By Jeffrey M. Verdon, Esq. Managing Partner, Jeffrey M. Verdon Law Group, LLP

Very few people were immune from the losses to their real estate and securities portfolios in 2008 and 2009.  Investors have become extremely conservative in their investment planning seeking preservation of principal vs. preservation of capital. Here we describe a tax and investment planning structure that will not only take advantage of the temporarily higher Estate and Gift Tax exemption amount, but will do so in a manner that will facilitate the recovery of investment losses using investment grade life insurance. The plan can be accomplished with the proper life insurance product.

How This Strategy Works

Example:  Let’s assume Bob, age 66, and Mary, age 60, are both in good health.   Their net worth has been significantly depleted by the Great Recession and are reluctant to take much risk in their investment philosophy, looking instead for preservation of principal.  Bob and Mary love their children and would like to pass as much of their estate to their adult children and grandchildren as possible, but not at the expense of sacrificing their own lifestyle. 

Bob and Mary set up an irrevocable trust in a qualifying jurisdiction and are named as “discretionary beneficiaries” within the trust instrument.  Bob and Mary each make a tax-free gift of $1M in cash to the trust, utilizing their respective $5M unified gift tax exemption.  Under the PLR 200944002, Bob and Mary will be deemed to have made a completed gift despite being able to receive distributions in the sole discretion of the independent but friendly trustee.  Thus, the $1M gift plus any life insurance proceeds will be removed from Bob and Mary’s taxable estate at their respective deaths.

The trustee then applies for an investment grade life insurance policy with a highly rated company on each of their lives making the owner and beneficiary of the policies the trust.  Bob’s one time $1M premium buys a life insurance policy of $2.7M plus the policy has a cash value account of 99.6% of the premium paid.  Mary’s $1M single premium buys a $3.7M death benefit and has 99.7% of the premium paid.  In short, the life policy is similar to a high yielding tax-free bond but with a bonus feature called “death benefit”.

Under this structure, Bob and Mary have collectively turned $2M that would have been worth only $1,000,000 to their heirs into $6.4M ($2.7M and $3.7M); both income and estate tax free wealth for their children and grandchildren whether death occurs now or after age 100. 

Moreover, utilizing the benefits of the above-described PLR, during Bob and Mary’s lifetime, the trustee can access the cash value of the policies for Bob’s and Mary’s personal use, on a 100% income tax free basis, if desired.  Each year, based on current assumptions, the cash value of the policies will increase at a rate of 5.25% and if interest rates increase, so will the interest rate paid on the cash value.  Moreover, the increase in the cash value is not subject to income tax and may be removed from the policy income tax free.  Bob and Mary suffered investment losses during the Great Recession.  This plan allows them to replace up to $6.4M of those losses from the insurance company’s death benefit payment.

What If Liquidity Is a Problem"

If you don’t have the cash to make the gift to fund the life insurance policy, consider financing the premium.  For example:  If Bob and Mary have the net worth and want to take advantage of the higher gift tax exemption but don’t have the ready cash to fund the policy, a bank that specializes in premium financing will loan Bob and Mary each $1M to purchase the life insurance. 

The policies can then be transferred to the trust qualifying for the gift tax exemption.  The lender will take a collateral assignment (lien) of the insurance policy and its cash value while the loan is outstanding. Premium financing loans carry an interest rate between 2.75% to 5%, depending on the financial and credit strength of the borrower.  The interest is paid annually on an interest only basis so the cost to carry the policy is manageable. 

The policy will be designed to have sufficient equity to repay the lender when it is desired and the lender removes the collateral assignment and the death benefit and cash value will be free of liens. It is necessary to leave a sufficient amount of cash value in the policy so the policy doesn’t expire from lack of liquidity.  In the meantime, the lender will look for repayment from the life insurance policy at the death of the insured provided the borrower continues to make the annual interest payments. Consider the result, $27,000 - $50,000 annually to create $6.4M income and estate tax free asset, the return on investment is very compelling.

What Congress Giveth Congress Can Take Away 

Since the new $5M gift tax exemption is available for the next 2 years only, we are recommending our clients fund the maximum gift tax exemption of $5M in case Congress reduces the amount of the gift tax exemption to a lesser amount. Once the gift is made to the trust, the amount will be grandfathered and any subsequent change in the law will not apply to previously made gifts.

For more information on this technique or other similar planning strategies involving the new gift and estate tax laws, please contact: