Using IDGTs to create the family bank through the tax favorable purchase of life insuranceArticle added by Roccy DeFrancesco on November 2, 2011
Roccy Defrancesco

Roccy DeFrancesco

MI

Joined: May 24, 2006

An intentionally defective grantor trust provides an excellent way to acquire significant amounts of life insurance without having to worry about taxable gifts on premium payments.

Typical estate planning

Most high-net-worth clients who have put off implementing proper estate planning end up having their advisors tell them at some point in their lives that they must set up an irrevocable life insurance trust so the death benefit of a life insurance policy will pay estate-tax free and be used to pay for the inevitable estate taxes that will be due.

While it is easy for an advisor to tell a high-net-worth client to gift $150,000 in premiums to an ILIT, most clients are upset when they hear they must pay gift-taxes on some of the premium gifted to the ILIT (or use their limited lifetime gift tax exemption).

Better planning

An intentionally defective grantor trust provides an excellent way to acquire significant amounts of life insurance without having to worry about taxable gifts on premium payments.

Examples are always the best way to explain difficult topics:

Marty and Sylvia, ages 68 and 67, have an estate valued at $18 million and would like to acquire a $4.5 million second-to-die survivorship life insurance policy for the benefit of their only child, Matt. Due to medical issues; however, the premium for the policy will be $150,000 per year.

While there is plenty of cash flow available to pay the premium, Marty and Sylvia are concerned over the gift taxes that would be imposed on the premium payments if they were to gift $150,000 a year to an ILIT. Among the assets owned by Marty and Sylvia are real estate investments valued at $7 million, generating income of 6 percent or $420,000 per year.

To use an IDGT, Marty and Sylvia contribute their real estate interests to a newly formed family limited partnership and receive a 1 percent general partnership interest and 99 percent limited partnership interests. Working with an appraiser, a 35 percent valuation discount is applied to the partnership interest.

Marty and Sylvia then create an IDGT and sell their limited partnership interest to the trust in exchange for an interest only note.
  • Gross value of property: $7,000,000
  • Discounted value: $4,550,000
  • Term of payment: interest only 15 years
  • Income on property: 6 percent
  • Property growth: 0.2 percent
Why would Marty and Sylvia want to transfer their assets to an FLP, discount them and sell them to an IDGT for a 15-year installment note?

The simple answer is that because of the discount (35 percent) on the FLP interest, the installment note, which will be paid to the clients, is based not on the $7 million of income producing real estate in the FLP, but instead is based on the discounted value of $4,550,000. This is the key to the transaction. Because of this, there will be significant surplus cash flow which stays in the trust.

That surplus income can be used to pay life insurance premiums in a completely gift tax free manner where the death benefit will remain out of the estate.
Let's see how this arrangement can help fund life insurance premiums without imposing gift taxes.

Year Installment Note Based on Trust IncomeInterest on NotePremiums for a $4.5 Million PolicyExcess Cash FlowValue of Property
1$4,550,000$420,000$266,175$150,000$3,825$7,140,000
54,550,000454,621266,175150,00038,4467,728,566
104,550,000501,939266,175150,00085,7648,532,961
154,550,000554,181266,175150,000138,0069,421,078


This planning has allowed $4,871,078 (which is derived by subtracting the installment note from the property value in year 15) in value to be shifted to Matt free of all taxes while creating a death benefit of $4.5 million that will also be received totally tax free.

It has also allowed Marty and Sylvia to make substantial tax-free gifts to the trust in the form of income taxes paid on the trust income.

The $266,175 of interest paid to them annually for 15 years is not taxable, but the $420,000 of income created inside the IDGT is taxable annually to Marty and Sylvia as grantors. Taxes on $420,000 at the 40 percent rate are $168,000 and, typically, a portion of the installment note payment of $266,175 is used to pay that tax.

If the grantor is still alive in 15 years when the note becomes due, there are a few options. The note could be re-done, or it could pay the $4.5 million due. Upon redoing the note, it could also be structured to start to pay down principal.

The family bank

Everyone likes the sound of creating a family bank for their heirs. With the IDGT situation just illustrated, the family bank has been created and will be funded upon the death the clients.

When Marty and Sylvia die, a $4.5 million death benefit will pay to the trust. The trust can distribute some of this money outright to the children, however, when thinking of a “bank,” many clients will set the trust up to use the money as a lending source for the entire family for generations to come.

Therefore, when a grandchild wants to purchase his/her first house and has poor credit or doesn’t have the down payment, he/she can borrow money from the IDGT with very favorable, although commercially reasonable, lending terms. Also, if a child or grandchild would like to find an investor to help invest in a start-up business, he/she can look to the IDGT to be that investor.

Perpetual nature

To have the family bank live for generations to come, some of the money in the trust each generation is used to purchase more life insurance on the older beneficiaries of the trust. Then when they die, the trust will have a new influx of tax free cash which can be used for the next generation’s family bank.

Summary

If you have affluent clients, you really should learn how to use IDGTs to benefit them in multiple ways. Doing so will help you grow your businesses and allow you to provide better advice to your clients.

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