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Monday, January 28, 2008


The Importance of Proper Trust Maintenance

The trustee of an irrevocable life insurance trust (ILIT) must follow numerous rules and regulations laid out by the IRS in order to exclude the ILIT’s policy proceeds from federal and state estate tax. The insured and the trustee should check to see that these rules and regulations are in compliance annually because any significant mistake — even an honest one — may lead the IRS to challenge the trust and tax the life insurance proceeds.

Life Insurance Trust Basics
An ILIT holds one or more life insurance policies on your life. Each year, in order to pay the premiums on the life insurance policy, you must gift money to the ILIT and then your trustee uses this money to pay the premiums. After your death, your trustee will distribute the insurance proceeds according to your instructions.

If established properly, you will not have any control over the life insurance policy itself or any of the assets in the ILIT. Normally, if you do not have control over an asset, it is not taxable for estate tax purposes. The IRS is not happy about the ability of people to pass on vast sums of money without paying tax and they may scrutinize your ILIT for mistakes so it can collect the estate tax. Accordingly, even though you have no control over the assets in your ILIT, it is still important that it is properly maintained.

Funding the ILIT
After the trust document is drafted, the trustee will either purchase an insurance policy on your life or transfer an existing policy into the trust. In either case, the trustee must be the policy’s owner and beneficiary. For policy that is not paid in full, the trustee must open up a bank account for the trust and you must deposit money into the ILIT’s account to cover the premium.

Your gift to the ILIT -- whether cash or an existing insurance policy -- qualifies for the annual gift-tax exclusion of up to $12,000 per beneficiary (for calendar year 2007). If you decide to transfer an insurance policy to the trust via gift, you must figure out the value of the policy. A good rule of them is the value of a term policy is approximately the current year’s premium or the cash surrender value for a whole life policy. (This is not exact however and there are exceptions, so you must get an official valuation from the insurance company - this is known as the interpolated terminal reserve plus a portion of that year's premiums paid by the owner.)

If you transfer an existing policy to your ILIT and you die within three years of that transfer, the proceeds will be included in your estate for estate tax purposes. If you are insurable, the three-year rule can be avoided by gifting cash to the trust and having the trustee purchase a new policy. You can then surrender the old policy and use the cash value, if any, to pay the premiums on the new policy.

Premiums and Crummey Notices
Each year you make a gift to the ILIT, whether to pay the annual premiums or otherwise. The gift will qualify for the annual gift-tax exclusion as long as the IRS considers the gift a gift of a “present interest.” In order for the gift to be deemed a gift of a “present interest”, your trustee must give the beneficiaries a right to withdraw the gift. This is known as a demand right or a Crummey power. (If a beneficiary is a minor, your trustee should send a Crummey notice to their parents or guardians of that minor.)

This notice requirement applies to the first year’s gift as well as every subsequent year’s. If your trustee forgets to send the Crummey notices, the IRS may say that the beneficiaries did not have a “present interest” and include the gifts as part of your taxable estate.

As soon as the withdrawal period lapses -- typically after 30 days and assuming the beneficiaries don’t exercise their withdrawal rights – the trustee can use the money to pay the premium. Due to this time constraint, money should be put into the trust account at least 45 days prior to the premium being due.

There is always a danger that the beneficiary will actually take the money, so you should explain to your beneficiaries that allowing the right to lapse each year without withdrawing the cash is in their long-term best interest.

It should be noted that if the trust owns a second-to-die policy on your and your spouse’s lives, the survivor should continue to make gifts to the ILIT so that the premiums can continue to be paid.

Records and Tax Returns
If the ILIT has gross income in excess of $600 for the year, your trustee is responsible for filing annual income tax return. The trustee should also maintain certain records in the event that the IRS chooses to audit the ILIT’s operation. These records include:
· Copies of all Crummey notices sent to the beneficiaries along with any related correspondence;
· Canceled checks from your individual (or joint checking account for a 2nd to die insurance trust) showing the gifts you made to the ILIT; and
· The trust’s checking account records, showing gift deposits and premium disbursements.

Avoid Incidents of Ownership
To maintain your ILIT’s tax-advantaged status, avoid exercising any control over the trust. In IRS terms, the insured party must not have any “incidents of ownership” during the trust’s life. If you violate this rule, the IRS will include the insurance policy in your estate and tax the proceeds. Incidents of ownership include the ability to:
· Change or add a beneficiary,
· Surrender or cancel the policy,
· Assign the policy or revoke a policy assignment,
· Borrow against the policy or pay premiums with policy loans; or
· Pledge the policy as collateral for a loan.

Mistakes Can Be Costly
Any significant mistake -- even an honest one -- may prompt the IRS to challenge the trust and tax the insurance policy’s proceeds. If you or your trustee has any questions about the proper way to handle your ILIT, please call before you act.

Saturday, January 12, 2008

Benefits of a Second to Die Life Insurance Trust

I. General Benefits
A. Tax savings
B. Control of assets after death
C. Second to die policies typically provide guaranteed money for your heirs which is cheaper to obtain than single life premium policies.

II. Reasons to establish a Second to Die Life Insurance Trust
A. Pay taxes upon death for assets outside of trust
B. Provide guaranteed funding for disabled child
C. Guarantee liquidity (so sentimental assets are not forced to be sold in a fire-sale)

III. How does a Second to Die Life Insurance Trust Work?
A. The trust should be created prior to the purchase of the policy (otherwise there is a 3 year lookback for tax purposes).
B. The trustee of the trust then purchases the life insurance on the joint life expectancy of you and your spouse.
C. A bank account must be set up for the trust.
D. The premium should be paid into the trust’s bank account at least 45 days prior to the premium due date.
E. Immediately after the trust’s bank account is funded, a beneficiary designation notice must be sent out. (In order to make gifts to the trust tax free, the beneficiaries of the trust must be allowed a window in which to withdraw the money. This is known as a Crummey trust.)
F. Thirty days later (this time frame various depending upon the trust document), the trustee can pay the premium.
G. Upon the death of the survivor of you and your spouse, the insurance is paid to the trust.
H. The trustee then pays out the money according to the terms of the trust.

IV. Putting the Tax Savings into Real Dollars
A. Let’s assume Harry and Winny have $7,000,000 in assets. They have two kids, one of whom has autism and needs permanent care. Even with proper planning, if Harry & Winny passed now, they would have a potential tax liability of about $1,500,000.
B. By setting up a life insurance trust, 100% of the money in trust can pass free of federal estate taxes as well as state estate and inheritance taxes. Additionally, the trust can be established to benefit Harry & Winny’s autistic child in a way that he remains eligible for government benefits.
C. To revise the example above, if we properly move $1,000,000 of assets into this life insurance trust, leaving a taxable estate of $6,000,000, the potential tax liability is reduced to about $1,000,000. This a savings of about $500,000.

Friday, January 4, 2008

Taxing Politics

The 2008 political season officially began last night in Iowa. Accordingly, I thought it would be helpful to look at each candidate's tax policies, especially their estate tax policies. I've listed only those who I consider to be the viable candidates. For fun, I put them in order of how they finished in the Iowa caucuses.

The Democratic Candidates

  1. Barack Obama
    Income Taxes
    --> Senator Obama appears to favor a reduction in income taxes for individuals making less than $50,000. This appears to be balanced by an increase on those whose income puts them in the top 1% of the country. He voted against a repeal of the alternative minimum tax.

    Estate Taxes
    --> It is clear that Senator Obama is in favor of keeping a federal estate tax, but it is unclear at what level. He voted againt raising the threshold to $5,000,000 per person.
    Other Tax and Probate Related Issues
    --> Senator Obama is in favor of closing tax loopholes for companies that move jobs abroad and in favor of rewarding companies that create jobs in America.
  2. John Edwards
    Income Taxes
    --> Senator Edwards appears to favor using a combination of credits to reduce the taxes of those earning less than $75,000. The most notable credit is a large increase for Child Care. He voted against a repeal of the alternative minimum tax. He wants an increase in the capital gains tax rate to 28% for those earning over $250,000.
    Estate Taxes
    --> Senator Edwards is in favor of keeping the federal estate tax at the same levels as are currently in place, $2,000,000 per person.
    Other Tax and Probate Related Issues
    --> Senator Edwards is in favor of closing tax loopholes for hedge fund and private equity managers (meaning that they would be taxed at income tax rates, not capital gains tax rates). He also had a very interesting proposal that would require the IRS to prepare tax returns for those people who are simply W-2 workers or receive all income from 1099's.
  3. Hillary Clinton (No real public plan yet)
    Income Taxes
    --> Senator Clinton wants to keep the AMT, but it is unclear at what level.
    Estate Taxes
    --> Senator Clinton is in favor of keeping the federal estate tax at the same levels that will be in place starting in 2009, $3,500,000 per person.
    Other Tax and Probate Related Issues
    --> Senator Clinton proposes increasing or removing the $95,000 cap from the payroll tax. Currently, only the first $95,000 of income is subject to payroll tax. Payroll taxes are for such things as Social Security, Medicaid and Medicare.

The Republican Candidates

  1. Mike Huckabee
    Governor Huckabee wants to eliminate ALL income, payaroll, gift, estate, capital gains, alternative minimum, Social Security, Medicare and self employment taxes. He wants to replace these with a consumption tax (i.e. a tax on what we buy - similar to a sales tax). The consumption tax rate would be about 23% inclusive (or about 30-34% exclusive). For a view of the plan known as FairTax given by supporters, click here. For an opposing view, click here. The consumption tax would theoretically be on EVERYTHING, including new home purchases, rent, doctor's bills, and worst of all - LEGAL FEES. It would however exclude used items. (Hmm... I wonder if you can have used legal services...)
    Income Taxes
    --> See above
    Estate Taxes
    --> See above
    Other Tax and Probate Related Issues
    --> See above
  2. W. Mitt Romney
    Income Taxes
    --> Governor Romney generally wants to lower tax rates for everyone.
    Estate Taxes
    --> Governor Romney is in favor of permanently repealing the estate tax. It is unclear if he wishes to repeal the gift tax.
    Other Tax and Probate Related Issues
    --> Governor Romney wants to get rid of taxes on interest, dividends and capital gains for those with an adjusted gross income under $200,000.
  3. Fred Thompson
    Income Taxes
    --> Former Senator Thompson plans to index the AMT for now and repeal it eventually. He believes in instituting a flat tax which would give much larger personal exemptions, but get rid of all deductions.
    Estate Taxes
    --> Former Senator Thompson wants to elimate the estate tax. It is unclear if he wishes to repeal the gift tax.
    Other Tax and Probate Related Issues
    --> He has an interesting proposal to let tax payers choose the current tax forms or a flat rate form with only 2 exemptions.
  4. John McCain
    Income Taxes
    --> Senator McCain is in favor of permanently repealing the AMT. He would make the currently scheduled tax levels permanent.
    Estate Taxes
    --> It appears Senator McCain wants to elimate the estate tax. It is unclear if he wishes to repeal the gift tax.
    Other Tax and Probate Related Issues
    --> Would ban taxes on cell phone messages. (I don't think that there is one...)
  5. Ron Paul
    Congressman Paul wants to get rid of the income tax completely (which would require severe spending cuts).
    Income Taxes
    --> See above
    Estate Taxes
    --> It appears that Congressman Paul wants to eliminate the gift, estate and GST tax.
    Other Tax and Probate Related Issues
    --> It appears he wants to fund the goverment with fees such as: tariffs, excise taxes, user fees and highway fees.
  6. Rudy Giuliani
    Income Taxes
    --> Former Mayor Giuliani intends to permanently lower the marginal rates to what they will be under the Bush tax act, or lower. He intends to tie the AMT to inflation. He also proposes an income exclusion up to $15,000 for families without employer based health care.
    Estate Taxes
    --> Former Mayor Giuliani wants to eliminate the estate tax. It is unclear if he wishes to repeal the gift tax.
    Other Tax and Probate Related Issues
    --> He wants to drop the corporate tax rate from 35% to 25%.

Sources include: www.ontheissues.org, the candidate's websites, and various news articles.