FOR ESTATES / LEGACY

LIFE AND LEGACY BALANCE

We approach work with your high net-worth clients not as estate planners, but as estate strategists. What this means is that we believe your client likely has ideas and priorities important to them both while LIVING and in DEATH. Furthermore, we do not take a cookie-cutter approach, nor do we start with discussions that quickly complicate.  Instead, we want to spend the time to get to know your client, their family, any businesses, their finances, goals, and who around them they consider their top advisors currently. We understand fully the critical and needed role of a competent estate planning attorney. As your client’s financial advisor, you quarterback the team, which involves careful coordination between your client’s estate attorney and qualified CPA. You are at the front lines helping your client understand all financial aspects of his planning and the many estate maximization techniques discussed. Through careful questioning, listening and fact gathering of your client, priorities can be ranked, and a current and projected estate value can be established. Then and only then should possible solutions be mapped out that can be used both today and at death. Your clients are left with less confusion and stress, balancing and maximizing their present life with future legacy.

STRATEGIES TO BUILD A LASTING LEGACY

Minimizing transfer taxes and passing on wealth to future generations are often dual goals of your wealthy client. Some common strategies that advisors, legal and tax professionals may wish to consider include:

  • In an irrevocable trust, the grantor is giving up all rights in any property transferred to the trust and retains no ability to revoke, terminate or modify the trust in any material way. When this type of trust owns life insurance on the grantor’s life, or the life of the grantor and his spouse, it is called an Irrevocable Life Insurance Trust (ILIT). Typically, ILIT’s are used to accomplish four primary objectives:
  • to help meet liquidity needs of the grantor’s estate;
  • to avoid estate taxation of the death proceeds;
  • to help provide for survivors’ income needs, after other liquidity costs satisfied; and,
  • to shelter assets from creditors at death.
  • Beneficiaries of an ILIT typically are family members of the grantor / grantor’s spouse: children and grandchildren and their spouses. Most ILIT’s are unfunded, which means that beyond the life insurance policy, the trustee has no other property in the trust with which to pay premiums. Annual cash gifts from the grantor / grantor’s spouse are therefore necessary to pay the premiums. In some cases, the amount necessary falls within the allowable annual gift per person (beneficiary), currently $15,000 each. If more cash is needed, the additional transfers could be applied against the donor’s available combined lifetime exemption. One additional crucial step to secure the annual gift tax exclusions (as present interest gifts) is the ability of the trust beneficiaries to withdraw their annual gifts to the ILIT, which is known as a “Crummey power”. Formal written notification must be provided each beneficiary of this right at each transfer, which generally is drafted with stated limitations of time and amount available to withdraw. Most trust beneficiaries understand the greater purpose of the ILIT and do not exercise these powers, allowing them instead to expire so that the annual cash gifts can be used by the trustee to pay premium on the life policy.
    • Using a specially drafted ILIT for married couples, called a Spousal Lifetime Access Trust (SLAT), one spouse gifts separate property funds to the SLAT, while the other spouse is a named lifetime beneficiary. Like the ILIT, the trustee uses the transfers, which ideally are gift-tax free, to purchase life insurance insuring either the grantor solely, or both spouses, through a second-to-die policy. The trustee of the SLAT has the discretion to take withdrawals or loans from the policy’s available cash value, which generally are income tax free, and make distributions to the non-grantor spouse during her lifetime.  These too are income and gift tax free, presuming the SLAT has no other taxable income. The policy’s death benefit is then paid to the SLAT at the grantor’s death if a single-life policy used, or at the second death if a joint life policy used, free of both income and estate taxes, transferring out to the remaining trust beneficiaries.
  • If your client has a high-yielding or appreciating asset, transferring it into a Grantor Retained Annuity Trust (GRAT), another type of irrevocable trust, may allow a tremendous amount of wealth to be passed to the next generation, with minimal or potentially no gift tax. This occurs because the grantor retains the right to an annuity interest for a fixed term of years. Since the gift tax value of the asset is determined by subtracting the value of the retained annuity interest from the asset’s fair market value at time of transfer, it is possible to have a zero-remaining value for gift tax purposes, especially in a low interest rate environment. From that point, if the transferred asset’s value takes off and your client survives the GRAT term, the appreciated remaining asset will pass to the trust’s beneficiaries with no additional tax. If your client dies prior to the end of the retained interest time frame, a portion, up to the full value of the trust assets at that time of death, likely will be included in his taxable estate.  Life insurance owned outside the GRAT, within a separate ILIT, is often purchased to provide liquidity at death to pay any estate tax due.
  • A Dynasty Trust is an irrevocable trust used by those clients who want to leave a legacy for children, grandchildren, and future generations. Unlike other types of irrevocable trusts, a Dynasty Trust is designed to continue for as many generations as permissible under state law (according to it’s specific “rule against perpetuities”) and to protect the assets in the Dynasty Trust from not only gift and estate taxes, but also from the generation skipping transfer (GST) tax. Just as with any other ILIT, the Dynasty Trust is named as the owner and beneficiary of a life insurance policy insuring the life of the grantor, or the lives of both spouses, through a survivorship policy. The grantor, and his spouse (if applicable), then transfer cash to the trust in the form of annual exclusion gifts and/or gifts using their lifetime gift tax exemptions. By fully allocating ones GST exemption to all gifts to the trust, assets owned by the trust, including life insurance proceeds, will not be subject to estate tax or GST tax.
  • An Intentionally Defective Irrevocable Trust (IDIT), also known as an Intentionally Defective Grantor Trust (IDGT) describes a type of irrevocable trust where trust income is treated as the grantor(s) for income tax purposes, but assets of the trust are not treated as the property of the grantor(s) for estate tax Thus, an IDIT or IDGT is purposely structured to be ”defective” for income tax purposes, but “effective” for estate tax purposes.
  • Generally, the IDIT is “seeded” with a gift of cash or other assets. Next, the grantor sells property to the IDIT in exchange for an interest-bearing promissory note, payable over a term of years. No gain on this sale is recognized. The trustee then uses income generated from the IDIT assets to make installment payments of principal and interest, which the grantor does not recognize, since he and the IDIT are treated as the same “person” for income tax purposes. All income generated by the assets held inside the IDIT, however, is reported on the grantor’s income tax return.
  • To provide estate tax liquidity, the trustee may utilize some of the IDIT’s assets or income to purchase and own life insurance on the grantor or grantor and spouse. At claim, the death proceeds pass to heirs as stipulated by the terms of the trust.
    • As a type of legal entity, established under a state’s partnership laws, the Family Limited Partnership (FLP) is generally established for the following reasons:
      • to manage and pool wealth among family members;
      • to provide some asset protection; and,
      • to transfer property to downline generations at reduced transfer tax costs.
    • A typical family limited partnership has two types of partners:
      • General Partners: May consist of one or more members, who have unlimited liability; therefore, their assets are available to creditors. The general partner(s) are paid according to the partnership operating agreement, with some receiving a portion of profits, while others a fixed salary. The general partner(s) are responsible for the day-to-day management of the FLP.
      • Limited Partners: Family members, who, in exchange for contributions of money or assets, receive ownership in the project, but have no direct day-to-day management or executive responsibilities. They generally cannot lose more than they have invested. They vote on the partnership agreement to establish the rules of the FLP, and collect profits, as agreed, but are not entitled to demand distributions.
    • Even if the limited partners own the majority of the FLP, they do not outvote the general partners. They are like “silent partners” or passive investors. They may not sell or assign their partnership interests without consent of the general partner(s), nor force the FLP to liquidate. The general partners are in complete control of the FLP, although they do not own the assets in the FLP.
    • In the context of estate planning, the general partners use some of their gifting to transfer the limited partnership interests to their children or other loved ones, who are the limited partners. Due to the typical restrictions placed on the limited partnership interests, the value of these interests may be discounted to reflect the lack of marketability of the interests and the limited partners lack of control, thus lowering the gifted amounts. There are several tax and legal concerns about the use of FLP’s within estate planning, and thus they may be subject to greater IRS scrutiny.
    • In a private loan arrangement, the grantor(s) lend money to their ILIT (referred to as a “private IRC Section 7872 loan”), to assist in paying premiums. If structured properly, the loan should not be considered a gift for gift tax purposes, because it is a loan, not a gift. The grantor(s) make either annual loans or a lump sum loan to the ILIT in exchange for a promissory note at the Applicable Federal Rate (AFR). Any excess funds are invested by the trustee.
    • The trustee of the ILIT purchases a life insurance policy on the life of the grantor(s), and the ILIT retains ownership and beneficiary rights to this policy. The trustee pays premiums to the carrier to fund the life insurance policy and pays loan interest to the grantor(s) each year, or has the option to defer the loan interest. A restricted collateral assignment is used to assign a portion of the death benefit and cash surrender value to the grantor(s) or their estate to repay the loan.
    • Loans in private financing arrangements are either demand or term loans. If a repayment date is specified in the note, the loan is treated as a term loan, and the grantor(s) do not have the right to demand loan repayment prior to the end of the term. However, if the insured(s) die prior to the end of the term, repayment of the loan should be accelerated. Term loans fall under these categories
    • Short-term:  a loan term of less than 3 years;
    • Mid-term:  a loan term of 3 to 9 years; or,
    • Long-term:  a loan term of 9 or more years.
  • Demand loans must use an interest rate at least equal to the blended AFR, which is re-determined each year.
    • A private split dollar arrangement (PSD) can help grantors make funds available to an ILIT while retaining some ability to have these funds returned, if later needed. In this strategy, the grantor supplies the funds to pay the premiums, but reserves the right to be repaid the greater of the policy premiums paid or the policy cash values. This is accomplished using a restricted collateral assignment.
    • Each year, the grantor makes a gift to the ILIT equal to the value of the life insurance protection. This amount is often much less than the premium paid, and is referred to as the “reported economic benefit” (REB). This also allows the grantor(s) to leverage the gift tax value of the premiums into larger death benefits that eventually will be paid to the ILIT.
    • At death of the insured(s), or termination of the agreement (whichever comes first), the trustee will repay the estate or grantor(s) the greater of the cash values in the policy or the total premiums they advanced to the ILIT. All remaining death benefits are retained by the ILIT and distributed under the terms of the trust.

    A RECAP

    The framework around which U.S. estate planning occurs today comes from the enactment of the Taxpayer Relief Act of 2012 (ATRA), which permanently set the federal estate, gift and generation skipping transfer (GST) tax exemption limits. In 2017, this exemption stood at $5,490,000. However, in a late 2017 revision (Public Law 115-97), a temporary doubling of the exemption level was adopted, effective for the years 2018 to 2025. Currently, the filing of an estate tax return (IRS Form 706) at death is required for estates with combined gross assets and prior taxable gifts exceeding $11,400,000. (This amount has been indexed for inflation since ATRA took effect.) In addition, as of January 2011, a surviving spouse may elect on the estate tax return to pass any of her deceased spouse’s unused exemption to herself, which effectively translates to a current $22,800,000 exemption for married couples.

    Keep in mind that the new exemption amounts are scheduled to revert to the previous ATRA amount (adjusted for inflation) as of January 1, 2026. This means that the $11.4 million is temporary and clients should plan accordingly with their attorneys. For clients with irrevocable life insurance trusts (ILIT’s) funded with life insurance who think they may no longer need them, they should think twice before taking any action. Congress could lower the exemption amount at any time and without an extension the reduction is a certainty in 2026. If your clients expect to live beyond that date, their ILIT, along with the life insurance inside it, is still needed.

    The $11.4 million amount is an aggregate lifetime exemption; therefore, a taxpayer could instead choose to gift (transfer asset ownership) up to this amount while living. In addition, annual gifts of up to $15,000 each are allowed to any number of persons. If these thresholds are adhered to, no gift tax is owed by the donor or the recipient. In some cases, regardless of whether gift taxes are owed or not, filing a gift tax return (Form 709) may still be required. With the recent tax changes, individuals may want to consider making lifetime gifts, especially those individuals who have already exhausted their prior exemption amounts, to take advantage of the increased exemption amount while it is available.

    Technically, the tax laws today refer to calculating the tax and applying a unified tax credit, which under the current formula, results in no tax due up the maximum $11.4 million estate value. When the estate value at death is above this combined lifetime exemption, the remainder (overage) is termed the “taxable estate”, and it is assessed a 40% tax.

    Attempts to mitigate the amount of, and/or, provide a liquid fund to pay this tax, are at the foundation of estate planning for the affluent.

    SOURCES

    Access Trusts – Using Life Insurance to Accumulate, Access, and Transfer Wealth, Prudential, December 2016.

    Estate Tax, IRS, https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax, October 2016.

    Frequently Asked Questions on Gift Taxes, IRS, https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes, April 2017.

    Framing Your Legacy – With Transfer Tax Certainty, It is Time to Consider Your Estate and Life Insurance Planning, Pacific Life, February, 2015.

    New Estate Tax Laws – Advanced Markets Minute, Mutual of Omaha, March 6, 2018.

    Private Financing Strategy – Leveraging Wealth Transfer Using Private Financing, Symetra, May, 2014.

    Private Split Dollar Arrangements, VOYA, September 1, 2014.

    Recent Changes in the Estate and Gift Tax Provisions, Congressional Research Service, January 11, 2018.