on a client's death, any remaining investment in the contract is forfeited. Accordingly, if an individual invested $1 million in a SPIA and died two months later, the $1 million premium would be forfeited.

A UL policy is a flexible premium permanent life insurance policy. Some UL products offer guaranteed death benefit riders, which work well with the arbitrage strategy described below. The idea is to couple the two products to create a "yield" between the annuity payments and the life insurance premiums.

By pairing a SPIA and a guaranteed UL policy, a client avoids the risk of forfeiting the SPIA premium if he or she dies prematurely, because at death the life insurance proceeds will replace the investment in the SPIA. For an older client (i.e., age 70 and over), there is an opportunity to create a spread between the annuity payment and the premium needed to carry a death benefit to replace the SPIA investment.

Example 2: T invests $1 million in a SPIA that pays $160,000 a year for life. If a $1 million guaranteed UL policy costs $85,000 per year, there is a $75,000 excess each year, which equals a 7.5% yield on the $1 million investment.

Because the life insurance repays the SPIA investment at death, this strategy can be viewed as an alternative, fixed-income investment. It has several benefits, including the fact that the investment principal's value does not fluctuate with interest rates (advantageous when interest rates are rising). In addition, pursuant to the annuity rules, during T's life expectancy, a significant portion of the annuity payments are deemed a return of principal, and, accordingly, are not subject to income tax. Thus, the yield is tax-favored through T's life expectancy. However, if the insured lives past life expectancy, the entire yield would be taxable.

The strategy is illustrated in Exhibit 2 above.


Unlike bonds, the annuity contract's principal cannot be accessed. Accordingly, a client should not commit all of his or her assets to this type of strategy. Nevertheless, the arbitrage is a powerful diversification tool to boost wealth with a portion of a client's portfolio.


The current legislative environment has made it difficult for financial and estate planners to minimize clients' taxes and, at the same time, preserve and increase their wealth. Despite this, insurance continues to be a valuable tool and is becoming increasingly important in light of the uncertainty surrounding the current estate and gift tax regimes.

Editor's note: For further information about this column, contact Mr. Minker at (212) 790-5826 or, or Mr. Pincus at (908) 561-2270 or

Andrew S. Pincus, J.D., CPA

Managing Member

Regal Wealth Advisors, LLC

Warren, NJ
COPYRIGHT 2005 American Institute of CPA's
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Article Details
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Author:Pincus, Andrew S.
Publication:The Tax Adviser
Date:Jul 1, 2005
Previous Article:Planning strategies to avoid intermediate sanctions.
Next Article:TAP: mission and methods.

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