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Estate Planning Life Insurance Charitable Gift Annuity Risk Management Deferred Annuities

Slice of pie

Splitting the insurance bill

Family split-dollar arrangements can reduce gift taxes

Dave and Susan have established an irrevocable life insurance trust (ILIT) to purchase and hold a second-to-die life insurance policy, because they assume the estate tax will be in effect. (This article is written under the same assumption. See the Estate Planning Pitfall on page 7 for information on the 2010 estate tax repeal.) When the second spouse dies, the death benefit will be paid to the trust estate-tax free and then distributed tax free to their daughter, Anna, the trust’s beneficiary.

There’s just one problem: To cover the policy’s $40,000 premium, Dave and Susan make annual contributions to the ILIT, which are considered taxable gifts to Anna. Because of the way the trust is structured, the couple can use their combined annual gift tax exclusions (currently, $26,000 per year) to shield a portion of each
contribution from gift tax. But they’re still stuck with a taxable gift of $14,000 per year. A family split-dollar insurance arrangement may be the answer.

The split-dollar solution

Dave and Susan’s estate planning advisor suggests they consider a split-dollar insurance arrangement to reduce or possibly eliminate their gift tax liability. Under their arrangement, Dave and Susan will continue to make contributions to the ILIT equal to 100% of the premium amount.

When the second spouse dies, however, the insurance proceeds will be split between the spouse’s estate and the ILIT. The policy’s cash surrender value (or the total amount of premiums paid, if greater) will go to the spouse’s estate, while the ILIT will retain the rest for Anna’s benefit.

If the split-dollar arrangement is designed properly, the gift tax value of Dave and
Susan’s contributions will be based on the “economic benefit” received by the
ILIT. To determine the economic benefit, the IRS measures the current cost of life insurance according to IRS tables. Generally, this amount is only a fraction of the total premium.

Be aware that, even though this strategy reduces gift taxes, the sums that go to
the second spouse’s estate are potentially subject to estate tax, depending on the
size of the estate and how much estate tax exemption is available. So the amounts repaid to the spouse’s estate, as well as any estate tax liability they might generate, should be taken into account in determining the appropriate amount of insurance to purchase.

The split-dollar risks

Ordinarily, when you own an insurance policy on your own life, the insurance proceeds are included in your taxable estate when you die. By having a properly structured ILIT own the policy, you can keep the policy – as well as the death benefit – out of your estate, preserving more wealth for your family. To ensure this result, however, you must not retain any “incidents of ownership” in the policy, such as the right to change beneficiaries or borrow against its cash value.

In Dave and Susan’s arrangement, there’s a risk that the IRS will claim that, by retaining rights to the cash surrender value, they’re the policy’s owners for estate tax purposes. If that’s the case, the entire amount of insurance proceeds could be brought back into the second spouse’s estate and subject to estate tax. Part of the problem is that, for gift tax to be based on the economic benefit rules, Dave and Susan must be deemed the owners of the policy for purposes of the splitdollar
regulations.

Last year, however, the IRS issued a private letter ruling (PLR 200910002) accepting an arrangement like the one described above. But PLRs have no precedential value, and facts and circumstances can vary greatly, so there’s no guarantee that the
IRS will accept similar arrangements in the future.

Split decisions

This split-dollar insurance example is just one of several types of split-dollar arrangements. There are other ways of splitting the costs and benefits of life insurance between you and your beneficiaries, including having beneficiaries pay a portion of the premiums. Your estate planning advisor can help you determine whether a split-dollar insurance arrangement would benefit you, which type of arrangement would be appropriate and whether the potential rewards justify the risk.

* Split-Dollar Insurance is not an insurance policy; it is a method of paying for insurance coverage. A split-dollar plan is an arrangement between two parties that involves "splitting" the premium payments, cash values, ownership of the policy, and death benefits. Split dollar arrangements are subject to IRS Notice 2002-8 and Proposed Regulations that apply for purposes of federal income, employment and gift taxes.
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