Passing On Family Wealth Without Making Gifts
New Wealth Transfer Opportunities. At the end of 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010 or the Act) became law. Its major purpose was to continue the “Bush tax cuts” through 2012.
In the area of federal transfer taxes, however, TRA 2010 didn’t just extend those tax cuts, it greatly expanded them. As a result, wealthy people have new opportunities to pass on family wealth. The Act temporarily increased both the lifetime gift tax exemption and the generation skipping transfer (GST) tax exemption to $5 million per person. The Act allows married couples to combine their gifting and GST exemptions so that together they may transfer up to $10 million free of federal gift or GST taxes. Because the expanded gifting and GST limits expire on December 31, 2012, many well-to-do parents and grandparents are being advised to make significant gifts before 2013.
Gifting Isn’t for Everyone Just because someone has the financial ability to make gifts doesn’t necessarily mean they should. Many well-to-do people want to protect their financial security and feel more comfortable waiting to pass on their extra wealth when they die. Gifting away assets could potentially reduce their standard of living and weaken their financial flexibility. Before making large gifts, parents and grandparents need to be comfortable with these facts:
1. Gifts are irrevocable. Once a gift is completed, it can not be recovered. Even if a donor’s circumstances or objectives change, assets given away can’t be retrieved.
2. Control over gifted assets is lost. Once a gift is completed, control over the asset passes to the recipient; thereafter, the parent/grandparent can’t limit, restrict or control how it is used.
3. Gifted assets may be claimed by outsiders. Assets gifted away can potentially be claimed by a donee’s creditors. Or, if there is a divorce, the gifted assets could wind up in the hands of the ex-spouse.
Passing on Wealth without Gifts Still, most parents/grandparents love their children and grandchildren and want to pass on their wealth to them. Although they have no obligation to leave them an inheritance, many are interested in doing so. Although they may not wish to make large gifts, they may be willing to reposition some of their assets to increase what they pass on to their children/grandchildren as long as: (1) there is no negative impact on their own financial security, (2) the transfer takes place after they die, and (3) they retain control over the assets while they are alive, including the ability to recover their costs and change which family members or charities will receive the funds.
Jim and Nora Jones Jim and Nora Jones are both 65 years old and in good health, and they just celebrated their 37th wedding anniversary. They have three adult children and seven grandchildren and a combined net worth of $4 million. They would like to pass on as much money as possible to their children and grandchildren, but not in a way that will weaken their own financial security. They are ready and willing to help if their children need financial assistance, but they aren’t interested in making gifts. Instead, they prefer to pass on most of their wealth at death.
Life Insurance May Help. Healthy, well-to-do people like Jim and Nora often use life insurance in their overall wealth transfer strategy. A policy insuring a parent or grandparent will pay death benefits when the insured dies—exactly the time when many parents and grandparents prefer to pass on their assets. Life insurance policies on either or both Jim and Nora have the potential to provide several important advantages, including:
1. Predictable Value. The policy may be structured to pay a known death benefit amount when the insured dies.
2. Death Benefit Values Not Linked to Market Performance. The policy may be structured so that the death benefit is a fixed amount which can be known in advance.
3. Liquidity. The death benefits are paid in cash; generally no transfer costs, commissions or management fees are subtracted from the death benefit.
4. Federal Income Tax-Free Payment. Policy death benefits (including the amount in excess of premiums paid) are generally income tax-free under IRC Section 101.
5. Growth/Leverage. Premiums paid for life insurance death benefit protection can provide significant leverage in the early years and may provide a competitive rate of return through life expectancy. The amount by which the death benefit exceeds the premiums paid is growth that is transferred to the policy beneficiaries free of federal income taxes.
Effective use of life insurance to transfer wealth often requires thoughtful planning. Parents/grandparents may want control over the policy and access to its cash values without having the death benefits taxed in their estates. Including the death benefits in their taxable estates could potentially increase their estate taxes or create an estate tax when none was previously due. Careful planning for policy ownership and payment of premiums may help them pass on more family wealth without making lifetime gifts.
Let’s assume that Jim and Nora qualify for a $1 million survivorship policy (which would pay death benefits after they have both passed away). The annual premium is $20,000. What options do they have for owning the policy and paying premiums?
Any of three strategies may help them: • Standby trust • Inter-family loan • Private split dollar arrangement
The Standby Trust Strategy The standby trust strategy is a policy ownership arrangement in which a couple (usually a husband and wife) work together to use a survivorship life insurance policy to transfer funds to younger family members. This strategy gives one spouse control over the policy and the ability to access policy cash values as needed. When this strategy is properly implemented, policy death benefits should be estate tax-free.
Here’s how the standby trust strategy works:
1. The spouse with the shortest life expectancy (Jim) purchases a survivorship life insurance policy insuring both himself and Nora. Death benefits are paid when the survivor (Nora) dies. Jim pays premiums out of personal funds. As the policy owner, he makes the policy management decisions and has the ability to access policy values.
2. Jim creates a credit shelter trust as part of his estate plan. This trust can be created in his will or his revocable trust. Jim names this trust as the policy’s contingent owner and contingent beneficiary. This credit shelter trust “stands by” to receive the policy when Jim dies.
3. Jim’s credit shelter trust becomes the policyowner and beneficiary at his death. The trustee manages the policy according to the terms of the trust. Only the cash value in the policy on the date of death is included in Jim’s taxable estate.
4. When Nora dies, the policy death benefits are paid to the credit shelter trust without becoming part of her taxable estate.
5. The trustee distributes the policy death benefits and other trust assets to the children and grandchildren according to the terms of the trust.
Inter-Family Loans Another strategy Jim and Nora should consider uses inter-family loans. Inter-family loans can be quite attractive when market interest rates are low. Currently interest rates are at or near historical lows. Table 1 shows how low the IRS short, mid, and long term rates are today compared to rates over the last five years.
In inter-family loans, neither Jim nor Nora owns the policy. Instead it is owned by their children, grandchildren or a trust for their benefit. Jim and Nora supply premium dollars by making loans to the policyowner. There can be one large loan that can be used to pay premiums for several years or there can be a series of smaller annual loans.
The legal formalities of loans need to be followed, and interest on the loan balance must be accounted for annually. Under the terms of the loan, policy cash values are assigned to Jim and/or Nora as security for repayment of the loan balance. An assignment of policy cash values gives Jim and Nora significant control over the policy.
The amount of interest due depends on whether the loan is a term loan (which must be repaid at a specified time) or a demand loan (which can be called for repayment whenever the lender chooses). In term loans the interest payment is a fixed percent for the life of the loan, while in demand loans the interest rate changes from year to year.
The loan arrangement continues until the lender (Jim) demands repayment (a demand loan), the term of the loan ends (a term loan) or the insured parent/grandparent dies. If the insured dies, the policy death benefits are first used to repay the loan balance and then the remaining death benefits are distributed to the policy beneficiaries (usually the children or grandchildren).
Irrevocable Life Insurance Trusts (ILITs). Allowing ownership of the policy to be shared by several children may create problems. To avoid these problems, Jim and Nora can create an irrevocable life insurance trust (ILIT) to own the policy. Their children/grandchildren would be the beneficiaries of the ILIT. Jim and Nora can lend the trustee the funds needed to pay the policy premiums.
Although some costs will be incurred to draft and administer an ILIT, well-to-do people often use them in their estate plans because ILITs give them the potential to:
1. Provide equal treatment to all children. In place of managing separate loans and policies for each child/grandchild, an ILIT allows the parent/grandparent to provide for all of them in one series of loans and use one life insurance policy so the death benefits can be distributed fairly under rules that apply to all.
2. Control the policy and its death benefits indirectly through provisions they included in the trust concerning policy management and distribution of death benefits.
3. Protect the policy and its death benefits from claims by beneficiaries’ creditors and ex-spouses. Such claims should not have access to either the policy or the death benefits in the trust.
4. Prevent policy death benefits in excess of the outstanding loan balance from being subject to either federal income or estate taxes.
Private Split Dollar Arrangements Suppose neither Jim nor Nora wants to deal with the interest costs that come with inter-family loans. When that is the case, using a private split dollar strategy to pay the life insurance premiums may make sense.
In a private split dollar arrangement, Jim and Nora pay premiums through a split dollar “advance” rather than lending funds to pay premiums. The policy is often owned by an ILIT. The trustee and the parent/grandparent agree in writing to share the life insurance policy.
In return for advancing premium dollars, Jim and Nora will receive a portion of the death benefit equal to the policy’s cash values or the total premiums advanced, whichever is larger. The ILIT receives all the remaining death benefits. If the arrangement ends before both Jim and Nora die, they receive the greater of policy cash values or premiums advanced.
Private split dollar arrangements are not loans, and the ILIT trustee has no obligation to pay interest on the advances. Instead, Jim is deemed to make an annual gift to the ILIT beneficiaries of the term insurance value of the trust’s share of the life insurance protection. This value is known as the “economic benefit value” and can be determined under IRS Table 2001.
The annual gift is the term insurance value of the trust’s share of this year’s life insurance protection. It is not the premiums paid. The gift is “imputed” from the trust’s share of the life insurance protection, and no additional funds are transferred to the trust. Thus, the premium advances are essentially “cashless” gifts.
Jim retains the right to be repaid the greater of the total premiums paid into the policy or the policy cash values when the arrangement ends. When the policy used is a survivorship policy, the economic benefit value is usually relatively small while both Jim and Nora are alive. After one of them dies, the economic benefit value will start to increase substantially.
Private split dollar arrangements can be more complex than loan arrangements. The agreement itself should be drafted by a qualified attorney, and annual administration may be necessary. The economic benefit value increases each year as the insured ages. This means that the size of the imputed annual gift increases annually as well.
If there comes a time when Jim no longer wishes to continue the split dollar arrangement, he can have the option to convert it to an inter-family loan arrangement. In that case the split dollar premium advances he has made to date and future premiums will be treated as loans.
Conclusion TRA 2010’s increase in the gift tax and GST tax exemptions gives wealthy parents/grandparents a great opportunity to transfer significant wealth to their children and grandchildren before 2013. Those who would like to transfer some wealth but who don’t wish to make gifts should consider using a standby trust strategy, inter-family loans, or private split dollar arrangements as alternatives. These strategies use life insurance ownership and premium paying strategies to increase what’s passed on to children/grandchildren. They avoid or minimize gifts while giving the policyowner the ability to recover some or all of his money if his circumstances or objectives change. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone. Each taxpayer should seek advice from an independent tax advisor.
Peter L McCarthy for February 2012 issue of Broker World Magazine. Author’s Bio Peter L. McCarthy, JD, MBA, CLU, ChFC JD, MBA, CLU, ChFC, is a senior advanced sales consultant for ING’s life sales support