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.
The Problem
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
the wealthy.