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Scott M. McCullough is an associate at Callister, Nebeker & McCullough in Salt Lake City, Utah, and can be reached at email@example.com.
A flexible irrevocable life insurance trust, holding a second-to-die policy, can provide additional benefits as compared to a standard irrevocable life insurance trust, lessen the premium burden on the family, and provide the peace of mind many clients need when considering irrevocable estate planning strategies.
Estate planners advising clients with substantial wealth face a significant problem helping these clients formulate a tax-efficient strategy to pass wealth to their children and grandchildren without the crippling effect of gift, estate, and generation-skipping transfer taxes while at the same time allowing the clients to maintain some level of control over their assets and ensure adequate income for the remainder of their lives. Most wealthy clients share the common fear of losing control over the assets they have spent their lives accumulating or running out of money if they "give it away" or "lock it up" before they die. Many, if not all, clients would welcome an estate planning option that could be flexible enough to allow the client and his or her spouse some level of control and, perhaps more importantly, provide the security of an additional source of income for the spouse in the event of an unfortunate change in the family business, health, or other financial means while at the same time keeping the asset across the "tax river" outside of his or her taxable estate.
Since the introduction of the unlimited marital deduction and unified credit amount by the Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172, a husband and wife with proper estate planning can delay estate taxation until the surviving spouse passes away. The use of life insurance benefits to pay estate tax liability is an often recommended strategy to lessen the estate tax burden. Typically life insurance of any substantial amount would be held in an irrevocable life insurance trust (ILIT). On the death of the insured, the trustee would exchange the policy's liquid death benefit for the decedent's nonliquid assets (such as real property) with the personal representative of the decedent's estate, so that the liquid life insurance benefits can be used to pay any estate tax liability. Although clients may understand the general role life insurance can play in alleviating the burden of estate tax liability and maintaining the value of the wealth passed intergenerationally, most seem very reluctant to incur the often large premium payments required to maintain individual life insurance policies on both husband and wife.
A survivorship or second-to-die life insurance policy, however, may be an alternative. One major advantage of a second-to-die insurance policy is the reduced burden of the premium. Typically premium amounts for second-to-die policies are substantially less than the premiums for individual life insurance policies because the odds of both spouses dying before their life expectancies is far less than one of them dying before his or her life expectancy. Therefore, the risk to the insurance company is less and the premiums for such a policy are reduced. Traditionally the drawback to a second-to-die insurance policy inside an ILIT is that neither of the insureds has any control over, nor benefits from, the assets in the ILIT for fear of possessing any incidents of ownership that would cause the death benefits to be included in their taxable estates.
A creative, but seldom used, option to solve the high cost of individual life insurance policies and lack of flexibility in a traditional life insurance trust is the spousal access trust (SAT). Simply put, this specially drafted ILIT holds as its primary asset a second-to-die life insurance policy on the client and his or her spouse and provides a creative way to maintain access to the cash value of the policy while excluding the eventual death benefit from the taxable estate of either the husband or wife. The SAT is drafted in such a way that (1) only one of the insureds is the grantor of the trust; (2) the chosen independent trustee has discretion to make distributions to the nongrantor spouse during his or her lifetime; (3) the nongrantor spouse may make withdrawals from the SAT; (4) the trustee may make loans from the SAT to the grantor; and (5) the proceeds of the life insurance policy, payable after the surviving spouse's death, can be either used to pay the incurred estate tax liability or held in separate creditor-protected estate and generation-skipping tax-exempt trusts for each of the grantor's children or grandchildren.
For purposes of this article, a hypothetical client, Gary, will be examined. Gary is age 60 and his wife, Mary, is age 55. Gary is insurable, but at a less than desirable rate because of his poor health, and Mary is in fine health. Because of potential estate tax liability on the death of the survivor, they are considering a second-to-die life insurance policy with a $5 million death benefit. The premium for such a policy is $36,000 annually. The annual premium for a single life policy on Gary and Mary, respectively, may be $50,000 and $25,000. Gary will be the grantor of the SAT. Gary and Mary have three children who, along with Mary, are the listed beneficiaries of the SAT. Through the use of Crummey waivers, the premium will be paid using the annual gift exclusion from Gary to each child. Gary and Mary's trusted friend, Tim, will serve as independent trustee. Tim will be granted the discretionary power to make distributions to Mary (the nongrantor spouse) or the children during their lives.
How an SAT Works
Unlike a typical second-to-die ILIT in which both spouses are grantors, only one spouse can be the grantor of the SAT, and the grantor cannot be a beneficiary (although an argument could be made that if the SAT is established in Alaska, Nevada, or another state with a well-drafted self-settled trust statute the grantor could be a discretionary beneficiary). If possible, the older and unhealthier spouse should be the grantor because if the nongrantor spouse dies first, the discretionary distributions to him or her cease. Some suggest that the trustee could be the nongrantor spouse; however, many advisors suggest that another family member, trusted friend, or institutional trustee should be selected so that the nongrantor spouse has no "incidents of ownership" in the policy, thus avoiding possible inclusion in his or her taxable estate under Code § 2042. The beneficiaries of the SAT are the nongrantor spouse and children (grandchildren also can be beneficiaries of a SAT, but the drafter should consider generation-skipping tax issues if he or she includes grandchildren as beneficiaries). The trustee then applies for and pays the premiums for a second-to-die life insurance policy on the lives of both the grantor and nongrantor spouse. The trustee is the listed owner and beneficiary of the policy. If the policy is already in place with the grantor as owner and the spouse as beneficiary, the policy should be sold to the SAT rather than transferred by gift to avoid re-inclusion of the policy proceeds in the grantor's taxable estate under Code § 2035 should he or she die within three years of the transfer.
Premiums must be paid from the separate property and accounts (not jointly owned) of the grantor and should be clearly documented to limit any argument by the IRS that the nongrantor spouse contributed to the SAT. The effect of such a contribution will most likely include the insurance proceeds in the nongrantor spouse's taxable estate under Code §§ 2036, 2038, or 2042(2). Planners also must watch out for any indirect contributions by the nongrantor spouse such as the transfer of funds from the nongrantor spouse's account to the grantor's account followed by the making of premium payments. An additional twist occurs in community property states in which clear documentation (such as a separate property agreement) of separate accounts and assets must be kept.
During the life of the grantor, the trustee may make discretionary distributions from the SAT to the nongrantor spouse limited by the ascertainable standard of health, support, and maintenance. Such distributions should not be used for, or commingled with, the grantor's accounts. The nongrantor spouse also may make withdrawals from the SAT. Such withdrawals should be limited to annual withdrawals of the greater of $5,000 or 5% of the value of the SAT. Any withdrawal of more than $5,000 or 5% can allow the IRS to treat the nongrantor spouse as the grantor and include the policy in his or her taxable estate.
Moreover, the trustee could determine to make loans from the SAT to the grantor. Loans from the SAT, or any ILIT, and the authority to make such loans are a subject for discussion in a separate article. Suffice it to say, if the grantor's ability to borrow is limited to the assets of the trust and not a loan from the insurer and such a transaction is done at "arm's-length" (that is, it does not exceed 80% of the trust assets, does contain market rate interest, is secured with collateral, and requires at least annual payments (with the full balance due and payable at the death of the grantor)), borrowing from the SAT should not cause inclusion in the taxable estate of either the grantor or nongrantor spouse under Code § 2042(1).
Using the example of Gary and Mary above, Gary would establish a separate bank account and fund this account with his separate property. Gary then transfers money to the separate SAT account (using his annual gift exclusion), which Tim will use to pay the annual premiums on the policy. It can be assumed that over a 10-year period the policy may accumulate up to $360,000 in cash value. The cash value could be accessed by Tim and used to make discretionary distributions to Mary and the children (payable into Mary's separate account). Up to $18,000 can be withdrawn annually by Mary and up to $288,000 of the cash value can be accessed by Tim as trustee of the SAT and then loaned from the SAT to Gary (at arm's-length terms).
One of the drawbacks to the typical ILIT is that it forces a client to make irrevocable decisions. Clients are concerned about future changes in their health, business ventures, and other financial matters that would create a need to access assets they may have "locked up" in an irrevocable trust. Flexibility is the major benefit of the SAT. The SAT allows the nongrantor spouse access to the assets held inside it by allowing the trustee to make discretionary distributions in the event of a change in the family's financial situation. Another benefit of the SAT funded with a second-to-die policy is the lower premium payment as compared with single life policies.
Many of the additional benefits of an SAT are identical to a standard ILIT. These benefits include the protection of the policy's cash value from the potential creditors or liabilities of the grantor, removal of the insurance proceeds from the taxable estate, tax-free growth on investments held inside the policy, and income- and estate-tax-free proceeds passing to the children on the death of both the grantor and nongrantor spouse either to be used and enjoyed by the children or to pay any estate tax liability.
In the case of Gary and Mary, the lack of flexibility in an irrevocable trust and the high cost of individual premiums were the roadblock to their planning for their potential estate tax burden. The SAT provided them with the peace of mind that Mary, at Tim's discretion, could have access to the assets held in the SAT if she needed them, and the second-to-die policy was the solution to the high cost of individual policies.
The SAT generates a few concerns for estate planners, especially the lack of authority and guidance from the IRS. First, if the nongrantor spouse predeceases the grantor, or in the case of divorce, the family has no access to the cash value (except perhaps through loans as described above), thus eliminating the major benefit of an SAT over a typical ILIT. This concern is hedged by selecting the least healthy spouse as the grantor (not a beneficiary) and the spouse expected to be the survivor as the beneficiary.
Second, if the grantor dies first, how will future premium payments be made? If such payments are made by the nongrantor spouse, Code § 2042 would include the insurance proceeds in the nongrantor spouse's taxable estate. Possible solutions to this dilemma are (1) to have the SAT purchase a small individual policy on the life of the grantor, which could fund the future premium payments (this could be vital to maintaining the premium payments should the grantor spouse die in the early years of the policy), (2) to pre-pay (overfund) the second-to-die policy so premium payments do not need to be made after the grantor spouse dies because the policy has enough cash to maintain the policy, or (3) to have the nongrantor spouse loan to the trustee, at arm's-length terms with interest at the applicable federal rate, the funds needed to maintain the premiums. A few insurance products provide an increase in the amount of cash value held within the policy on the death of either of the insureds that can provide enough additional cash to maintain the policy.
The third concern is that the IRS may argue that indirect contributions have been made by the nongrantor spouse. Planners must make sure clients understand that premiums must be paid from the grantor's separate property. The easiest way to overcome a costly mistake is to have the grantor spouse establish a separate account, fund it with separate property, and transfer those assets to a separate trust account for the trustee to make future premium payments.
The fourth concern with an SAT is that distributions may be made indirectly to the grantor. Again, the easiest way to overcome this problem is to have all distributions made to the nongrantor spouse's separate account that he or she uses only for her benefit or the benefit of the children. Of course, clients must understand and be willing to live with these separate accounts, specific controls, good documentation, and proper bookkeeping.
Similar to a typical ILIT, neither the grantor nor the nongrantor spouse can possess any of the following powers:
Perhaps the largest concern for advisors is estate tax inclusion because of the grantor's or nongrantor spouse's "incidents of ownership" under Code § 2042. Code § 2042 says that the value of the gross estate shall include the value of insurance policies on the life of the decedent (1) receivable by the executor to the extent of the amount receivable by the executor and (2) receivable by other beneficiaries for which the decedent possessed any incidents of ownership. Although Code § 2042 does not specifically define the term "incidents of ownership," the corresponding regulations (Treas. Reg. § 20.2042-1(c)(2)) provide some guidance, describing such incidents as
To be safe, controls should be established so the surviving spouse does not become a trustee of the SAT. Avoidance of inclusion in his or her taxable estate under Code § 2042 could be difficult if he or she serves as trustee. Most advisors would recommend that a third-party (but friendly) trustee be appointed, which could include the grantor's children. The children, although related to the grantor, will be considered adverse or independent trustees because, as beneficiaries of the SAT, every dollar they distribute to their parent is one less they receive for themselves.
Authority (Sort of)
Code § 6110(k)(3) provides that a private letter ruling may not be used or cited as precedent. PLRs are directed and useful only to the taxpayer who requests them. Nevertheless, the only authority on this topic is found in PLR 9748029, which involved an SAT holding a second-to-die insurance policy. Some additional support is found in PLR 9748020.
In PLR 9748029 the IRS ruled that the value of an ILIT holding a second-to-die life insurance policy is not includable in a surviving spouse's estate, even though that spouse is a beneficiary of the ILIT, because the spouse made no contributions to the trust and possessed no rights under Code §§ 2036 or 2038. In this case, the irrevocable trust was established by the client for the benefit of his spouse and children. The trust was funded with a second-to-die insurance policy on the lives of both the client and his spouse. The trustees were the client's two children. The trust had Crummey withdrawal powers and authorized the trustee to make discretionary distributions of excess funds available for the welfare and comfort of the spouse and children after making premium payments on the insurance policy. The IRS determined that the policy would not be included in the nongrantor spouse's estate under Code §§ 2036, 2038, or 2042(2) because the nongrantor spouse made no direct or indirect contributions to the trust and because the nongrantor spouse did not possess any incidents of ownership (Code § 2042) or the right to possess or enjoy the property, designate the persons who shall possess or enjoy the property, receive income from the property (Code § 2036), or the right to alter, amend, revoke, or terminate the trust (Code § 2038).
The IRS did not opine on Code § 2042(1) regarding the value of the insurance proceeds receivable by the executor of the estate of the spouse stating that such a ruling would be dependent on the facts presented at the death of the spouse (that is, is the trustee legally bound to pay the spouse's burial expenses, medical or funeral expenses, and any estate tax liability).
In PLR 9748020 the trustees requested a ruling that the decedent's spouse will not possess any incidents of ownership over the life insurance policy on her life held by the trustees of a trust in which she is a beneficiary and that the proceeds of the policy will not be includable in her gross estate under Code §§ 2036 and 2042(2). The IRS ruled that the proceeds from a policy held in the trust would not be included in the estate of the insured who was also a beneficiary of the policy provided that (1) he or she does not transfer any assets to an ILIT, (2) the premiums on the policy are paid from the principal of the ILIT, (3) he or she does not maintain the policy with personal assets, and (4) he or she is not the trustee of the ILIT. It seems that the current position of the IRS is that unless the decedent retains incidents of ownership in the insurance policy, as explained above, the SAT is the flexible irrevocable strategy for which many clients are looking.
The SAT can be a cost-efficient method of providing the benefits of a typical ILIT while providing added flexibility and peace of mind. In the case of Gary and Mary, the SAT strategy resolved their concerns about an ILIT. The potential estate tax liability was a worrisome burden for their family. Insurance as the solution to this liability seemed a good solution, but, because Gary suffered from poor health, premiums on a single life policy were far too expensive to maintain. Gary and Mary also were not comfortable with planning that included irrevocable trusts, because of the lack of flexibility. The SAT with a second-to-die policy was the planning solution to their estate tax burden because it provided relief from future estate tax liability while lessening the burden of the annual premium and providing flexibility for the unknown future.
For any client establishing an SAT, as long as the grantor spouse makes all contributions to the SAT from separate property, the nongrantor spouse can be a discretionary beneficiary of the SAT without being deemed to have any incidents of ownership over the insurance policy. Adequate care should be taken to ensure that the premiums continue to be made on the death of the grantor spouse. PLR 9748029 provides guidance for creating, funding, and maintaining an SAT, ensuring that the assets in the SAT are available for the benefit of the nongrantor spouse and the couple's children in the case of an emergency or changing financial circumstances through the discretion of an independent, but friendly, trustee. The SAT is a flexible irrevocable strategy that could benefit many clients.
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