The Great 2012 Gifting Opportunity - Part 7: Life Insurance Can Pay Tennessee Gift Tax Clawback

This is the seventh article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For prior articles, see below.

Two prior articles discussed the Tennessee Gift Tax clawback issue. Last week, I met with a couple to establish a trust for their children. They plan to make a gift of $10.2 million to the trust later this summer. We discussed the Tennessee clawback issue and the potential solutions. The wife is seven years younger than the husband and does not have any major health issues. She will be making the entire gift. Even though this decreases the chances of the gift tax clawback from applying, there is still a chance that the wife could get run over by the proverbial beer truck.

We discussed the possibility of including a contingent marital trust that would make the husband a beneficiary of the trust if the wife dies within three years after making the gift. Since a primary purpose of the trust is to provide an asset base and income for their children, they did not like the option of the contingent marital trust.

We came up with a different solution. The trust will purchase a term life insurance policy on the wife’s life that can be dropped after three years. When the wife makes a gift to the trust, she will require the trustee to assume liability for any Tennessee inheritance taxes that are eventually imposed on the gift. If the wife dies within three years, the trust will collect life insurance and will be able to pay the additional Tennessee inheritance taxes.

          Part 1: Use It or Lose It

          Part 2: Can You Afford to Make a Large Gift?

          Part 3: When Should You Make the Gift?

          Part 4: Will a Large Gift Demotivate Your Children?

          Part 5: Tennessee Gift Tax Clawback

          Part 6: Tennessee Gift Tax Clawback Solutions

Widow Collects $1.9 Million From $1 Million Life Insurance Policy

In Kristen Cox Morrison v. Paul Allen et al, the Tennessee Supreme Court allowed a widow to collect $1.9 million on a $1 million life insurance policy. Shortly before his death, the husband applied for a $1 million American General life insurance policy. The agent who filled out the application checked “No” for the question asking whether the applicant had a driving violation within the previous 5 years. In fact, the applicant had been arrested for DUI.

After the decedent’s death, the widow applied for payment of the $1 million life insurance benefit. American General denied the claim due to the incorrect answer on the life insurance application. The widow then sued American General and the life insurance agents who assisted with obtaining the policy. Subsequently, the widow settled with American General and received $900,000.

The widow continued her suit against the agents and was awarded $1 million from the agents due to their failure to procure the policy that had been requested by the applicant. The agents were unsuccessful in their effort to get a credit against their damages for the amount paid to the widow by American General pursuant to the settlement. Even though the husband signed an incorrect application, the court decided that he was not accountable since the agents filled out the application.

The widow actually collected significantly more from the policy than she would have collected if the application had been filled out correctly! Apparently, the court decided that the agents needed to be punished for their sloppiness in filling out the life insurance application.

One lesson to be learned from this case is to be careful about switching from an existing life insurance policy to a new policy. As a general rule, there is a 2 year contestability period for new policies. Therefore, you should consider maintaining the old policy for 2 years to make sure that the new policy cannot be contested.

Another lesson is for both the agent and the applicant to make sure that all of the questions on the life insurance application are answered correctly. An incorrect answer may constitute grounds for the insurance company to deny benefits. Furthermore, the agent can be held accountable for failing to procure an incontestable policy.

A final lesson concerns sympathetic plaintiffs. American General was smart enough to realize that their attempt to deny benefits to a widow would probably not be well received in a trial. They settled for 90% of the claim despite an admittedly fraudulent application which gave them a sound legal reason for denying the claim. The agents took their chances against the widow and paid the price.
 

Use of Life Insurance to Pay Estate Taxes is on the Rise

The enclosed article written by Mark Maremont and Leslie Scism in the Wall Street Journal states that an increasing portion of large insurance policies sold to affluent individuals are used to help their families with the payment of estate taxes. I often recommend that my clients use life insurance as part of their plan for combating estate taxes. Life insurance should be combined with a gifting strategy that will reduce the ultimate estate tax liability.

Life insurance enjoys numerous tax benefits. First, the “inside” buildup of cash value in the policy is not subject to income taxes. Second, the receipt of death proceeds is not subject to income taxes. Finally, the proceeds can be exempt from estate taxes if the ownership is properly structured. The most common structure for protecting the proceeds from estate taxes is to have the policy acquired and owned by an irrevocable life insurance trust.

The article raises the concern that Congress might choose to curtail the tax benefits of life insurance as a way to raise revenue. As the purpose of life insurance shifts from providing a safety net for the insured’s family to providing money to pay estate taxes, the justification for providing the tax benefits seems less compelling. The insurance industry has clout in Washington. I am predicting that there will be no significant reduction in the tax benefits of life insurance within the next few years.
 

Switch ILIT Solves Estate Planning Dilemma for Wife in Second Marriage

Recently, a client told me “as is so often the case second marriages, the value of the wife’s estate that she can leave her children will vary significantly depending on whether she predeceases her husband.” My client’s observation is so accurate. I have encountered this dilemma when working with other clients, but had not understood that this problem affects numerous second marriages.

My client’s husband is very wealthy and plans to make a generous bequest to her in his Will. Furthermore, they jointly own a valuable house.

If her husband dies first, she will own the house and will receive the bequest from her husband’s Will. If she dies first, she will have neither the house nor the bequest.

She is comfortable with the amount that she will be able to leave her children if she survives her husband. However, she is concerned that the inheritance for her children will be insufficient if she predeceases her husband.

The solution that I proposed works as follows:

The couple establishes an irrevocable life insurance trust (“ILIT”) that will buy a last to die insurance policy on the lives of the husband and wife. If the wife dies first, her children will be the beneficiaries of the ILIT. If the husband dies first, his children will be the beneficiaries of the ILIT.
The parties agreed to split the premium payments during their joint lives. The will of the first to die will make a bequest to the trust that is sufficient to pay premiums during the period of survivorship.

The “Switch ILIT” solved my client’s dilemma of making sure that her children will be well provided for regardless of whether she predeceases her husband.
 

Give Your Life Insurance Trust a Tune-Up

My clients often want to make changes to an irrevocable life insurance trust (“ILIT”). Fortunately, there are at least 6 methods for making changes to an ILIT.

I recently worked with a business owner who used 4 different techniques to restructure a series of ILITs that he established over a 25 year period. Two of the ILITs owned insurance on his life. Two other ILITs owned last-to-die policies insuring the business owner and his wife.

 

The first step was to create two new ILITs. The wife is a beneficiary of the new Family Trust which now owns the single life policies. The other new ILIT was designed as a Dynasty Trust and now owns the last-to-die policies, as well as one single life policy.

 

Next, the wife exercised a power to appoint the assets of one ILIT to the Dynasty Trust. The trustee of another ILIT used the leapfrog power of TCA Section 35-15-816(27) to distribute its policy to the Family Trust.

 

The trustee of a third ILIT merged that trust into the Dynasty Trust pursuant to TCA Section 35-15-417. Finally, the trustee of the fourth ILIT sold its policy to the Dynasty Trust, which was structured as a grantor trust in order to avoid potential income tax issues associated with this sale.

 

I would have preferred to use the same technique for moving all 4 of the old ILITs into the Family Trust and the Dynasty Trust. However, different techniques were required due to the specific wording of the trusts, and other factors including tax consequences. Even though it was complicated, the business owner accomplished his goals and several generations of his family will benefit from these changes.

 

Incidentally, the two techniques that we did not use were: (i) amending the trust pursuant to TCA Section 35-15-411; and (ii) buying a new policy, which was not a viable alternative due to the age of the policies involved and health changes that have occurred.

See the enclosed article (PDF) for more detail on these techniques.