TAX PLANNING THROUGH THE USE OF LIFE INSURANCE & LIFE INSURANCE ADVANTAGES UNDER THE TAX CODE Copyright 1994, J. Raymond Karam LIFE INSURANCE PLANNING Life Insurance proceeds are generally included in the estate of the insured for estate tax purposes. If the policy is community property, one half will be included in the deceased spouse's gross estate. When the spouse of the insured is the beneficiary, the unlimited marital deduction will cause the proceeds to escape taxation on the death of the first spouse. It is upon the death of the second spouse, that the proceeds will be then included in her (or his) gross estate for Federal Estate Tax purposes. Life insurance proceeds can be removed from the estates of both spouses through the use of Irrevocable Life Insurance trusts. The insured spouse transfers all ownership in a life policy to an irrevocable trust for the benefit of the noninsured spouse for life with the right to income and  principal as needed for the health, support, maintenance or education of the noninsured spouse. The noninsured spouse may also be given a special, limited power of appointment over the corpus of the trust; the right, in effect, to control the designation of the successor beneficiary. The thing to be avoided is the existence of a general power of appointment. This is a power that permits the holder to appoint the property or corpus to herself, her estate, her creditors or her estate's creditors. The existence of such powers will cause inclusion in the gross estate of the holder of the power. In the typical life insurance trust, the surviving spouse does not have the powers necessary to give rise to such estate inclusion. The right to income is a passive right, that when granted by another, will not create inclusion. This should be distinguished from the situation where the grantor retains the right to receive income in himself in which case the right to income causes estate inclusion. That is because the law treats differently powers retained by a donor or a grantor. In the typical life insurance trust, the donor (insured) does not retain anything at all, whatsoever. Not incidents of ownership, not rights to income, not a retained life estate under Section 2036, and especially  not the power to alter amend revoke the transfer under I.R.C. Section 2038. Different rules apply to powers transferred from another. They do not need to be subjected to the scrutiny of sections 2036 & 2038. They only need be subjected to the scrutiny of sec. 2041 regarding general powers of appointment. The power to invade principal as needed for health, support, maintenance, and education is specifically excepted from the definition of general power of appointment as a power subject to an ascertainable standard and therefore will not cause inclusion in the estate of the holder of the power for federal estate and gift tax purposes. The special limited power of appointment to designate a successor beneficiary, though if it were something retained by a donor would cause estate inclusion as a retained power to alter , revoke or amend, when it is something conferred by another, will not be a "retained" right and therefore will not cause estate inclusion. These are the same concepts that govern the traditional A/B Trust estate plan and its use of the bypass or residuary trust as a shelter from estate inclusion. Instead of the sheltered amount being limited to the $600,000 unified credit exemption equivalent amount, the entire amount is sheltered by virtue of its having been removed from the estate. Although this is a tremendous tax favored treatment for policyholders, who avail themselves, it is purchased at the cost of not being able to alter or amend the trust and the underlying policy. Once the insured transfers the policy, he may no longer have any "strings" attached. Complete control rests in the trustee. The spouse of the insured may be the trustee, but some may favor the use of an independent third party as trustee, in an abundance of precaution. In order for the spouse of the insured to enjoy freedom from the scrutiny imposed upon a donor, such spouse should not have any ownership interest. Accordingly, a community property interest of the noninsured spouse should be purged, by a partition of community property rendering the ownership of the policy the separate property of the insured spouse. In this way, the noninsured spouse will not be deemed to have any ownership in the policy, and therefore will not be scrutinized as a donor but as merely a third party donee who does not possess a general power of appointment. Likewise the premiums should be paid from gifts to the trust from the insured spouse's separate property to avoid having a portion of the trust being treated as owned by the noninsured spouse. A transfer of a policy or transfers of premium payments are potentially taxable gifts. To the extent that they are not sheltered by application of the unified credit exemption equivalent amount, or to the extent that such squandering of the credit is sought to be avoided, the transfers of the policy and subsequent premium payments may be sheltered by the $10,000 per year per donee exclusion under Section 2503(c). This exclusion is not available for transfers of future interests though. A future interest is an interest in which the present right to use, enjoyment or possession is postponed until some time in the future, such as in a trust of this nature. We are not concerned with things passing to the spouse of the insured because of the unlimited marital deduction. Instead we are concerned with the part of each gift or transfer that is for the benefit of beneficiaries other than the spouse, such as children. A long recognized  safe harbor to this exception is where the grantee receives notice and an opportunity to withdraw the transfers to the trust for his benefit. This so called "Crummey" provision (named for the taxpayer who was held by the court to have used it successfully) constitutes a present interest in the grantee and therefore causes the transaction to be entitled to the annual exclusion. Since the grantee has a present interest, for no matter how short a time, it would be included in his estate as a general power of appointment which was held and allowed to lapse. The lapse is treated as a gift. This is not unfair if the beneficiary ultimately receives the property, but in cases where it passes to a remainder beneficiary there is exposure to estate and gift taxation at the intermediate level. This is partially ameliorated by what is known as the 5&5 rule, which holds that the greater of $5,000 or 5% of the principal subject to the power will be excepted from inclusion of a lapsed power. Certain transfers are included in a decedent's gross estate for federal estate and gift tax purposes if the decedent dies within 3 years of making the transfer. Among these are life insurance premiums and transfers of policies. This can undermine the entire effect of an irrevocable life insurance trust estate plan if the insured dies within three years. The most prudent course would be to undertake a "nothing ventured, nothing gained approach". Indeed nothing can be gained by inaction. The 3 year rule does not apply to new policies that were applied for and purchased by the trust because there is no "transfer" to be attacked by the rule. GENERATION SKIPPING TRANSFER TAX (GSTT) LEVERAGING THROUGH LIFE INSURANCE A logical extension of a transfer tax schematic is to eliminate  transfers when possible. An ideal circumstance would be to create successive life estates stacked upon one another in which a life estate would terminate and another would then become present and possessory if not ad infinitum, at least as far as the rule against perpetuities would permit. Congress has now foreseen this inevitable technique and has imposed a separate tax of 55% on such "Generation Skipping Transfers". Fortunately there is a $1 million exemption from the Generation Skipping Transfer Tax (GSTT). The $1 million exemption may be doubled in a situation involving spouses similar to the doubling of the unified credit in traditional A/B estate plans. However if a decedent leaves the marital deduction share to a spouse outright there will be no utilization of the GSTT exemption as to that portion. If instead, it is left to a Marital Deduction or QTIP Trust, it may be used to avail itself of the GSTT exemption. Consider the use of transfers which qualify for the GSTT exemption being used to fund Life Insurance. An huge amount of proceeds could be sheltered into successive generations free of tax. The amount of ultimate coverage that may be purchased with $1 or $2 million, depending upon the age of the insured and other actuarial factors, could be quite substantial. All would escape an entire level of taxation. It is important to note that the amount of the exemption is determined by "snapshot" at the time of the election to apply the said exemption. If this election is not made prior to death , it will be too late and the leveraging opportunity will have been lost. Therefore the election should be made at the time of the transfer in order to have all subsequent increases covered by the initial election. FAMILY LIMITED PARTNERSHIPS The use of Family Limited Partnerships in estate planning has been gaining increasing popularity. The technique offers potential estate tax savings as well as asset protection from creditors. Estate Tax savings can be realized from the ability to value an asset portfolio at a discount by virtue of its being held in a family limited partnership. The discounts are based on lack of marketability, minority ownership, and the lack of liquidity. Conservative valuation practices can easily yield a 35% discount. Because the discount is based in part on minority ownership, in order to fully utilize the technique the assets or transfers should be less than 50% at the point when they are measured for estate or gift purposes. Since all assets are transferred to the family limited partnership, all that is owned by the transferor is an interest in the family limited partnership. An owner may then transfer less than 50% of the total and be availed of the 35% valuation discount. Likewise upon death, if the owner of the family limited partnership interest owns less than 50% of the whole, it will be valued at the 35% discount. Given this, an estate of $1 million could, with the proper program of gifting and retention of less than 50% ownership, be compressed to $650,000 in value for federal estate and gift tax purposes. In addition, the $10,000 annual exclusion can be leveraged into approximately $15,000 of underlying assets because of the discount. The family limited partnership offers protection from attachment of the family limited partnership interest or the underlying assets by creditors of the owner. The Uniform Limited Partnership Act provides that a family limited partnership interest may not be attached or alienated except as provided in the agreement creating the family limited partnership. The agreement will typically provide that a "super majority of interest holders is required for alienation or attachment of an interest. The creditor's only remedy is then a "charging order" that provides that a creditor will be entitled to the debtor partner's distributions if, as, and when paid. Under such a cloud, the partners will not allow any distributions. Money or property may still be bailed out as compensation which is exempt from garnishment in Texas. Almost as if to add insult to injury the tax code will cause taxation of partnership income to the creditor though no actual money or property is received. The family limited partnership can also provide an attractive alternative to the irrevocable life insurance trust, especially in cases where the insured does not wish to completely part with control as is necessary in an irrevocable life insurance trust. The family limited partnership will own the policy and the insured will either gift partnership interests or money with which to finance premium payments to the objects of his bounty. These gifts will be sheltered by the $10,000 annual exclusion, and in the case of a gift of partnership interests, will be subject to the 35% valuation discount. The insured may be the general partner of the family limited partnership and continue to rule the roost. Family limited partnerships are excellent vehicles for the preservation of a family enterprise or dynasty. A business or empire may be preserved for a long period of time while slices of the asset pie can be passed on to successive generations outright or in spendthrift trusts as the overall estate plan may require. BUY SELL AGREEMENTS In a sophisticated economy, multiple ownership of business is quite commonplace. The shared ownership is usually taken for granted until for reason of death, disability, divorce or retirement, succession of the ownership interests is called into question. A successful means of addressing these eventualities is the use of Buy Sell Agreements. Under a common form of buy sell agreement an entity is given the option to purchase the ownership interests of a departing owner upon the happening of some triggering event such as death, disability, divorce, intended sale, termination or retirement. If the entity does not exercise the option, it is then incumbent upon the remaining ownership holders to do so. The funding of the purchase may be provided for by the use of life or disability insurance. The entity will purchase the coverage, and upon death or disability receives the proceeds tax free to redeem the ownership interest. In the case of death, the ownership interest will generally receive a tax free step up in basis so that there will be no gain to the owner upon sale of the interest to the entity. This attractive tax advantaged transaction results in bringing peace of mind to all concerned by removing the unwanted business associate, providing her (or him) with a welcome cash buyout, and concentrating ownership in the surviving business members. In situations where it is not feasible to insure against the eventuality, such as with divorce or termination, the buy sell agreement may provide for a deferred payout of the buyout price. A secured promissory note will be delivered to the seller usually secured by the stock or other ownership interests in the entity or the assets or both. INCOME TAX CONSEQUENCES AND USE OF INSURANCE IN BENEFITS PLANNING Life insurance benefits received by reason of the death of the insured are generally not included in the gross income of the insured. This rule applies regardless of whether or not the proceeds are payable in a lump sum or in installments. Interest paid on installments is taxed however. Life insurance proceeds received by a corporation may be subject to the corporate alternative minimum tax. An important exception to this is the transfer for value rule which causes taxation of life insurance proceeds when the policy has been acquired for valuable consideration. The recipient would be taxed on the proceeds to the extent that they exceed his investment in the policy. The transfer for value rule does not apply to a transfer where the transferee would have the same basis in the policy as the transferor's basis, as would be the case in a gift of the policy. Nor does the rule apply in case of a transfer to a policy owner's related entity (eg. controlled corporation or a partner of the transferor. The payment of premiums on life insurance are generally not deductible to a corporation. Nor is interest on a loan used to acquire life insurance. A common exception to this rule is group term life insurance in which payments for coverage of up to $50,000 are deductible to the employer and not taxable to the employee. A corporation may also deduct premiums in a case where they are taxed to an employee as a bonus or compensation. In this case, the premium payments are deductible as ordinary and necessary business expenses under Section 162 of the Internal Revenue Code. This would be justified in circumstances where the payment is to reward or otherwise motivate an executive or valuable employee. Disability insurance premiums are generally not deductible when paid, nor are benefits includible in income when received. These premiums may be deducted in an accident or health plan, however. These are covered by ERISA. Executive benefits can take the form of deferred compensation.  The more well known variety of deferred compensation are the qualified plans. These are very strict plans that have a plethora of requirements, not the least of which is nondiscrimination in favor of key employees. The principal advantage of these types of plans is the deductibility of employer contribution coupled with deferral of recognition of income by the employee until the money is distributed The most common forms of qualified deferred compensation are IRA's, SEP's, Profit Sharing Plans, Money purchase pension plans, 401(k) plans, Keogh or HR-10 plans, and ESOP's. These are the subject of probably the most vast and complicated area of the law and are far and well beyond the scope of this article. Under an alternative, less rigid approach deferred compensation can take the form of nonqualified deferred compensation. This type of deferred compensation does not have the as powerful a tax punch as the qualified plans with their deductibility and deferral. However, these do permit discrimination in favor of an executive or highly valued employee. The employer may not take a deduction until the money or benefits have been received by or are available to the employee. in order to be available to the employee, a present interest in property must be transferred. The employee recognizes income when the benefits are no longer subject to the risk of forfeiture by the employee and are transferrable. Life insurance is often used as a means of providing benefits under either qualified or non qualified plans. Variations on this theme are found in the Rabbi Trust and its opposite, the secular trust. Under the Rabbi Trust, the beneficiary is permitted deferral of a funded amount because the trust is subjected to the claims of creditors of the employer. It is therefore viewed as a grantor trust of the employer who is then taxed on the continuing income. In the secular trust the property is not subject to the claims of the employer's creditors, and is therefore "funded" and accordingly deductible by the employer and taxable to the beneficiary. It too is a grantor trust with the grantor being the beneficiary who is then taxed on the continuing income of the trust. Annuities are an excellent savings and investment vehicle because of their tax deferral treatment. Prior to 1993, annuities, unlike life insurance were not protected from the claims of creditors, unless they were a provided under a plan or program in use by an employer. This meant an ERISA plan. Amendments to Article 21.22 of the Texas Insurance Code extended the exemption from creditors to all annuities, thereby elevating them to an extremely favorable status. This is magnified by the introduction of variable annuities which permit the ownership of mutual funds within the annuity. Perhaps the most studied benefits technique of all time is the "split dollar" arrangement. The essence of this plan is that the employer will pay a portion of the premium on a policy for the employee's beneficiaries. The employer's share of the premium is the amount  the increase in cash value of a policy. This amount is treated as a loan from the employer and is repaid upon collection of the proceeds. The employee pays the balance of the premiums, usually from compensation received from the employer or when the employer pays the employee's share, it is treated as compensation to the employee.