As we head toward the holiday season, many people may already be dreading the inevitable tiptoeing that occurs at family gatherings around “taboo,” “controversial” or “hot-button” conversations that are sure to leave even the most delicious meals with a bitter aftertaste. If you’re looking for a unifying topic to neutralize tension, try life insurance. It turns out 87% of Americans believe it’s something most people should have.1 But, don’t kill the party by discussing all the typical ways owning life insurance will be beneficial once your family member departs. Instead, here are five innovative ways life insurance can help create a smart estate plan.
SLATs With Life Insurance
Spousal lifetime access trusts (SLATs) are a popular way for couples to use up federal estate and gift tax exemption amounts. Combining a life insurance policy with the use of SLATs allows clients to use their exemptions without sacrificing access to any funds in the event one of the spouses passes away. The estate and gift tax exemption amounts are now doubled until the end of 2025. A couple may transfer $22 million out of their estate, rather than the standard $11 million. This extra amount, however, is a “use it or lose it” exemption. If a couple only transfers $11 million ($5.5 million from each spouse) in an effort to lock in the extra exemption amount, they’ve actually only used the old exemption and won’t have any more available once the tax cuts sunset. To lock in the doubled rate, each spouse must transfer the full $11 million.
With SLAT planning, each spouse creates a trust for the benefit of the other and gifts assets equal to part or all of their lifetime exemption amount. For example, Husband and Wife first enter into a marital property agreement in which they agree to convert a portion of their community property into two separate property halves. (Note that for those who aren’t residents of community property states, a partition would be unnecessary, but one spouse may need to transfer a batch of assets to the other spouse.) Husband then creates a SLAT for the benefit of Wife and funds it with $11 million of his separate property. Wife has access to her trust for her needs during her lifetime. On Wife’s death, the remaining assets would be split into separate trusts for their children.
At a later date (perhaps several months or a year later), Wife creates a separate SLAT for the benefit of Husband and funds it with $11 million of her separate property. These two SLATs should be carefully drafted to avoid identical provisions that would violate the reciprocal trust doctrine. Husband has access to his trust for his needs during his lifetime, and just like Wife’s SLAT, the remaining assets would be split into separate trusts for their children on Husband’s death. While both Husband and Wife are living, the couple retains access to the full $22 million of assets. At the death of the first spouse, however, the surviving spouse would only be able to access the assets in his/her own trust, with the children receiving the deceased spouse’s assets in trust. Because many clients are hesitant to dispose of assets prior to death, it’s helpful to incorporate life insurance into the SLAT strategy.
To replace the potential lost assets, each SLAT buys an $11 million life insurance policy on the life of the other spouse. If Husband dies first, then at Husband’s death, Wife would continue to benefit from her own SLAT. Her SLAT would also collect $11 million on Husband’s life, so her access to the full $22 million isn’t diminished when Husband dies. In this way, clients can move large amounts of wealth out of their estate and take full advantage of available exemption amounts, while retaining access to any assets they may need or want during their lifetimes.
Mixing Bowl Partnership Planning
Life insurance can also facilitate effective basis planning. Using mixing bowl partnership planning, clients can use appreciated assets to purchase life insurance with no taxable gain. Essentially, the basic purpose of this planning is to shift basis from one asset to another. While this particular tool can require a timeframe of up to seven years, if the client has the time, it can be extremely useful for those who own highly appreciated assets.
Under this planning scenario, a client is interested in the income tax benefits of owning private placement life insurance (PPLI) and desires to sell an appreciated asset to purchase a policy, but the client understandably wishes to avoid paying any capital gains tax on the sale of the asset. For instance, let’s say the client owns a commercial building with a fair market value (FMV) of
$1 million and a basis of $100,000. For the first step of this strategy, the client would borrow $1 million, secured by the building. The client then gifts the commercial building (with FMV of $1 million and a basis of $100,000) to a dynasty trust, which retains the $100,000 basis. Note that the dynasty trust should be drafted as a non-grantor trust so that it can later join with the client in creating a partnership that will be treated as a true partnership for tax purposes. When the client gifts the building, he agrees to remain responsible for paying off the loan, so the trust isn’t burdened with the obligation to pay it off. The client files a gift tax return reporting the gift of the building to the trust, which eats up $1 million of the client’s lifetime exemption.
Next, the client and the dynasty trust enter into a partnership agreement. After contributing the $1 million of cash to the partnership, the client holds a 50% partnership interest with an outside basis of $1 million. The dynasty trust then contributes the building to the partnership in exchange for a 50% partnership interest. The dynasty trust’s outside basis is $100,000. See “Mixing Bowl Partnership Strategy,” p. 30.
The partnership then uses the $1 million cash to buy PPLI. The purchase is structured so that premiums are paid over time, which prevents the insurance policy from being treated as a modified endowment contract. Additionally, special drafting provisions are included in the partnership agreement and the trust to ensure that the insured has no incidents of ownership over the policy. After seven years, the partnership is liquidated.2 The client receives the building, now with a basis of $1 million, and the dynasty trust receives the PPLI, now with a basis of $100,000. Because the dynasty trust is a partner of the insured, there are no transfer-for-value implications.
The client then sells the building for $1 million—which results in no gain—and repays the loan. Essentially, the client has used the building to purchase PPLI without recognizing any gain on the building. The dynasty trust holds the life insurance policy until the client dies, which makes its low basis a non-issue. Because life insurance proceeds are income tax exempt (as long as there’s been no transfer for value), when the client dies, the trust receives the proceeds free from gain or loss. Moreover, although the client has used up $1 million of his lifetime exemption by gifting the building to the dynasty trust, the PPLI—with proceeds in excess of $1 million—is removed from the client’s estate.
And, what happens if the client dies before the assets are distributed from the partnership? The building would be left outside the client’s estate. Yet, even though it wouldn’t receive a basis bump and capital gains tax would be owed once the building is sold, overall the client (or client’s estate) would come out better economically. Assume, for example, that the $1 million PPLI policy carries a death benefit of only $2.5 million. The building doesn’t receive the basis bump from $100,000 to $1 million, and accordingly, when the building is sold, capital gains tax will be due on $900,000 of gain, resulting in a tax of $214,200 ($900,000 x 23.8% = $214,200). The partnership, however, would receive the life insurance proceeds of $2.5 million, which is in effect a return of the $1 million paid for the policy, plus $1.5 million of tax-free income. The life insurance proceeds would more than cover the amount of taxes owed from the sale of the building.
Per Capita Payout for Grandchildren
As you glance around the table at your next family gathering, you may be able to pick out grandma’s or grandpa’s favorite grandchildren. Typically, however, the eldest generation claims to love all their grandkids equally. Yet, even with the most fair of intentions, many clients have estate plans that will disproportionately favor some grandkids over others. This is because, with a traditional per stirpes inheritance, grandchildren with more siblings will receive less than grandchildren with fewer siblings.
Assume Generation One (G-1) has a son with two children, a daughter with four children and a $12 million estate. After G-1 dies, the son and daughter (G-2) each receive $6 million. After G-2 dies, however, the son’s children (G-3) each receives $3 million while the daughter’s children each receives $1.5 million. This inequality could potentially cause strife and division within the family and may not be the best way for G-1 to preserve or promote harmony. Fortunately, with the use of a life insurance policy, drastic changes to an estate plan aren’t necessary to address this issue.
Specifically, G-1 takes out a life insurance policy on G-1’s life, for the benefit of G-3 per capita to be paid on G-1’s death. Under a per capita distribution, each member of G-3 would receive an equal share. The policy could alternatively be on G-2’s life for the benefit of G-3 per capita, to be paid to G-3 at G-2’s death, which would provide more coverage because of G-2’s younger age. If the policy is taken out on G-2, then G-1 could either pay the policy premiums as a gift or lend money to G-2 to pay the premiums. The remainder of the estate plan remains intact, and new assets are created to use for gifting to G-3 without disrupting G-2’s inheritance.
Intergenerational Loans
While it’s true that the high exemption amounts have reduced the number of people impacted by the federal estate tax, basis-focused income tax planning continues to grow in popularity. Furthermore, for those who do have estates large enough to bring the estate tax into play, basis planning has often resulted in a Catch-22 scenario. Moving assets outside of the client’s estate to avoid estate tax simultaneously ensures that those assets won’t receive a basis adjustment on the death of the client, thereby subjecting the client’s family to a 23.8% capital gains tax when the asset is sold.
There is, however, a way to use intergenerational loans and life insurance to reduce estate tax and preserve a basis adjustment, in essence to have your cake and eat it too. To illustrate, let’s say a client owns a $30 million ranch with a $10 million basis and approximately $5 million of other assets. Using the intergenerational loan planning strategy, the client first borrows $30 million from his bank and then loans the $30 million to a Children’s Trust (a non-grantor trust) in exchange for a promissory note at the long-term applicable federal rate. The note is due on the death of G-2.
Using the $30 million, the Children’s Trust purchases a life insurance policy on G-2, and the bank takes a collateral assignment in the policy. This collateral assignment allows the bank to charge a lower London Inter-Bank Offered Rate-based interest rate on the note owing from the client. The insurance policy purchased by the Children’s Trust will be unusually structured in that it will have a very high cash surrender value while also having the least amount of death benefit possible without violating Internal Revenue Service life insurance corridor rules.
The estate holds the $30 million note owing from the Children’s Trust, and because of the locked-in low rate and long, uncertain duration, the note receivable would be highly discounted—assume 50%. At the client’s death, the estate tax will be zero. See “Intergenerational Loan Reduces Estate Tax,” this page.
G-2 will receive a step-up in basis in the ranch to $30 million. Accordingly, if G-2 sells the ranch, no income tax will be due following the sale.
But, even though the client’s estate tax is reduced and the ranch receives a step-up in basis, at the client’s death, the note receivable will receive a step-down in basis to $15 million. When the note is later repaid, the estate will owe income tax on the $15 million capital gains. There is, however, a way to avoid this. Instead of the client retaining the note until death, two to three years after the loan is made, the client sells the note (Note 1) to a new grantor trust for the benefit of G-2 and G-3 (the dynasty trust). The client sells Note 1 to the dynasty trust in exchange for a $15 million promissory note (Note 2). Note 2 would have an adjustable rate, would hold different terms than Note 1 and wouldn’t be valued at a discount. See “Sale of Note,” p. 32.
Because the client sells Note 1 to a grantor trust while the client is still alive, Note 1 still has a $30 million basis. The client avoids a basis step-down on Note 1 by getting it outside of her estate before she dies. Because the dynasty trust is a grantor trust as to the client, the sale of the note to the trust is ignored for income tax purposes. Ultimately, the dynasty trust owns Note 1 with a basis of $30 million, and the client owns Note 2 with an FMV of $15 million. At the client’s death, her estate tax will still be zero. See “A $0 Taxable Estate,” p. 33.
Following the client’s death, the ranch will receive a basis step-up, so no income tax will be due on a later sale. The Children’s Trust can cash in the life insurance policy and pay off the $30 million Note 1 it owes to the dynasty trust. Because Note 1 is out of the client’s estate, there’s no basis step-down; the basis of Note 1 remains $30 million; and there’s no gain when Note 1 is repaid. The dynasty trust uses $15 million to pay off Note 2 owing to the client’s estate. Because Note 2 had a $15 million FMV at the client’s death, it now has a $15 million basis, and there’s accordingly no gain when Note 2 is repaid. Finally, the dynasty trust can use the extra $15 million it received to buy assets from the client’s estate, which provides the estate with liquidity to pay back the bank.
Use a FAST
For those clients who are earnestly looking to impact their family in a positive way, life insurance can be used to facilitate the creation of a family advancement sustainability trust (FAST). While the process of estate planning continues to focus on technical factors (for example, tax and asset protection), there’s an evolving call to add to that planning model a focus on clients’ qualitative goals. Typically, this manifests in a client’s desire not only to prepare the estate for their heirs but also to prepare their heirs to responsibly receive, manage and maintain the estate.
The FAST is a new type of trust designed to help fill the family leadership vacuum that often occurs on the death of the eldest generation. A FAST: (1) sets aside funds to pay for best practices learned from successful families (such as annual retreats, travel and family education), and (2) puts a leadership structure in place to make sure these family enrichment activities happen.
Although there are several ways to fund a FAST, using a life insurance policy preserves the rest of the family’s assets for distribution and allows the FAST to serve as an estate plan enhancement without causing major disruptions in the established plan structure. A FAST is, at a basic level, a dynasty trust created in a state with directed trust laws, which allows decision making to be split up among separate co-trustees, advisors or trust protectors. With a divided structure, family members and trusted advisors are permitted to directly participate in the governance of the trust. The four main decision-making bodies of the FAST are: (1) an administrative trustee, (2) an investment committee, (3) a distribution committee, and (4) a trust protector committee. A FAST’s unique structure allows family members to participate in and take accountability for the carrying on of a family legacy. The actual functioning of a FAST will vary from family to family, but the ultimate goal of the trust is the promotion of the family itself. Life insurance proceeds may offer the immediate benefit of tax-free income, but using the proceeds to establish a FAST can create a lasting impact that just might give your client’s family a reason to keep on gathering together for generations.
Endnotes
1. Life Happens and LIMRA, “2019 Insurance Barometer Study,” www.tbrins.com/uploads/9/5/9/7/95973204/2019_insurance_barometer_study.pdf.
2. If the low basis asset is already in a partnership, it may be possible to shift basis in the desired manner without waiting seven years.