Wealthy clients can benefit by the carefully planned use of an intentionally defective grantor trust.
Clients don't dislike life insurance: They dislike life insurance premiums. Often, the key to a significant life insurance sale is finding a creative strategy that allows a client to feel that he can afford the policy. Clients are often willing to fund the policy in one transaction, but tax advisors caution against the significant gift tax liability that can be created by large transfers to trusts. Too often these advisors are slaves to Crummey powers. As an alternative, insurance professionals and tax advisors should "think defective"-the intentionally defective grantor trust (IDT)-as the centerpiece of a gift/sale transaction.
Recently, Beth, a wealthy 80-year old widow, expressed interest in purchasing a large insurance policy as an alternative to a far more complicated gifting strategy. Life insurance, after all, is relatively simple, is easily removed from the insured's estate and allows the client to retain direct control of her assets until her death. A $3 million policy would be necessary to allow the family's wealth to pass to Beth's two children and one grandchild without the burden of transfer taxes. Premiums for a universal policy guaranteed to age 100, at standard nonsmoker rates, would be slightly less than $190,000 per year, but only $36,000 of potential Crummey powers would be available to offset the annual premium, leaving more than $150,000 not sheltered by annual exclusion gifts. The gifting shortfall could be absorbed by the $1 million of Applicable Exclusion Amount that is available for lifetime gifts. If the entire Applicable Exclusion Amount were available, it would shelter slightly more than six years of annual premium.
Unfortunately, Beth had less than $200,000 of Applicable Exclusion remaining. She and her late husband had planned extensively, and had successfully transferred substantial wealth to their children and grandchild. Beth shared her late husband's aversion to enriching the U.S. Treasury, and although Beth was determined to ensure that her remaining wealth passed to her descendants tax free, she was reluctant to pay federal gift tax at a 41% rate in the first year of the new life insurance plan. The IDT provides the solution.
The IDT Solution
Transferring property interests to an IDT would allow Beth to substantially increase the amount of property that is transferred without tax. An "Intentionally Defective Grantor Trust" is an irrevocable trust created so that the assets of the trust are not attributable to the grantor for gift, estate or Generation-Skipping Transfer Tax (GSTT) purposes, but the grantor of the trust is responsible for federal income tax attributable to the trust property. The "defect" is that the grantor reports all of the income, deductions and credits of the trust on his Form 1040, just as if he owned the trust assets in his own name. Because the grantor pays the income taxes, the trust assets grow on a tax-free basis, which is effectively a gift-tax free gift to the trust beneficiaries. In addition, the trust is structured so that its assets are not includible in the grantor's estate for estate tax or Generation Skipping Transfer Tax (GSTT) purposes.
A sale between the grantor and his IDT will not result in any capital gain or loss. The trust is ignored for federal income tax purposes, so if the grantor sells an asset to his IDT at fair market value there generally is no gift tax, no capital gain or loss and no income tax on the payments the grantor receives in return for the transferred property. With proper planning, the IDT can usually be converted into a complex trust that pays its own taxes, which will relieve the grantor of the obligation to pay the IDT's taxes.
What Assets Should Be Transferred To An IDT?
Beth has a substantial limited partnership interest in a Limited Partnership (LP) that her late husband had formed decades ago with his brother and three unrelated business associates. For Beth's planning, these LP interests are among the best assets to transfer to the IDT because the LP interests create significant additional discounts that further leverage the transaction.
A limited partnership offers substantial gift and estate tax savings because the value of a limited partnership interest, for gift tax purposes, is less than the fair market value of the underlying LP assets. Because a limited partner has little, if any, control over partnership activities, valuation discounts for lack of control are appropriate. Similarly, because there is no ready market for interests in privately held partnerships, a discount for lack of marketability is also available. While valuation discounts can vary from partnership to partnership, a combined discount of 35% to 45% is not uncommon. The planning can also be implemented using a limited liability company or a corporation that has elected to be taxed under Subchapter S (i.e., an S Corporation). A nonvoting interest is the key for discounting purposes.
Sale And Gift To An IDT
A small gift, followed by an installment sale of property to an IDT can be an effective means to transfer assets with relatively little gift or estate tax cost. Typically, a gift of 10% of the property to be transferred to an IDT would precede a sale of the remaining 90% of the property to be transferred to the trust.
After gifting the 10% limited partnership interest in the LP valued at $162,500 (but with underlying assets of $250,000) to the trust, Beth will sell her remaining 90% nonvoting interest to the trust for a purchase price of $1,462,500 (assuming a 35% discount of the limited partnership interest). The purchase price would be in the form of a promissory note with 4.84% interest (for a May 2006 transaction), payable each year and a balloon payment in year nine. It is also possible to structure the promissory note on an amortized or partially amortized basis, or even as a self-canceling installment note (SCIN). A SCIN increases the size of the payment to the grantor, and makes sense only when there is a significant likelihood that the grantor will not attain his life expectancy.
Each year, the LP will make distributions to the IDT, which will use the proceeds to make the interest payment to Beth and to fund the annual insurance premium. If the income is not adequate, the underlying investments can be sold or liquidated, cannibalizing the IDT's investments in order to provide the money necessary to fund the premium payments. At the end of year nine, the principal amount of the note will need to be repaid. This may require a liquidation of a portion of the trust's assets, but as long as the trust has earned a higher rate of return than the 4.84% mid-term AFR, the planning will be successful.
Even if Beth died relatively soon after acquiring the policy, this planning would be highly advantageous to the IDT beneficiaries. The IDT may still owe Beth's estate on the promissory note, but the IDT would own both a valuable LP interest and the proceeds of a life insurance policy.
The news is great if Beth survives, too. By making a taxable gift equal to less than two years of premiums, Beth ensured that an extra $154,000 per year would be available to help pay premiums on a $3 million life insurance policy. And at the end of nine years, assuming a 9% before-tax annual total return on the portfolio, the promissory note would have been repaid and the IDT would own an LP interest representing a little over $1 million of underlying property. It's true that the value of the IDT's property will generally decrease as it pays many years of insurance premiums. However, using this technique, Beth should be able to "carry" the $190,000-a-year policy while making only $36,000 of annual exclusion gifts for almost 20 years.
In addition, all of the property owned by the IDT is GSTT exempt. This is accomplished by allocating GSTT exemption to the gift portion of the transaction (i.e. $162,500). If Beth died at the end of nine years, the IDT would hold approximately $4 million, all of which could be distributed to grandchildren or further lineal descendants without incurring the additional 46% GSTT. This entire fund, and any future growth, could be used for the benefit of the children and would also pass estate tax free on their deaths. The IDT can also be drafted to protect trust property (including the eventual life insurance proceeds) from claims of the beneficiaries' potential creditors, including divorcing spouses.
Edward A. Renn is a private client
tax attorney with WithersBergman LLP, which serves ultra-affluent
clients. Frank W. Seneco is a life insurance expert specializing in the
sophisticated use, structuring and the placing of life insurance for