Leveraging IRA funded Credit Shelter Trusts for the Next Generation
Increasingly we find that in planning for the Federal Estate Tax many clients must look to fund a Credit Shelter trust with retirement plan assets.
The problem with these assets, chiefly IRA accounts, is that the client has successfully avoided the imposition of the Federal Estate Tax at the death of the surviving spouse, but the next generation, the children of our client, are faced with a tremendous Federal Income Tax burden. The IRA accounts had been funded with pre-tax dollars, so the inherited IRA will be fully taxable, often at the highest income tax bracket.
While it may be possible to defer payment of the Federal Income Tax, the tax burden cannot be avoided. Often we will see the $2 Million IRA balance reduced, effectively, to $1.2 Million after taxes have been paid by the surviving children.
In many cases the surviving spouse has sufficient assets outside of the Credit Shelter Trust that the deceased spouse's IRA is not required for purposes of income or principal in the survivor's lifetime. It is not uncommon to find the surviving spouse with $2 Million or more in other assets and an income being generated from those assets of $150,000 per annum or greater.
An innovative solution to this problem which can both:
- Eliminate the Federal Income Tax on the IRA, and also
- Amplify the amount inherited net of Federal Estate Tax and Federal Income Tax.
Tools and Techniques of Leverage
The surviving spouse will create an Intentionally Defective Grantor Trust (IDGT). Every client is taken back when we, in the legal profession, suggest that we are drafting a “defective” instrument, the intent is to create a trust whose principal (also known as trust corpus) will not become a part of their estate for purposes of the Federal Estate Tax, but at the same time will not be treated as a separate entity (taxpayer) for purposes of the Federal Income Tax. Since the client (taxpayer) and the IDGT are the “same person” for tax purposes, transactions can take place between the client and his or her trust without unwanted tax ramifications.
Our first step is to determine the level annual income stream generated by converting the IRA cash balance to a lifetime annuity payout. We next calculate the annual income tax that the client must pay on the annual payments. Note: this technique is the same if the surviving spouse is a direct beneficiary (in which case the IRA balance at the death of the surviving spouse would be subject to both the Federal Estate Tax and the Federal Income Tax) or is the beneficiary of a “see through” Credit Shelter Trust.
Once we know the annual after tax sum of money available from the IRA we determine what face amount of life insurance on the life of the surviving spouse can be purchased by the trustee of the IDGT. In advising clients I recommend the structuring of a ten payment life insurance policy, i.e. the policy should be fully paid for in ten years. If a Whole Life policy this can be done through application for a limited payment life policy or the purchase of an option known as “paid-up additions,” and if Universal Life by making reasonably conservative estimates of mortality and interest crediting projections.
The premium contributions in these estates will generally be quite significant and the traditional “Crummey” powers tend not to be sufficient for purposes of the Federal Gift Tax.
Yet another tax burden on transfers is the Federal Gift Tax. At present each taxpayer may, during his of her lifetime, make taxable gifts totaling $1 Million dollars without the imposition of tax. This is known as the Lifetime Exemption. Each year a taxpayer may gift $12,000 to an unlimited number of recipients without the imposition of the Federal Gift Tax. These gifts are referred to as the Annual Exclusion.
A full discussion of Crummey powers is beyond this essay, but note that the limits are $5,000 or 5% of trust principal to avoid Federal Gift Tax per trust beneficiary. All transfers to the IDGT above that amount would become part of the Lifetime Exemption which would result in the following: (i) annual premium payments become subject to the Federal Gift Tax, currently set at 35%, and (ii) the Applicable Credit Amount (aka Federal Estate Tax exemption) for the surviving spouse would be diminished.
Each year, during the ten year funding period (if the surviving spouse survives for ten years) the client will make a loan of the funds needed for the annual premium payment to the IDGT. The trust will execute a promissory note back to the client. In the client's Will there will be a clause forgiving any indebtedness from the trust to the estate. This will cause inclusion in the surviving spouse's estate of the face of the outstanding notes forgiven.
The results will vary by the exact ages and amounts being funded, but for most estates the leverage will be to amplify the net inheritance to the next generation by a factor of 300% to 400%.
EXAMPLE
In the following example husband died leaving a $2 Million IRA which is funding a Credit Shelter Trust. When surviving spouse dies, assuming full $2 Million remains in the IRA at time of her death, their two children would receive $2 Million but incur a Federal Income Tax liability of $700,000 (today) to $800,000 (after Bush tax cuts expires). The net inheritance to the two children could be reduced to $1.2 Million.
Surviving spouse elected to have the inherited IRA funding the Credit Shelter Trust converted to an annuity income stream which yielded an after tax payment of $200,000 per year.
She then executed an Intentionally Defective Grantor Trust and made a loan of $200,000 to the trust. The trust, in turn, applied for a $5 Million 10 Pay life insurance policy on the life of the surviving spouse. This was repeated for three additional years. The surviving spouse had made total loans to the trust in the amount of 4 x $200,000 = $800,000. This debt was forgiven by the Will of the surviving spouse.
The trust now collects $5 Million from the life insurance company. These proceeds are free from Federal Estate and Federal Income Tax. The $800,000 forgiven by the Will is added to the surviving spouse's estate and could be the subject of up to 50% Federal Estate Tax, which would be $400,000.
Bottom line: $5,000,000 insurance proceeds minus $400,000 increase in Federal Estate Tax yields net inheritance of $4,600,000. Without this planning the net inheritance to the children would have been $1,200,000. The net inheritance has been amplified by almost 400%.
