Many families with substantial wealth are worried about having enough time – and liquidity – to take advantage of today’s generous lifetime estate and gift tax exemption before any tax policy changes reduce its value. They also worry that transferring those assets to a trust will put them permanently out of their control.
Background
The lifetime gift and estate tax exemption established by the Tax Cuts and Jobs Act of 2017 (TCJA) is due to expire on Dec. 31, 2025, reducing today’s $13.6 million exclusion to its 2017 level of $5 million, adjusted for inflation. But will efforts to increase federal revenues via tax policy changes reduce the exemption level before then?
Client Scenario
Take David and Judith Williams for example. [1]
They are a successful, affluent couple with a large family, two vacation properties, and several businesses and investments that produce substantial income every year.
They’d like to take advantage of the opportunity they each have under current tax law to "gift" a maximum of $13,610,000 ($27.2 million combined) to their children over the next several years without incurring gift taxes. But they worry that:
if they wait too long, future changes in the tax laws will dramatically reduce the gift tax exemption they can take, and
if they use a trust to hold the gifted assets tax-efficiently, outside of their estate, they will lose control of those assets completely.
A Solution: a specialized trust funded with life insurance.
The couple can achieve the best of both worlds by immediately establishing an Intentionally Defective Grantor Trust (IDGT) funded with a permanent life insurance policy.
The IDGT allows the Williams to take full advantage of today’s lifetime gift tax exemption without losing control of the "gifted" assets. Here’s how an IDGT funded with life insurance could maintain flexibility:
The Williams, as grantors of the trust, make a gift of assets to the IDGT that is equivalent to their desired lifetime gift exemption. This irrevocable trust effectively removes those assets from their future taxable estate.
Although still considered irrevocable, the Williams’ IDGT is written to give them two specific powers: a) The "right of substitution" that allows them to "swap" the gifted assets for a Promissory Note of equal value and put the originally gifted asset back on their financial statement, under their control. b) The "spousal lifetime access provision" which gives each of them the right to access the transferred assets and benefit from the wealth those assets accumulate. The intentional trust "defect" that results from giving the Williams these extra powers is that they must pay the taxes due on any Trust income. Normally, the Trust would pay the income taxes.
The terms of the Williams’ Promissory Note: Provides for a duration of 20 years or less.
The non-taxable annual interest they pay on the Note can take advantage of interest rates.
The Trust may then use the interest payments to increase the wealth transferred to the Williams’ beneficiaries by using the annual interest cash flow to fund a tax-advantaged, second-to-die, permanent life insurance policy that insures both of them.
When the second insured dies, the ultimate net wealth to the Williams’ heirs will include the principal amount of the Promissory Note plus the insurance policy’s death benefits -- all income and estate tax free. In summary, the substitution rights and spousal lifetime access provisions of the IDGT give the Williams the power – and flexibility – they desire to access the assets they give away via a Promissory Note.
For more detailed information, let's connect. Now is a good time to explore and implement wealth transfer strategies that include life insurance to help you:
take advantage of today’s higher estate tax exemptions and gift tax exclusions
prepare for potential changes to tax policy
review your options and evaluate your existing coverage
Any solution you decide to pursue that requires trust creation and management should also involve a skilled estate planning attorney and the other legal, accounting, and financial professionals who fully understand your goals, preferences, and risk profile.
[1] This hypothetical scenario is provided for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
An insurance contract's financial guarantees are subject to the claims-paying ability of the issuing insurance company. While estates under $13.6 million per individual ($27.2 million per couple) currently are not subject to federal estate taxes, you may still have to pay estate taxes at the state level. Because of the rapidly changing nature of tax law, we make no warranty or guarantee that the gift maximum amounts will remain constant.