New Tax Law Creates Opportunity to Recover All of the Year 2008 and 2009 Real Estate Investment Losses

In our previous Client Alert, we described the vehicle by which you can create an Estate Freeze utilizing your $5M gift tax exemption ($10M for married couples) in conjunction with a special asset protection trust, and retain a “beneficial interest” in the $5M of cash or property given to the trust.

Very few people were immune from the losses to their real estate and securities portfolios in 2008 and 2009. Investors have become extremely conservative in their investment planning seeking preservation of principal vs. preservation of capital. This Client Alert will describe a tax and investment planning structure that will not only take advantage of the temporarily higher Estate and Gift Tax exemption amount, but to do so in a manner that will replace all or most of the investment losses using investment grade life insurance. Yes, we all hate life insurance – but just indulge me for a bit longer.

Example: Let’s assume Bob, age 66, and Mary, age 60, are both in good health. Their net worth has been significantly depleted by the Great Recession and are reluctant to take much risk in their investment philosophy, looking instead for preservation of principal. Bob and Mary love their children and would like to pass as much of their estate to their adult children and grandchildren as possible, but do not at the expense of sacrificing their own lifestyle. As we like to say in the firm: Fly First Class or Your Kids Will!

Bob and Mary set up an irrevocable trust in a qualifying jurisdiction and are named as “discretionary beneficiaries” within the trust instrument. Bob and Mary each make a tax-free gift of $1M in cash to the trust, utilizing their respective $5M unified gift tax exemption. Under the PLR 200944002, Bob and Mary will be deemed to have made a completed gift despite being able to access up to the entire gift made to the trust by the “independent but friendly” trustee. Thus, the $1M gift plus any life insurance proceeds will be removed from Bob’s and Mary’s taxable estate at their respective deaths.

The trustee of the trust applies for an investment grade low-load life insurance policy with a highly rated company on both Bob and Mary, and the trust is named owner and beneficiary of the policies. Bob’s one time $1M premium buys a life insurance policy of $2.7M death benefit, plus the policy has a cash value account of 99.6% of the premium paid. Mary’s $1M single premium buys a $3.7M death benefit and has 99.7% of the premium paid. In short, the life policies perform similar to a high yielding tax-free bond but with a bonus feature called “death benefit”. Under this structure, Bob and Mary have collectively turned $2M that would have been worth only $1,000,000 to their heirs into a $6.4M ($2.7M and $3.7M) secondary estate recovering all or most of their investment losses, both income and estate tax free wealth for their children and grandchildren whether death occurs now or after age 100.

Moreover, utilizing the benefits of the above-described PLR, during Bob’s and Mary’s lifetime, the trustee can access the cash value of the policies for Bob’s and Mary’s personal use, on a 100% income tax free basis, if desired. Each year, based on current assumptions, the cash value of the policies will increase at a rate of 5.25% and if interest rates increase, so will the interest rate paid on the cash value. Moreover, the increase in the cash value is not subject to income tax and may be removed from the policy income tax free. Bob and Mary suffered investment losses during the Great Recession. This plan allows them to replace up to $6.4M of those losses from the insurance company’s death benefit payment.

LIQUIDITY A PROBLEM? – Never: If you don’t have the cash to make the gift to fund the life insurance policy, consider financing the premium. For example: If Bob and Mary have the net worth and want to take advantage of the higher gift tax exemption but don’t have the ready cash to fund the policy, a bank that specializes in premium financing will loan Bob and Mary each $1M to purchase the life insurance. The policies can then be transferred to the trust qualifying for the gift tax exemption. The lender will take a collateral assignment (lien) of the insurance policy and its cash value while the loan is outstanding. Premium financing loans carry an interest rate between 2.75% to 5%, depending on the financial and credit strength of the borrower. The interest is paid annually on an interest-only basis so the cost to carry the policy is manageable. The policy will be designed to have sufficient equity to repay the lender when it is desired and the lender removes the collateral assignment and the death benefit and cash value will be free of liens. It is necessary to leave a sufficient amount of cash value in the policy so the policy doesn’t expire from lack of liquidity. In the meantime, the lender will look for repayment from the life insurance policy at the death of the insured provided the borrower continues to make the annual interest payments. Consider the result, $27,000 – $50,000 annually to create $6.4M income and estate tax free asset, the return on investment is very compelling.

The Loan Arbitrage Planning Pointer: For those with substantial liquidity and who want to supercharge their wealth transfer planning (and not give up the income stream), the following might just be for you: Bob and Mary have a substantial tax free bond portfolio with a 4% coupon rate. Bob and Mary want to maximize the use of their $5M gift tax exclusion but do not want to liquidate their fine bond portfolio. Bob and Mary use their bond portfolio as collateral for two $5M loans issued by a national premium financing lender. The lender will charge Bob and Mary 2.75% interest on the loan. Bob and Mary gift the loan proceeds to the trust, and along with their children and grandchildren, are discretionary beneficiaries of a qualifying trust under PLR 200944002. The trust purchases the aforementioned life insurance policy on both Bob and Mary naming the trust as the owner and beneficiary.

Under this scenario, Bob is able to purchase $14M of death benefit, and has a 1st year cash value account balance of $4,980,000. Mary is able to purchase a policy with a $19M death benefit and a 1st year cash value account balance of $4,985,000. Bob and Mary have a loan balance with the premium financing lender of $10M and annual interest payments of $275,000. They also have a tax free bond portfolio earning 4%, or $400,000 on $10M. Bob and Mary use a portion of the bond interest to pay the premium financing lender and make the interest spread of $75,000 each. Lastly, if either Bob or Mary die before the premium financing loan is repaid, the debt will constitute a liability for which the estate will receive a deduction in computing his or her taxable estate.

If interest rates begin to rise, the trustee can withdraw $5M from the cash value account (tax free) and distribute the funds to Bob and Mary to be used to repay the premium financing lender. In short, using life insurance, Bob and Mary have turned their $10M gift into a secondary estate of $33M, income and estate tax free (at their deaths) using assets they already own.

The foregoing will vary according to your age and health. If you are unable to qualify for life insurance, consider applying this modeling for your adult children. You may make a gift to the trust and qualify for the $5M gift exclusion. Your children, as trust beneficiaries, can be the insured on the life policies and at their death, the death benefit will pass to their children (your grandchildren) estate tax free. In the meantime, you can continue to access the cash values of the life insurance policies as described above.

What Congress giveth Congress can take away… In my view, when Congress realizes the extraordinary gift they have thrust upon the American taxpayer, they will not extend the gift tax exclusion beyond 12/31/2012. Therefore, we are advising our clients to maximize their gift tax exclusion or “lose it.” Once the gift is made to the trust, it will be grandfathered and any subsequent change in the law will not apply to previously made gifts.

For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact Jeffrey M. Verdon Law Group, LLP at or (800) 521-0464.

Posted in Client Alert.