ILITs and IDGTs: The Renewed Case for Old Friends
When Congress passed the American Taxpayer Relief Act of 2012 (“ATRA”), the unified credit for gift and estate tax became permanently set at $5 million. Not only was the unified credit set at the highest amount in its history, but it was further increased by annually indexing it for inflation. While an increase of 3 percent might sound nominal, when applied to $5 million that represents an additional $150,000 of exemption per individual. Clearly, the annual compounding of such increases means that fewer individuals will be subject to the estate tax regime each year. In this new age of the super exemption, many practitioners believed the estate planning tools of the past would disappear or at least become an endangered species. While this prediction has largely held true, there are still strong arguments for using the vehicles of the past—particularly the irrevocable life insurance trust (“ILIT”) and the intentionally defective grantor trust (“IDGT”). The new uses for these tried and true tools mean even those of modest wealth should consider the validity of such planning in their estate plans.
The ILIT – Protect the Assets
The ILIT, as the name suggests, is a trust specially designed to hold one or more policies of life insurance. By definition, the trust is irrevocable, and therefore, assuming it is properly drafted it is outside of both the probate and taxable estates of the grantor. The typical ILIT is structured to accept annual contributions for the purpose of paying the premiums on the policy. Including provisions modeled after the Crummey case, the annual gifts qualify for gifts of a present interest, thereby eligible to fall under the annual gift exclusion under Section 2503(b) of the Internal Revenue Code of 1986, as amended (the “Code”). The traditional use of the ILIT was for the high net worth family holding policies of insurance. By holding the policies in the ILIT, the annual premiums were not subject to the gift tax, assuming a sufficient number of eligible withdrawal beneficiaries. Additionally, when the grantor dies, the proceeds from the policy were not included in the taxable estate. This was a win-win, as long as the face value of the policy exceeded the annual premiums.
While the aforementioned benefits of an ILIT still exist, these are certainly are not compelling reasons for the family of modest wealth to implement such planning. Instead, the argument is one of asset protection rather than of transfer tax planning. In the modern era of rising medical costs and increasing litigation, end of life tragedies can decimate an estate, including any policies of life insurance. While the chances may seem remote, consider the instance where the decedent was the at-fault driver of a horrific accident. Due to his injuries, the decedent was on life support for several days and underwent multiple surgeries. Clearly, there are significant medical bills. Further, consider that the accident paralyzes another driver. In the months following his death, the family and estate are served with a lawsuit. Given that the decedent was deemed at-fault for the accident, there is a chance the estate will lose. If the decedent named his estate as the beneficiary of his life insurance, those proceeds would be at stake. If the life insurance was held in an ILIT, the proceeds would be protected from both the medical creditors and the lawsuit from the accident. Certainly, there are other ways to avoid this type of exposure, but an ILIT is the most comprehensive vehicle of protecting the life insurance proceeds from creditors and predators.
The ILIT also affords a degree of privacy that is lost when the proceeds flow through the probate estate. In the case of a blended family, all the children (natural, step, adopted) might receive the same holiday gift. However, they are rarely all treated the same when Mom or Dad passes away. A life insurance policy within an ILIT can be used to provide for one class of heirs in a manner separate from another class. Depending on the collection of assets, this can be a great way to plan for the ever-dreaded wife versus stepchildren battle in which the wife is the executrix of the will, while the kids must accept her management of the estate assets. Segregation is a wonderful attribute in this case. Allow the wife to be the beneficiary of a funded ILIT, and allow the natural children to be the heirs of the estate. In this way, each class has control over its inheritance without the other being involved. No matter how cordial a step-parent relationship is during life, it almost always changes when the natural parent deceases. Mitigate the potential for a contentious relationship by bifurcating the assets into separate vehicles before death. In the case of life insurance proceeds, the ILIT is the perfect choice.
The IDGT – Maximize the Basis
The IDGT is a curious creature (one could question what individual would want something that is “intentionally defective”). On the one hand, the income of the IDGT is taxable to the grantor, whereas the value of the assets passes outside of the taxable and probate estates of the grantor. There are several powers that can be included in the trust agreement of the IDGT to allow for this seemingly bipolar nature. The two aforementioned benefits of the IDGT work in tandem to allow assets to growth at a subsidized rate outside the taxable estate. Once the initial gift is made, all future grow occurs outside the estate and outside the transfer tax system. Furthermore, since the income of the IDGT is taxable to the grantor, the assets of the trust are not depleted to satisfy the income tax liability. In this way, the assets grow at a rate in excess of the tax-free rate without the burden of income taxes. Therein lies the estate planning strategy of the IDGT. While the ability grow assets in a subsidized nature outside of the estate has tremendous value, it is not without pitfalls. The most notable negative pitfall of the effective IDGT is the lack of basis step up for the assets contained therein. Due to the fact that the assets are not includable in the taxable estate, the assets retain the basis of the grantor rather than receiving a step up in basis under Section 1014 the Code. Nevertheless, for the high net worth family with a taxable estate, escaping the estate tax rate of 45 percent at the cost of capital gains taxed at a rate of 23.8 percent is still good planning.
The benefits of the IDGT are clear for the high net worth family. In contrast, the typical planning would be harmful for a family without a taxable estate—no estate tax saved and additional income tax incurred by the family. However, understanding the provisions can convert this seemingly detrimental strategy into a powerful opportunity for families with modest estates.
While there are several powers available under Sections 671 through 677 of the Code to trigger the grantor trust status, one of the most common provisions is the ability to exchange assets of equal value under Section 675(4)(C) of the Code. This provision, affectionately known as the Swap Power, allows the grantor to swap assets of equivalent value from the IDGT for assets in the personal name of the grantor. Herein lies the potentially powerful planning opportunity for grantors with an IDGT. Using the Swap Power, the grantor swaps the low basis assets from the IDGT in exchange for high basis assets of equivalent value in his personal name. In this way, at his or her death, the low basis assets receive a basis step up under Section 1014 of the Code, while the high basis assets avoid an equally harmful basis step down under this same Section. The following scenario illustrates the benefits of invoking the Swap Power in this manner. Grantor A owns publically traded stock, ABC, valued at $100,000 with an income tax basis of $250,000 while his IDGT, Trust B, owns publically traded stock, XYZ, valued at $100,000 with an income tax basis of $50,000. If A invokes the Swap Power with respect to these assets, at his death, the XYZ stock receives a basis step up to its market value of $100,000, while the ABC stock preserves its basis of $250,000 within the IDGT (which is now a taxable trust following the death of A). Assuming a combined, effective income tax rate of 29.8 percent (a federal tax rate of 20 percent, a net investment income tax rate of 3.8 percent and a state tax rate of 6 percent) saves income tax of $14,900 and preserves an income tax benefit of $44,700 – saving the family a total of $59,600 in income taxes.
If a family limited partnership (“FLP”) is part of the family portfolio, this planning can be taken a step further. Many IDGTs are funded with FLP interests for two primary reasons. First, it is a difficult-to-value asset, which means some discounts may be afforded. Secondly, depending on the nature of the underlying assets, this can be the asset with the most growth potential. However, as previously noted, being held in the IDGT prevents a basis step up. Furthermore, if a Section 754 election is in effect, the basis of the underlying assets in prevented from being stepped up. For the FLP holding depreciable property, this means the family misses out on the potential for additional depreciation deductions. In contrast to the previous example, assume that Grantor A owns publically traded stock, DEF, valued at $250,000 with an income tax basis of $100,000, while his IDGT, Trust B, owns a 50 percent interest in FLP Holdings, a partnership, valued at $250,000 with an income tax basis of $100,000. Further assume that FLP Holdings owns a rental condominium valued at $500,000 with an income tax basis of $100,000 as its sole asset. On the surface, it seems as if swapping the DEF stock for the FLP Holdings interest accomplishes nothing. The amount of the basis step up is the same. However, with a Section 754 election in place, the basis step up in FLP Holdings flows through to the 50 percent interest in the condominium. In this way, the $150,000 of basis step up yields over $5,400 in annual depreciation expense to offset the rental income, which it taxed at ordinary rates. While the basis step up is the same, a step up in the DEF stock is not recovered until the position is sold, and then it is a benefit at the lower, long-term capital gain rates. In contrast, with a Section 754 election in place, the step up in the FLP Holdings interest provides annual depreciation expense at the higher, ordinary income tax rates. Thus, considering the time value of money (assuming the DEF stock will be retained) and the arbitrage in the ordinary income versus capital gain rates, tax savings are afforded to the beneficiaries of the estate.
While many families still face an estate tax problem, the overwhelming majority of individuals will die without an estate tax bill. The super exemption of ATRA removed the need for traditional estate tax planning techniques for those of modest wealth. Nonetheless, advisors to this demographic are remised in assuming a simple will with the option of disclaimers and portability is sufficient for these individuals. Considering that income tax rates continue to climb, particularly for taxable trusts, the need for careful planning remains imperative. Reviewing the composition and basis of assets is vitally important—more than the potential for future appreciation. Removing future appreciation for the estate may not save the heirs a dime of estate tax, but removing assets from a basis step-up opportunity could cost them a great deal more of income taxes. For clients with existing IDGTs, consider whether invoking the Swap Power might renew purpose for the vehicle that lost its luster when the exemption was permanently increased. When it comes to life insurance, the proceeds often represent a substantial portion of the estate for individuals of modest wealth. For younger individuals with minor children, the proceeds from these policies are supremely important for the future support, maintenance and education of these heirs. The cost of creating, funding and maintaining an ILIT is far less than prohibitive, but the cost for not housing the policy in an ILIT could be detrimental. Estate planners have long been challenged with considering the worst case scenario for their clients. ATRA did not change adversaries of this challenge; it only slightly altered the order in which they be considered.