contingent owner survivor life and the standby disclaimer ilit

The AALU Weekly Briefing Featured Article 1

Featured Article: Contingent Owner Survivorship Life and the Standby Disclaimer ILIT

Russell E. Towers JD, CLU, ChFC Vice President - Business & Estate Planning Brokers' Service Marketing Group Introduction The American Taxpayer Relief Act of 2012 has finally provided some degree of certainty for estate planning. The estate tax exemption in 2014 is $5,340,000 (indexed) for an individual and $10,680,000 (indexed) for a married couple. There is a “portability” election that can be made at the first death on the Form 706 U.S. Estate Tax return to carry over unused estate tax exemption from the first death to the second death if desired. Given this relatively high estate tax exemption amount, how should wealthy estate owners plan their financial affairs? Especially married couples with significant gross estates that are currently less than $10,680,000 but could grow to more than $10,680,000 (indexed) over time? Is there a financial, tax, and legal concept that could be put in place to provide estate planning flexibility depending on whether the estate stays below the indexed exemption threshold or grows in value beyond the exemption threshold? One concept that has promising potential to create a higher degree of flexibility is a personally owned cash value accumulation type of survivorship life insurance policy with contingent ownership features. The contingent ownership designation offers the possibility of utilizing a “qualified disclaimer” in favor of a so-called “standby” irrevocable trust. This arrangement offers a flexible alternative to the usual practice of placing ownership of the survivorship policy in an irrevocable life insurance trust right at the start of the plan. Planning Model Assume wealthy estate owners who are married would like to buy survivorship life insurance to pay federal estate taxes, if any exist, at the survivor’s death. Naturally, if their gross estate is greater than the estate tax exemption available at death, they would usually want the death benefit to be estate tax free. Placing the policy in an Irrevocable Life Insurance Trust (ILIT) would insure that the death proceeds would be estate tax free. However, the couple may hesitate to commit to this option because they are not sure they will ever be exposed to federal estate taxes in the future. If they will not be exposed to federal estate in the future, they would like direct access to the accumulated cash value of the policy (withdrawals/loans), an option that would not exist if the policy was owned by the ILIT at the start of the transaction. Can they achieve this dual need of estate tax exclusion if they are faced with estate taxes in the future, yet


retain direct ownership of the policy if estate taxes are not expected to be a problem in the future? Assume the husband (Life #1), because of age, health, or gender, is likely to die before the wife (Life #2). The policy ownership would therefore be issued to Life #1. The husband is the sole owner, and the wife has no ownership interest. Then, the husband (Life #1) names the wife (Life #2) as first contingent owner of the policy upon his death and the ILIT as second contingent owner in case the wife executes a qualified disclaimer within nine months of his death. If everything goes according to plan and Life #1 dies first, ownership will pass automatically by contract endorsement (contingent owner) to Life #2. If the estate will not be exposed to estate taxes at the second death, the wife (Life #2) keeps ownership of the policy and does not execute a qualified disclaimer. If the estate is large enough so that it will be exposed to estate taxes, the wife executes a qualified disclaimer in favor of the second contingent owner, the ILIT. Thus, even if the wife were to die soon after her husband, the death benefit would not be included in her estate under IRC Section 2042 because she never possessed any incidents of ownership. The qualified disclaimer in favor of the ILIT was executed within nine months of her husband’s death. Nor would the proceeds be included in her gross estate under the IRC Section 2035 three-year rule because her husband (Life #1) is considered to have transferred the policy ownership directly to the ILIT if she executes the qualified disclaimer within nine months. It’s as if she never owned the policy once she executes the disclaimer. Under this scenario, the insured estate owners have full control over the policy and access to the cash value while both are alive and significant planning flexibility after Life #1 dies depending on whether or not their estate will be exposed to estate taxes at the second death. In addition, if the survivor’s estate will be exposed to estate taxes and the wife executes the qualified disclaimer in favor of the ILIT, the trust could contain certain spousal lifetime access provisions in the form of limited powers of appointment to allow limited access to the policy cash values during the remainder of the wife’s lifetime. Certainly, the policy cash value will be included in Life #1’s gross estate, but the applicable exemption amount at death ($5,340,000 indexed) will allow him to shelter this amount from estate taxation. There is one possible downside to this plan if the estate will be exposed to estate taxes in the future. What if Life #2 (wife) dies before Life #1 (husband)? Since the husband would be both the surviving insured and the owner of the policy, the death proceeds would be included in his gross estate at death. He can avoid this negative estate tax exposure by transferring ownership of the policy to the ILIT, and surviving this transfer by three years. The value of the gift for transfer purposes would be its interpolated terminal reserve value at the time of transfer. This value could be offset by any remaining lifetime gift exemption he has available to him. To gain a deeper understanding of this transaction, let’s look at each of the component steps in more detail. Survivorship Policy Owned by Life #1 As stated above, Life #1 is the sole owner of the survivorship policy. As owner, Life #1 has direct access to policy cash value via tax free withdrawals and/or policy loans. In order to balance cash accumulation against death benefit, and not knowing whether they will be exposed


to estate taxes in the future, a limited premium payment schedule might be adopted. For instance, if the insureds were ages 55 and 54 respectively, a fifteen year premium schedule may offer a reasonable cash value accumulation if cash value becomes the more important factor because their estate will not be exposed to taxes. This cash value accumulation survivorship policy could be a current assumption universal life policy, an indexed universal life policy, or a whole life type of policy depending on preference. Naturally, when Life #1 dies first, the cash value of the policy is included in the gross estate. If ownership passes to Life #2 as first contingent owner, it qualifies for the estate tax marital deduction as property which has passed to the surviving spouse. If the surviving spouse executes the qualified disclaimer in favor of the ILIT, the cash value passing to the ILIT does not qualify for marital deduction but can be offset by the estate tax exemption available at the first death. If Life #2 dies first, Life #1 will have to give the policy to the ILIT and survive three years to avoid estate inclusion under IRC Section 2035. The value of the gift is the policy’s interpolated terminal reserve value and could be allocated against any remaining lifetime gift exemption amount. The applicable exemption amount for lifetime gift transfers is $5,340,000 (indexed). As policy owner, Life #1 has all the normal contractual rights of ownership, including the right to surrender the policy, the right to assign the policy, the right to reduced paid-up insurance, and the right to do an IRC Section 1035 exchange. Contingent Owner Endorsement The contingent owner designation/endorsement is the key to the success of the concept. Basically, a contingent owner designation automatically (contractually) transfers ownership of the policy if Life #1 dies owning the survivorship contract. Without this designation, the policy would have to pass through probate according to the terms of Life #1’s will. The contingent ownership endorsement becomes part of the contractual provisions of the policy with which the insurance company is bound to comply from a legal perspective. It must be accepted, stamped, dated, and recorded by the carrier. As stated previously, Life #1 will be the sole owner of the policy with the “standby” ILIT designated as policy beneficiary. The other spouse (Life #2) is the first contingent owner and has the opportunity to keep or disclaim ownership depending on future estate tax circumstances. If their estate will be exposed to future estate taxes, the spouse can file a written qualified disclaimer with the insurance carrier within nine months of Life #1’s death in favor of the ILIT as second contingent owner. Sample wording of such a contingent owner endorsement might read something like this:

“John Smith shall be owner of the policy during his lifetime. In the event of the death of John Smith prior to the death of Mary Smith, Mary Smith shall become owner of the policy pursuant to this endorsement. If Mary Smith, or her personal representative, executes a qualified disclaimer of policy ownership pursuant to IRC Section 2518, then XYZ Trust Co., Trustee of the Smith Family Irrevocable Trust, dated 1/1/2014, shall become owner and beneficiary of the policy pursuant to this endorsement.”


A second issue that must be addressed in the contingent owner endorsement is the

possibility of a simultaneous death of both insureds. A simultaneous death happens in tragic circumstances where it cannot be determined which person died first. Under state law, each person is presumed to have survived the other for purposes of estate distribution. Under these circumstances, Life #1 would be presumed to have survived Life #2. This would cause the full death benefit to be included in Life #1’s gross estate and frustrate the purpose of our plans.

In order to overcome this simultaneous death presumption, we must execute a written statement in the legal instrument of transfer, which is the contractual contingent owner endorsement. We must reverse the simultaneous death presumption by a “reverse simultaneous death” clause in the contingent owner endorsement. This clause would presume that Life #2 survived Life #1, and that Life #2’s personal representative (executor) would have the option of filing a qualified disclaimer on behalf of deceased Life #2 if the estate is large enough so that estate taxes are due at the time of the simultaneous death. This would allow our plan to still accomplish its purpose on the unforeseen occurrence of a simultaneous death. Sample wording of a “reverse simultaneous death” clause might read something like this:

“In the event that John Smith and Mary Smith shall die under circumstances that the order of death cannot be determined, it shall be presumed for purposes of this policy that John Smith predeceases Mary Smith.”

Qualified Disclaimers and IRC Section 2518 IRC Section 2518 is the section in the Internal Revenue Code that allows a person who has received property at another’s death by contract, joint tenancy, trust, beneficiary designation, probate, etc. to disclaim the receipt of such property. A contingent owner endorsement is considered a “contract in lifetime.” As such, a first contingent owner (Life #2) may disclaim receipt of property (i.e. the in force survivor life policy) by executing a qualified disclaimer in favor of the second contingent owner (the “standby” ILIT) within nine months of Life #1’s death. If this disclaimer occurs, Life #2 will be treated as never having received ownership of the policy. The policy ownership will be considered to have been transferred directly from Life #1 to the “standby” ILIT. Thus, no three year rule exists for Life #2 and the policy death proceeds will be estate tax free at the second death. We are assuming the survivor’s estate will be subject to estate taxes and thus, the need for Life #2 to execute the disclaimer is of paramount importance. To qualify as a disclaimer under IRC Section 2518, certain conditions must be met: (1) the disclaimer must be irrevocable and unqualified; (2) the disclaimer must be in writing; (3) the writing must be delivered to the legal representative (executor) of the transferor (Life #1) of the interest not later than nine months after the transferor has died; (4) the disclaimant (Life #2) must not have accepted the interest disclaimed or any of its benefits; and (5) the interest must pass to a person (i.e. the ILIT) other than the disclaimant (Life #2) without any direction on the part of the person making the disclaimer (Life #2). If Life #2 makes the qualified disclaimer, then for purposes of the federal estate tax, the disclaimed interest in property is treated as if it had never been transferred to Life #2. Instead it is considered as passing directly from Life #1 to the “standby” ILIT, and the intended results of our plan will be accomplished.


“Standby” Irrevocable Life Insurance Trust What is this “standby” ILIT that we have been referring to throughout this article? Is it something different or is it your garden variety ILIT that we have used for estate planning purposes all these years? Basically, it’s an irrevocable trust that has been executed by a grantor, but no significant property has yet been transferred into the trust. In effect, the trust is “standing by,” waiting to receive property at some point of time in the future. Initially, the trust may be “seeded” with a nominal amount of cash. In fact, if the survivor’s estate will not be large enough to be exposed to federal estate taxes in the future, Life #2 may decide not to execute the qualified disclaimer in favor of the ILIT. In this case, absolutely nothing will end up in the ILIT. It will have been “standing by” all those years waiting to receive ownership of the insurance policy, but its wait will have been in vain, and it will serve no purpose. But, assume that estate taxes will exist for the survivor after the death of Life #1, and Life #2 does execute the qualified disclaimer in favor of the “standby” ILIT. What ILIT provisions would provide the most estate planning flexibility to accomplish our objectives? Remember, when Life #1 dies, continued premiums may still be needed to maintain the financial viability of the policy. And the policy will then be owned by the ILIT and Life #2 will not have direct access to policy cash values. Here are some suggested trust provisions that may be important as we go forward with the plan:

(1) Make sure the trust has “Crummey” powers for the trust beneficiaries so that future transfers of cash to the trust for premiums will be considered present interest gifts that qualify for the gift tax annual exclusion;

(2) Life #2 should not be a trustee of the ILIT. Thus, no trustee “fiduciary incidents of ownership” under Treas. Reg. 20.2042-1(c)(4) could be attributed to the surviving spouse which would cause the second death proceeds to be included in the survivor’s gross estate;

(3) The trust could give the surviving spouse (Life #2) a limited power of appointment to withdraw the greater of $5,000 or 5% from trust principal on a non-cumulative basis. The trust principal to measure this so-called “5 and 5” power against would be the accumulated cash value of the insurance policy. This “5 and 5” limited power provides limited access by Life #2 to policy cash value via tax free trust withdrawals or policy loans (retaining tax free character from trust under IRC Section 662(b)) without causing the ultimate death proceeds to be included in the survivor’s gross estate as a general power of appointment (see IRC Section 2041(b)(2));

(4) Allow the third party trustee discretionary authority to provide additional distributions of trust principal (cash value) to Life #2 via tax-free withdrawals/loans from the policy;

Conclusion

Simply, the results of the contingent owner survivorship life plan with a standby disclaimer ILIT can be stated as follows: (1) If the estate will potentially be exposed to estate taxes at the death of the surviving spouse (Life #2), the surviving spouse should consider executing the qualified disclaimer in favor of the ILIT as second contingent owner. (2) If the estate will not be large enough to worry about estate taxes at the death of the surviving spouse


(Life #2), the surviving spouse should consider retaining ownership of the policy as first contingent owner and not executing the qualified disclaimer in favor of the ILIT.

Even if the survivor’s estate will not be exposed to estate taxes, and Life #2 ends up owning the policy, life insurance will still be very valuable property to own for all the usual reasons. (1) The cash value grows tax deferred; (2) Withdrawals to basis and policy loans can be made income tax free; (3) The ultimate death benefit is income tax free; (4) Life insurance cash values and death benefits have significant creditor protection in many states; (5) Death proceeds paid to a named beneficiary or trust avoid probate; (6) Very low present value cost in relation to the future death benefit paid (7) Very competitive Internal Rate of Return (IRR) on death benefit at joint life expectancy.

So, even in a situation where the survivor’s estate will not be large enough to be exposed to federal estate taxes, a life insurance policy personally owned by the survivor can provide liquidity to pay significant combined costs which can accrue at death. The insurance can offset the estate shrinkage caused by probate costs, attorneys fees, federal and state income taxes on IRD income, and state death taxes in those states that still levy some form of state estate tax.

In conclusion, a personally owned survivorship policy with contingent ownership features and a standby disclaimer ILIT offers significant flexibility where it is uncertain whether or not federal estate taxes will be a problem in the future.

Russell E. Towers JD, CLU, ChFC Vice President - Business & Estate Planning Brokers' Service Marketing Group

contingent owner survivor life and the standby disclaimer ilit

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