What is Grantor Trust Life Insurance?

With all of the talk about the “fiscal cliff” and potential huge change (negatively) for estate taxes, many people are beginning to look to ways to gift money legally before the end of the year.  Although we neither give tax nor investment advice, we did come across this great piece from our friends at DBS (Diversified Brokerage Services) in Minnesota about using Grantor Trusts to acquire life insurance.  Find out below how this could apply to you.

The opportunity to gift $5 million without gift or GST tax is still slated to come to a close on December 31, 2012. As of January 1, 2013, the gift tax exclusion will revert to $1 million and the gift and estate rate will revert to 55% unless Congress takes action in the lame-duck session. Many of your clients may have taken a “wait-and-see” approach to making significant gifts.

Many assets that are the subject of gifts to family members do not trade in a market such as marketable securities. Examples of assets that are often the subject of gifts include undivided interests in real estate and membership units in family limited partnerships or LLCs. For procrastinators, the time to make gifts involving hard-to-value assets, or assets involving valuation discounts, may have run out.Why?

The Valuation Problem

When a donor considers making a gift of any asset other than cash or marketable securities, an independent appraisal is necessary if the value is to have any chance of withstanding the scrutiny of an IRS audit. Gifts that employ discounts must be highlighted to the IRS by checking the box on Schedule A to the Federal Gift Tax Return – Form 709. This increases the risk of audit for such gifts.

Donors understandably want to be able to make gifts without a risk of a gift tax. To limit a donor’s exposure to unexpected gift tax resulting from an audit, tax and legal advisors typically rely on the use of “defined value clauses.”

A defined value clause generally provides that if the IRS successfully challenges the valuation claimed by the donor, the amount gifted is reduced to fit within the annual exclusion or exemption amount and the excess amount is usually transferred to a charity. Of course, there is the risk that the IRS and courts will not respect such a clause. However, in recent years defined value formula clauses have been upheld in many cases.

Even with the recent successes with defined value clauses, gifts of hard-to-value assets must be appraised before the transfer. Some of your clients may discover that their opportunity to take advantage of the $5 million exemption to transfer hard-to-value assets has passed because there is not enough time for an appraiser to conduct the necessary analysis.

If you have clients with hard-to-value assets who want to take advantage of the $5 million exemption, but find themselves in the situation where there is not enough time to conduct the appraisal, following is an option worth considering.

The Procrastinator’s Solution

Individuals who have waited too long to make gifts of hard-to-value assets should consider gifting cash or marketable securities of the maximum exemption amount to an intentionally defective grantor trust with substitution powers before the end of 2012. Such gifts have several benefits. First, the donor locks into what may be a once-in-a-lifetime opportunity to gift $5 million without gift tax. Second, a formal appraisal is not necessary. Finally, the valuation discount box on Form 709 does not need to be checked, thus reducing the risk of audit.

While the gift of cash or marketable securities does not result in the transfer of the hard-to-value asset as desired, this can be accomplished in the future using the power of substitution. The power of substitution requires that the property to be substituted must have a value equivalent to the property withdrawn. Hard-to-value or discounted assets can be substituted under this power with independent appraisal support.

You might be asking yourself . . . what does this have to do with life insurance? Intentionally defective grantor trusts are often used to acquire life insurance. The earnings from the marketable securities or hard-to-value asset may be used as premium payments for a life insurance policy on the donor’s life.

Life Insurance Education