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Keeping It ‘All in the Family’ with Life Insurance: Post 2017 Tax Act

Even after passage of the 2017 Tax Act, several common estate planning techniques that work well with low interest rates continue to be helpful for ultra-high-net-worth (UHNW) families to transfer legacies to future generations at minimal income, gift, estate and other transfer tax costs.  Even more importantly, and despite the estate tax cuts under the new tax act—which are set to expire in 2026– many affluent families, UHNW or not, desire liquidity for needs other than taxes– such as to repay debt, buy-out assets from one another, to equalize an inheritance, take care of a special need or circumstance, transfer a business interest, or even to replace wealth transferred to charity, for example.  To these ends, life insurance continues to work swimmingly with these strategies to create family liquidity efficiently.  Each of the approaches may have some of the following effects:

  • Discounting, if not completely eliminating, the value of the transfer for tax purposes;
  • Freezing an asset’s appreciation so it remains outside the taxable estate, creating an opportunity for additional tax-free gifts of the appreciation to be made;
  • Leveraging an asset’s income to create estate liquidity;
  • Minimizing income taxes by preserving basis, and;
  • Addressing non-tax issues, such as equalization, buy-outs, special circumstances and money management.

Several of these commonly used estate planning strategies that work well with life insurance are highlighted below:

Intra-family loan arrangements:

Making loans of cash to a trust, as a lump sum or as a series of cash loans– instead of outright gifts– allows families to transfer assets to beneficiaries with minimal gift tax cost, if any. Why? Because the loan must be paid back– it’s not a gift.  By making loans, parents have tremendous flexibility because the loan can be repaid, refinanced or forgiven later, depending on circumstances and tax law at the time. Of course, if the loan is forgiven, the value of the forgiveness will be subject to gift tax to the extent lifetime gift tax exemptions have already been used (currently, approximately $11.2 million per individual per lifetime can be exempted from gift or estate tax, generally, when assets are transferred).  And, unlike third party loans through a bank, loans made to family members don’t require loan approvals or collateral. In this way- families can be their own banks in the right circumstances.

Moreover, up until the passage of the 2017 Tax Act, in which estate taxes will apply to only the UHNW– those estates with a net worth of over $23 million over the next 7 years only, after which many estates worth over $12 million may be subject to the tax — estate planners took to weighing the cost of estate taxes with the costs of income taxes associated with lifetime transfers and often opted to minimize estate taxes. That is, when a gift of an asset is made during lifetime by the donor, the basis that carries over with the asset to the recipient is the basis of the owner at the time of the gift.  For instance, if the value of the asset is $1 million today and the owner paid $500,000 for the asset 5 years ago, the basis the recipient has in the gift is $500,000. This means that the gift will be subject to tax on the appreciation above $500,000 when the asset is disposed of by the donee, or new owner. On the other hand, when the asset is loaned instead of gifted away, the owner (the estate) will benefit from a “step-up” in basis to the fair market value of the asset at death.  So, in this example, if the fair market value of the asset appreciated to $2.4 million by the time the owner died, it would transfer to heirs from his or her estate at a value of $2.4 million, instead of $500,000. Any appreciation thereafter, above the $2.4 million, will be subject to tax when the asset is transferred or liquidated.

It is important to note that the IRS does require parents to enter into an arm’s length loan transaction with family–just like any other loan transaction.  This means, parents must charge a fair market rate of interest based on the applicable federal rate of interest (AFR), as published monthly. The AFR interest rate can be locked for the term of the note– assuming it is a ‘term note’, and not a ‘demand note’– in which case the rate changes every year. Hence, families that need to transfer assets can take advantage of locking into the current low interest rates by establishing an intra-family term loan.

A portion of the cash inside the trust can then be used to fund a life insurance policy. Often, a lump sum cash loan is made to the trust under this type of arrangement and is calculated based on premiums required, a return assumption on the lump sum loan balance annually, loan interest payments, and repayment of the principal balance of the loan. Note that the trust can be designed as a “grantor trust” –-which means all income generated by the trust is taxed to the grantor (mom or dad who created the trust) and essentially represents an additional tax-free gift made by them.  This means that there is more money available inside the trust to fund the insurance requirement when the trust does not need to pay taxes.  As long as the rate of return on the lump sum cash is higher than the loan interest, the arbitrage funds the life insurance premiums to create the liquidity the family needs.

As a side note- families use irrevocable trusts to transfer assets on behalf of children and grandchildren. The trusts have a myriad of provisions to manage assets, specify terms of distribution, protect the assets from creditors depending on state rules, and protect the assets from spendthrifts over subsequent generations.

Installment Note Sales:

Parents can also sell an income producing asset to the trust. The income from the asset can be leveraged inside the trust with another investment, such as life insurance. The asset appreciates inside the trust–as opposed to inside the taxable estate of the parents. Like the intra-family loan, a fair market rate of interest is charged, while the sale proceeds are repaid as a balloon payment at the end of the loan term. Here, the trust uses income generated from the transferred asset to pay for the needed insurance policy, as well as the interest due on the note. The trust uses cash or any other assets it reinvests in–or even the original asset itself– to make the balloon payment at the end of the note term, while the asset appreciates outside the taxable estate. And, unlike a third-party sale, if the trust is drafted properly, there is no taxable gain on the sale. What’s more, the asset may be discounted when the sale value is calculated, in some cases, to reflect a minority interest or marketability discounts, depending on the type of asset. This means that the transfer tax value is also discounted. It is generally recommended by some attorneys that a gift of “seed” money be made to the trust in advance of the installment note sale transaction to establish the trust as a substantive stand-alone entity.

Grantor Retained Annuity Trust (GRAT):

Affluent clients may also consider transferring property expected to appreciate in value to a Grantor Retained Annuity Trust (GRAT), while retaining the right to receive a fixed annuity payment for a term of years. In this way, a father (the grantor) can convert his business into a stream of retirement income, for example, in the process of selling it to his children who are to inherit and run a highly appreciating business, or other investment.  At the end of the GRAT term, the remaining trust property passes to the trust’s named beneficiary (typically a trust to benefit family members, such as a life insurance trust). For tax purposes, the transfer is considered a gift to the extent that the initial value of the trust property exceeds the present value of the grantor’s retained annuity interest. Again, the appreciation is outside of the taxable estate while the present value of the annuity payments is not part of the transfer tax calculation.

Advisors can tally the present value of the grantor’s retained annuity interest (income from the business, for example), which, unlike the intra-family loan or installment note sale, is determined by using the IRC Section 7520 rate for the month the GRAT is created. The 7520 rate is based on 120% of the AFR rate for mid term loans (3-9 year notes).  Therefore, if the trust property appreciates at a rate that exceeds the 7520 rate, the grantor removes all of the appreciation from the taxable estate, and passes it to the beneficiaries free of estate and gift tax.  One caveat: The grantor must survive the term of the GRAT, otherwise the entire trust property is included in the grantor’s taxable estate at death. For this reason, often these trusts are established for short terms, typically less than ten years.  Term insurance may be used to cover the potential for reversion during the GRAT term.

At the end of the GRAT term, the balance transfers to heirs, or to a trust of which the heirs are beneficiaries. Conveniently, GRATs are sometimes used as an exit vehicle to repay the note on an intra-family loan by naming the family’s irrevocable life insurance trust as beneficiary of the GRAT.

GRATs can also be used so that the retained income by the grantor can fund a life insurance policy to create the liquidity needed to equalize an inheritance, while the GRAT trust balance transfers to other heirs who may be running the business.

Charitable Trusts, such as a Charitable Lead Annuity Trust (CLAT):

This extremely effective tool helps families transfer wealth to heirs at a certain point in time, while allowing a charity to benefit from the trust in the meantime.  Under the terms of the CLAT, the donor transfers property to a CLAT and names a charity as an immediate beneficiary of the trust income during the trust term.  At the end of the trust term, the non-charitable beneficiaries, often the children of the donors, receive the trust balance at a discounted transfer tax value.

The transfer of the asset is an immediate and completed gift. The value of the gift is the initial value of the asset contributed, less the present value of the charity’s income interest. Because the present value is calculated using the IRC 7520 rate, if the assets in the CLAT appreciate at a rate greater than the 7520 rate, the family will receive more assets than were reported as a taxable gift.  Like a GRAT, a CLAT is also sometimes used as an exit vehicle, pouring into an irrevocable life insurance trust to repay an intra-family loan or to make the balloon payment on an installment note sale.

Of note, CLATs that are set up as grantor trusts may provide wealthier families with an opportunity to give to charity while also maximizing income tax deductions– despite the limits placed on itemized deductions under the 2017 Tax Act. That is, a grantor CLAT can still be an effective income tax planning strategy for clients who expect a large income tax year due to, for example, the sale of a business, a large bonus, or the exercise of stock options.

Low rates can’t last forever, particularly since the Fed has already begun rate increases as the economy and jobs numbers improve. While the last decade of low rates hasn’t been ideal for savers, it’s been an opportunity for higher net worth families to leverage wealth in the process of keeping it “all in the family”.  Indeed, even with the new tax act, now may be the time to lock in rates and create the liquidity families need through the use of life insurance–before interest rates rise.

As always, clients should work with their advisory team, including attorneys familiar with estate and income tax matters to take into account the full effect on their particular circumstances with any planning strategy.

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Lina Storm, CLU®, ChFC®, MBA

Lina Storm, CLU®, ChFC®, MBA

Vice President, Field Marketing at Highland Capital Brokerage
Lina Storm serves as Vice President, Field Marketing for Highland Capital Brokerage. She has an extensive background in marketing insurance and advanced planning strategies having spent most of her career leading the marketing for John Hancock’s notable Advanced Markets Group. She has been an industry thought leader, industry columnist, advisor’s coach, trainer, speaker, and brand strategist—helping advisors position their expertise, add value, and drive sales. Lina is a CLU®, ChFC® and received her B.A. from Trinity College in CT and an M.B.A. from Rensselaer Polytechnic Institute in New York.
Lina Storm, CLU®, ChFC®, MBA

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