By Richard R. Sanderson, CLU, ChFC, and Dawn C. Clifford, JD, CLU

The process of estate planning that came about in the early ‘80s with the passage of the Economic Recovery Tax Act (ERTA) led to the growth of second-to-die contracts and the use of irrevocable life insurance trusts (ILITs). For nearly two decades, that solution has been simple and effective.

Now, EGTRRA forces planners to take a new approach. In the past, a client’s estate-liquidity problems could be solved by the acquisition of a second-to-die contract held in an ILIT. The idea of gifting assets irrevocably to a trust was always a hurdle because of the lack of liquidity. The decline in the markets has magnified this hurdle. But there is a way to insure your clients that does not require them to gift away all of their liquid assets.

SOS
That way is the use of the Single-Owned Survivorship (SOS) trust, a technique first written about in 1996 by Robert Shadur and Bernard Weinberg in Estate Planning. This concept allows for tremendous flexibility and provides an exit strategy if estate tax repeal becomes a fact and requires no irrevocable gifting of assets. As the name implies, the survivorship contract will be owned by one of the individuals. All control of the contract will be in the hands of the client—not the ILIT trustee.
The SOS trust provides your client with the ability to access cash values at any time, the opportunity to adjust coverage as needs change and to avoid estate tax on the proceeds at the death of the surviving spouse. In short, the SOS Trust offers the benefits of an ILIT without the disadvantages.

The SOS trust provides your client with the ability to access cash values at any time.

A simple arrangement
In the SOS trust (Figure 1), the spouse with the shorter of the two life expectancies would own the survivorship contract outright. (For our example in Figure 1, the contract owner is assumed to be the husband.) A revocable living (Grantor) trust would be created at the outset and the trust would be named as the contingent owner at the time of the grantor’s death. The use of the unlimited marital deduction and A/B trust arrangements is also assumed.

By owning the contract outright, there is no requirement to gift premiums to a trust. The contract owner retains control over the contract. The spouse is an insured but not an owner of the contract. The revocable living trust is the contingent owner. At the death of the contract owner, the trust becomes irrevocable and the surviving spouse would be a beneficiary of the trust.

There is no death benefit paid at the first death, so there is no concern about estate taxes on the death benefit. However, the contract’s cash value would be included in the owner’s estate; therefore, it should pass as part of the credit shelter, or “B” trust. The SOS trust would be the “B” trust of the deceased spouse and would receive the contract, plus any additional assets necessary to take advantage of the federal estate tax credit. (For decedents dying in 2003, the credit shelter amount is $1 million, assuming no lifetime use of the unified credit. Therefore, the “B” trust could receive up to $1 million of cash surrender value and other assets without creating a federal estate tax liability.) The surviving spouse could have income rights to the trust based on the ascertainable standards.

This means that during their lifetimes, both spouses will enjoy access and control of the cash value. Provided the contract owner dies first and either an independent trustee with respect to the policy or the surviving spouse adheres to Health, Education, Maintenance and Support (HEMS), the income rights enjoyed by the surviving spouse could include continued access to the contract’s cash values. We can avoid estate tax at the second death—the same goal as in an ILIT. We create a new set of client benefits. Control over the policy and access to cash values allow the contract owner access to the living benefits of the policy. Avoiding gifts frees up assets to be used in other gifting arrangements such as Family Limited Partnerships. Finally, the client is not required to divulge any information regarding this arrangement to family members. Contrast this with the required Crummey letters normally associated with an ILIT.

Figure 1

Death out of order
All of the above is predicated on the notion that the contract owner-spouse (husband) dies first. If, in fact, the wife were to die first, the husband would be left owning a life insurance contract whose death benefit would likely be included in his taxable estate. This would seem to negate all the advantages we have created by this arrangement. In fact, this is not the case. There are three distinct options the contract holder would have at this point. Each option has individual merit and no decision is required until the death of the spouse.

One option the contract holder has is to simply keep the contract. If estate tax is repealed, this option is a simple, valid choice. With no estate tax applied, the death benefit would be completely tax-free. This would allow the contract owner to retain control. He could continue to access cash value or any other ownership right. Even in the face of estate tax, one could build an argument that if the net death benefit after estate tax is sufficient to cover estate-liquidity costs, then continued contract ownership is a valid option.

A second option would be to gift the policy to the same Grantor Trust created at the outset. There are at least two potential problems with this option:

• One is the three-year rule concerning gifts of life insurance. If the contract owner gifted the policy to his trust and died within three years, the death benefit would potentially be taxed in his estate.
  
• Another problem created by EGTRRA is the $1 million lifetime exemption on gifts. In other words, cash values in excess of $1 million would trigger a gift tax. This could prevent this option from being viewed as viable.

All control of the contract will be in the hands of the client—not the ILIT trustee.

Even with these concerns, gifting the policy remains an option. However, planners should exercise caution.

In the third option, the contract-owner spouse could sell the policy to his Grantor Trust for its fair market value. Any sale of life insurance requires a review of the Transfer for Value rules. If a sale of life insurance violates Transfer for Value, the death benefit would be considered taxable for income purposes. The applicable exception in this choice is “a sale to the insured.” Because the service generally considers the Grantor and his Grantor Trust as one and the same, the sale should avoid income taxation on the proceeds. If sold, there is no three-year rule and the contract would immediately be excluded from the contract owner’s estate.

More flexibility and control than an ILIT
In the final analysis, we created a method under which clients would not be required to create an ILIT at the outset to own the second-to-die contract. We have avoided the irrevocable gifts required by ILITs and freed up gifts to be used for other purposes. We have allowed more control and access to the second-to-die policy by the clients during their lifetimes and avoided estate tax on the death benefit at the death of the surviving spouse.

Of course, care should always be taken to consult with professional tax and estate planning advisors and attorneys before implementing this arrangement. Given the changes that have occurred in the estate planning process, the acquisition of a survivorship life insurance contract using SOS gives planners the ability to structure a flexible and creative solution to estate liquidity problems. If done properly, this arrangement may provide the ultimate in flexibility:

• The ability to revoke the entire arrangement—at least until the owner-spouse dies.
  
• The ability to modify the terms of the arrangement—at least until the owner-spouse dies.
  
• The ability to solve tax problems under either tax scenario created by the possible outcomes of EGTRRA.
  
• A method whereby reluctant clients may be more willing to act to solve their problems.

Richard R. Sanderson, CLU, ChFC, is a regional life consultant for Nationwide Financial covering the Southeastern U.S. (sanderr1@nationwide.com). Dawn C. Clifford, JD, CLU, is a regional life consultant for Nationwide Financial covering the metro New York area (cliffod@nationwide.com).

(The opinions expressed in this article are those of the authors and do not necessarily represent the opinions of Nationwide Financial Services, Inc.)

Web Exclusive Articles

Finding Your Niche in the Women's Market

Seven Secrets of Seminar Success

Talking Points on Association Membership

Realistic Expectations in Real Estate

The Five-Question Interview

Unlicensed Sharing

Top     LEGAL NOTICES     Contact Webmaster    

Change/Renew NAIFA Membership     Get Advisor Today: Join NAIFA

© Advisor Today 2003. All Rights Reserved.