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Friday, May 17, 2024
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Case Studies |
The Life Estate and ILIT Plan
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Case:
Gerard and Ruth Chapman own a home valued at $1,000,000. They purchased the home back in the 1970s for $350,000 and, due to the burgeoning real estate market in their area, the home appreciated nicely over the next 20 years. Gerard and Ruth have an estate valued at $15 million, including their home, and therefore, they find themselves in the top estate tax bracket. They have always thought that they would transfer the residence to their children upon their death, but realize that the estate tax "bite" would probably cause the children to sell the residence just to pay the estate taxes. Also, the children now are all grown and have moved out of the area and therefore probably would not want to keep the home anyway. However, the children would be more than happy to receive value from the home upon the passing of their parents, albeit net of estate taxes.
Question:
Even though these problems exist, Gerard and Ruth would at least like to see the value of the home transferred to the children upon their death without extensive estate taxes. They ask, "Is there a way to transfer the home or a like value to the children and not be subject to such onerous taxes?"
Solution:
Recently, Gerard and Ruth were having dinner with a very good friend of theirs, Joan Abbott, who is the Director of Major Gifts and Estate Planning at a major Medical Center Foundation. Joan is very creative, and she explained to Gerard and Ruth that, yes, there is a method allowing them to fulfill the objective of transferring the value of the residence to their children with little or no estate tax cost. The method actually would involve a two-step process as follows.
First, Gerard and Ruth would set up an irrevocable life insurance trust (ILIT) which would purchase a second-to-die policy of $1,000,000 on both their lives. Since they are both very healthy and do not have a history of health problems, they should not have any problem qualifying for life insurance of this amount. And with three children, they would be able to shelter up to $63,000 in premium dollars per year from gift taxes using the "Crummey" power. Then, since the trust owns the insurance policy, the proceeds of $1,000,000 will be transferred to the children completely free of estate taxes upon Gerard's and Ruth's passing. In checking with a major insurance company, they found that the annual premium for 10 years on a $1,000,000 paid-up policy for Gerard and Ruth would be $25,000. This amount would be well within the "Crummey" power limitations.
After Joan explained the insurance trust to them, they were quite concerned about "coming out of pocket" with $25,000 each year for the premium. That's where the second step comes into play. Joan explained that once the insurance trust is signed and the policy is in force, the residence would then be used to fund a charitable gift annuity combined with a life estate. It works like this: Gerard and Ruth would deed the residence to a charity and retain a life estate. In other words, they would retain all rights to live in the residence for the rest of their joint lives. As such, they would continue to pay all expenses related to the residence, including property taxes, insurance and maintenance expenses. The charity and the Chapmans would then enter into a gift annuity wherein the charity would agree to pay them an annuity payment for the rest of their lives based upon what is termed the "remainder value" of the home. Pursuant to Treasury tables, the remainder value as calculated is $678,784. Then, based upon their ages and utilizing the American Council on Gift Annuities rate structure, the gift annuity payout percentage is 6.5%. Multiplying the remainder value of $678,784 times the 6.5% rate yields $44,120.96 annually.
The results of this gift method are as follows: Gerard and Ruth are able to live in their home the rest of their lives. They receive annual payments of $44,120.96, which will pay the annual insurance premiums. Then, upon their passing, the home will belong to the charity and the $1,000,000 policy will be distributed via the ILIT to the children completely free of estate taxes. An added benefit is that they will receive a nice charitable income tax deduction of $280,103, which will result in tax savings to them of over $98,036 (which could also be utilized to pay the premiums). $500,000 exclusion on the sale of personal residences eliminates all capital gain tax due. Gerard and Ruth receive in annuity payments each year is tax-free. The balance of the payment is taxed as ordinary income.
Gerard and Ruth were so impressed with Joan's creativity and savvy planning that they decided to make the gift with Joan's Medical Center Foundation.
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