Business Owner Using Defective Trust To Purchase Life Insurance
Saves Money and Transfer Taxes
by Stuart A. Rader, Esq.
Successful business owners are often confronted with the problem of how to fund annual premiums for insurance policies on their lives owned by irrevocable trusts outside of their estates, without making significant taxable gifts that deplete their lifetime $ 1 million gift tax exemptions.
Sam is the sole stockholder of Samco, Inc. (¿Samco¿) an S corporation worth $20 million. He owns all 100 outstanding shares. He wishes to acquire a $10 million life insurance policy which requires an annual premium of $150,000 for the next 15 years. Sam is single. He lost his shirt in a divorce five years ago and states that he will never get married again. He has two children. With the assistance of his estate planning attorney, Sam creates his irrevocable life insurance trust (¿Standard ILIT¿) with an independent Trustee (¿Trustee¿) for the benefit of his children and the next generations. Sam annually gifts his two children $12,000 in cash. Therefore, each year Sam must report a $150,000 taxable gift that reduces his lifetime $1 million gift tax exemption. Starting in year 7, he must pay gift tax on $50,000 and on $150,000 each year thereafter. This Standard ILIT is illustrated by the table below:
| |
Taxable Gift |
Exemption
Applied |
Non Exempt Taxable Gift |
Gift Tax Paid |
|
Years 1-6 |
900,000 |
900,000 |
0 |
|
|
Year 7 |
150,000 |
100,000 |
50,000 |
10,600 |
|
8-15 |
1,050,000 |
|
1,050.000 |
386,800 |
|
Total |
2,100,00 |
1,000,00 |
1,100,000 |
397,400 |
With the Standard ILIT, Sam gifts the premiums, uses his $1 million lifetime gift tax exemption, and pays a gift tax of $397,400 on the gifts that exceed $1 million. This is a very expensive undertaking. One alternative to ease the financial burden is to have the Trustee borrow funds to pay the premiums. These types of loans are complicated transactions which involve the Trustee¿s pledging the policy¿s cash value or other assets to secure the loan, and payment of any outstanding loan balance at death which decreases the death benefit.
A more suitable alternative involves Sam modifying the Standard ILIT with two major changes:
· The irrevocable trust will be a Defective Trust which means that Sam remains responsible for all income tax consequences of the trust by reason of certain retained powers, but the assets transferred are a completed gift; and
· Sam funds the Defective Trust with 7 shares of Samco stock instead of cash.
The Defective Trust is a qualified S shareholder because Sam is deemed to be the stockholder for income tax purposes. Sam¿s funding the Defective Trust with 7 shares of Samco stock is a taxable gift. A conservative business appraisal concludes that the 7 shares are entitled to a 30% discount for lack of marketability and lack of control. This results in a taxable gift of $980,000. (1-.3 x (7/100 x $20 million). Assuming that Sam has made no prior taxable gifts, no gift tax is due, but a gift tax return must be filed reporting the $980,000 gift along with the appraisal.
Samco is a cash rich company and makes S distributions of $2,500,000 for the next 15 years. The Trustee of the Defective Trust, for the next 15 years annually: receives its pro rata S distributions of $175,000; pays the $150,000 premiums; and invests the remaining $25,000 in a growth and income portfolio. This table demonstrates the advantages of the Defective Trust funded with the Samco stock over the Standard ILIT.
| |
Exemption Used |
Gift Taxes |
Death Benefits free from Gift and Estate Taxes |
|
Standard ILIT |
1,000,000 |
397,400 |
$10 million life insurance |
|
Defective Trust with Samco stock with Samco stock |
980,000 |
0 |
$10 million life insurance & 7 shares of Samco & $375,000[1] plus growth. |
The Defective Trust is much more tax efficient than the Standard ILIT because:
It avoids payment of $397,000 in gift taxes and requires the filing of only one gift tax return, in the year of funding, starting the 3 year Statute of Limitations in the first year, compared to the Standard ILIT requiring the filing of annual gift tax returns for 15 years and separate Statutes of Limitations running for each annual gift;
$2,625,000, the 15 years of S distributions, passes in trust for the next generation free from both gift and estate taxes and is not reduced by income tax because Sam remains responsible for the income tax liability; and
The 7 shares of Samco stock were removed from Sam¿s estate by passing to the Defective Trust with a discounted gift tax value, in contrast to the Standard ILIT where the 7 shares would be part of Sam¿s taxable estate with a control premium.
Please contact the author to learn more about this technique and how it might apply to your or your client¿s estate plan.
Copyright October 2006. All rights reserved.
Not intended as legal advice but rather a general discussion. No transaction should be entered into without competent legal and tax advice.
[1] $25,000 invested annually for 15 years.