HOW TO USE TAX SAVING TRUSTS

Transcription

1 HOW TO USE TAX SAVING TRUSTS By William S. Moore ECONOMIC EDUCATION BULLETIN Published by AMERICAN INSTITUTE FOR ECONOMIC RESEARCH Great Barrington, Massachusetts Copyright American Institute for Economic Research 1991

2 About A.I.E.R. AMERICAN Institute for Economic Research, founded in 1933, is an independent scientific and educational organization. The Institute's research is planned to help individuals protect their personal interests and those of the Nation. The industrious and thrifty, those who pay most of the Nation*s taxes, must be the principal guardians of American civilization. By publishing the results of scientific inquiry, carried on with diligence, independence, and integrity, American Institute for Economic Research hopes to help those citizens preserve the best of the Nation's heritage and choose wisely the policies that will determine the Nation's future. The Institute represents no fund, concentration of wealth, or other special interests. Advertising is not accepted in its publications. Financial support for the Institute is provided primarily by the small annual fees from several thousand sustaining members, by receipts from sales of its publications, by tax-deductible contributions, and by the earnings of its wholly owned investment advisory organization, American Investment Services, Inc. Experience suggests that information and advice on economic subjects are most useful when they come from a source that is independent of special interests, either commercial or political. The provisions of the charter and bylaws ensure that neither the Institute itself nor members of its staff may derive profit from organizations or businesses that happen to benefit from the results of Institute research. Institute financial accounts are available for public inspection during normal working hours of the Institute. ECONOMIC EDUCATION BULLETIN Vol. XXXI No. 7 July 1991 Economic Education Bulletin (ISSN ) (USPS ) is published once a month at Great Barrington, Massachusetts, by American Institute for Economic Research, a scientific and educational organization with no stockholders, chartered under Chapter 180 of the General Laws of Massachusetts. Second class postage paid at Great Barrington, Massachusetts. Printed in the United States of America. Subscription: $25 per year. POSTMASTER: Send address changes to Economic Education Bulletin, American Institute for Economic Research, Great Barrington, Massachusetts

3 Contents INTRODUCTION 1 I. "BYPASS TRUSTS" AND OTHER TRUSTS DESIGNED TO REDUCE ESTATE TAXES ON A MARRIED COUPLE'S ESTATE 3 A. "Bypass Trust" Arrangements 3 1. What a "Bypass Trust" Is and How it Produces Estate Tax Savings 3 2. The Circumstances in which "Bypass Trusts" Should Be Used Steps to Maximize the Savings Produced by "Bypass Trusts"... 5 B. Other Trusts that Can Be Used in Conjunction with a "Bypass Trust" to Produce Additional Savings 6 1. A "Bypass Trust" for More Than the $600,000 "Unified Credit Exemption Equivalent" 7 2. A "Qualified Terminable Interest Property" Trust 9 3. A "Disclaimer Trust" 11 II. CHARITABLE REMAINDER UNITRUSTS AND POOLED INCOME FUNDS 14 A. The Basics of Charitable Remainder Unitrusts and Pooled Income Funds 14 B. Other Valuable Tax and Nontax Uses of Charitable Remainder Unitrusts and Pooled Income Funds Shielding Capital Gains from Tax while Producing an "Unreduced" Stream of Income and an "Unreduced" Charitable Deduction Use of a Charitable Remainder Unitrust as the Vehicle to Produce Both Growth and an Enhanced Stream of Income 18 C. Use of a Charitable Remainder Unitrust or Pooled Income Fund in Conjunction with a Life Insurance Arrangement 19 D. Structuring a Charitable Remainder Unitrust or a Pooled Income Fund Gift to Make Economical Use of the "Unified Credit Exemption Equivalent" 20 III. IRREVOCABLE INSURANCE TRUSTS 22 A. Should Insurance Be Acquired, and an Irrevocable Insurance Trust Established, to Meet Needs with "Untaxed" Funds? 22 B. Does an Irrevocable Insurance Trust Make Sense from a Basic Estate Planning Standpoint? 24 C. Can the Payments Used to Acquire the Insurance Initially and Pay Continuing Premiums Feasibly Be Shielded from Gift Taxes? 25 IV. PICKING THE TAX SAVING TRUST ARRANGEMENT FOR YOU 28

4 I. "BYPASS TRUSTS" AND OTHER TRUSTS DESIGNED TO REDUCE ESTATE TAXES ON A MARRIED COUPLE'S ESTATE IN this section of the booklet, I first discuss the purpose and operation of "bypass trusts," when they should be used, and steps that can be taken to maximize the tax savings they produce. I then show how other trusts including that favorite of acronym lovers everywhere, the "qualified terminable interest property trusts," or "QTIP trust" often can be combined with a "bypass trust" to increase the tax savings obtainable. A. "Bypass Tïust" Arrangements 1. What a "Bypass Trust" Is and How it Produces Estate Tax Savings A "bypass trust" is a trust established upon the death of the first to die of a married couple that is designed to cause the property in the trust to "bypass" the survivor's taxable estate and thereby produce estate tax savings upon the survivor's death. The usefulness of a "bypass trust" can easily be shown by first analyzing the estate tax consequences to a couple if the first to die leaves everything to the survivor, then contrasting those consequences with the taxes due under a "bypass trust" arrangement. If upon the death of the first of a couple to die, all of that spouse's property went to the surviving spouse, there would be no tax due on the first spouse's death because of the marital deduction. That deduction shields all property, no matter what the value, that passes to a surviving spouse either outright or in certain specified kinds of trusts. The problem is that if all property of the first spouse to die passes to the surviving spouse, then upon the surviving spouse's death, all of that property, plus accumulated income and appreciation on it, will be included in the surviving spouse's estate. Often the only significant credit or deduction available to the surviving spouse's estate will be the "unified credit," which can at most shield $600,000 from tax. Thus, if the surviving spouse's estate exceeds $600,000 the so-called "unified credit exemption equivalent" there will be Federal estate taxes on that estate. A "bypass trust" arrangement can significantly reduce estate taxes by taking advantage of the "unified credit" available to the estate of the first spouse to die, as well as of the "unified credit" available to the surviving spouse. Under such an arrangement, instead of having all the property of the first spouse to die pass to the surviving spouse, as much as $600,000 of the first spouse's estate would go to a "bypass trust." The "unified 3

5 credit" would shield this property from tax in the first spouse's estate, and the remaining property passing to the surviving spouse would be shielded from tax by the marital deduction, so there still would be no estate tax on the death of the first to die. Then on the surviving spouse's death, the $600,000 (or lesser amount) that went to the "bypass trust," plus accumulated income and appreciation on that amount, would escape taxation because they would not be included in the surviving spouse's taxable estate. 4 The net effect would be that instead of shielding only $600,000 from estate tax on the survivor's death, the couple would shield from tax that $600,000 and the $600,000 (or lesser amount) put into the "bypassing trust" on the death of the first spouse to die, plus accumulated income and appreciation on the latter amount. Rough estimates of the tax savings obtainable through the use of a "bypass trust" can easily be made. If a person's taxable estate exceeds the "unified credit exemption equivalent" of $600,000, the marginal Federal estate tax rate applicable to the portion of the person's estate in excess of $600,000 begins at 37 percent and continues up to a maximum of 55 percent. 5 Thus, if a married couple would have $100,000 taxed in the surviving spouse's estate if they did not use a "bypass trust" arrangement, the savings produced on the surviving spouse's death by having at least $100,000 go into a "bypass trust" on the death of the first of them to die would be roughly $37,000 ($100, percent). On the other hand, the savings to a married couple who would have at least $600,000 of their estate taxed at the maximum marginal rate on the survivor's death would be roughly $330,000 ($600, percent) if they had $600,000 go into a "bypass trust" on the death of the first spouse to die. These estimates are conservative because they do not take into account the likely increase in the value of the "bypass trust" through asset appreciation and accumulated income from the first spouse's death to the surviving spouse's death, which also would be excluded from the surviving spouse's estate. 6 4 It is important to emphasize that these tax savings will result only to the extent that the assets added to the "bypass trust" on the death of the first spouse to die, and income and appreciation on those assets, are retained in the "bypass trust" rather than distributed to the surviving spouse. 5 Under current law, the 55 percent maximum Federal estate tax rate is to be reduced to 50 percent beginning in The above estimates (and other tax estimates in this booklet) also do not take into account state death taxes, which in many states simply are a percentage of the Federal estate taxes due. (In certain states, however, such as New York and Massachusetts, the state death taxes are significant and should be carefully considered in estate planning.) In addition, the above estimates (and other tax estimates in this booklet) do not take into account certain other factors that should not affect the use of the estimates for purposes of illustration and comparison. 4

6 In most cases, of course, it cannot be known which spouse will die first. Accordingly, where a "bypass trust" appears advisable to produce estate tax savings, each spouse's will should include provisions that would establish the trust if he or she were the first to die The Circumstances in which "Bypass Tïusts" Should Be Used "Bypass trusts" should be used by virtually all couples whose total taxable estates for Federal estate tax purposes, including such often uncounted assets as life insurance, retirement plan benefits, and IRAs, would exceed $600,000. That is so because there virtually is no disadvantage or "downside" risk to offset the tax savings obtainable through the use of such trusts. As described in detail in "Basic Estate Tax Planning," a "bypass trust" can be very flexible. While the surviving spouse cannot be given complete control over it, he or she can be a trustee, even the sole trustee, and can receive distributions of both income and principal from the trust. There also can be other beneficiaries of the "bypass trust," either in addition to or to the exclusion of the surviving spouse. 8 Thus, the assets added to the trust do not have to be "locked up" and kept from the surviving spouse or any other beneficiaries. This flexibility means that even if a "bypass trust" is established but because of unforeseen circumstances it appears that no tax savings will result from the use of the trust, the trustee simply can pay out the trust assets, in accordance with the discretionary terms of the trust, to the surviving spouse or other beneficiaries. 3. Steps to Maximize the Tax Savings Produced by "Bypass lïusts" Steps can be taken to maximize the savings produced by "bypass trusts," both before the trust comes into existence and in administering it after it has been established. A "bypass trust" can be funded only by individually owned assets and assets whose disposition is controlled by designation of beneficiary forms, such as life insurance and retirement plan benefits, that are designated to go to the trust. Jointly owned property and life insurance and retirement plan benefits designated to pass to a beneficiary other than the "bypass trust" cannot be used to fund the trust because these assets will pass by operation of law to the surviving joint owner or designated beneficiary. Thus, a married coupie often needs to divide up their joint property, 7 As discussed in "Fundamentals of Estate Planning," sometimes it is advisable for the provisions establishing a "bypass trust" at death (and other dispositive provisions) to be included in a revocable trust established during a person's lifetime, not a will. 8 "Basic Estate Tax Planning" sets forth specific decisions that need to be made concerning the terms of a "bypassing trust" and the considerations bearing on those decisions. 5

7 change their beneficiary designations, and, in some cases, make transfers from one spouse to another in order for assets to be available to fund the "bypass trust" no matter which spouse is the first to die. The tax savings obtained through the use of a "bypass trust" also can be increased by proper administration of the trust after it has been established. One guiding principle here is that to the extent possible, the surviving spouse should attempt to live on his or her own income and principal before receiving distributions from the "bypass trust." The reason is very simple: when a surviving spouse receives income or principal of the "bypass trust," he or she is in most cases effectively adding to his or her taxable estate at death. By contrast, when the surviving spouse uses up his or her own income and principal, the surviving spouse is reducing his or her own taxable estate at death. Put another way, when a distribution is made from a "bypass trust" to a surviving spouse, the property involved is moving from a "nontaxable pot" the "bypass trust" to a taxable one the surviving spouse's estate. 9 Thus, unless a surviving spouse's estate is paid down below $600,000 or the surviving spouse has needs or wants that for some reason cannot be met adequately through the use of his or her own funds, the "bypass trust" should not be used for the surviving spouse. 10 Certain investment considerations also are somewhat unique to a "bypass trust." Such a trust often is not intended to produce current income for the surviving spouse or any other beneficiary, and in such cases it generally should be invested for long-term growth. This also makes sense from an income tax standpoint, because the maximum marginal income tax rates become applicable to trusts at much lower levels of income than they do for individuals. By taking steps such as these, both before a "bypass trust" comes into existence and after its establishment, a married couple can significantly increase the tax savings obtained through the use of a "bypass trust." B. Other Tïusts that Can Be Used in Conjunction with a "Bypass Trust" to Produce Additional Savings For taxpayers with quite substantial estates, it often makes sense to use another trust in addition to a $600,000 "bypass trust" to increase the 9 It of course follows from this discussion that it generally is inadvisable to require that all income be paid to the surviving spouse. 10 Payments to children and other beneficiaries need not be limited because such payments will not be taxed in the surviving spouse's estate; they instead will pass property to the next generation without subjecting the property to estate tax, which is the basic objective of the "bypass trust." 6

8 overall tax savings. Different types of trust can be used in conjunction with a "bypass trust" to produce increased tax savings, but each of these additional trusts is designed to produce tax savings in the same way. The additional trusts are intended to take advantage of the different marginal tax rates applicable to the estate of the first spouse to die and to the surviving spouse's estate. As explained above, a basic "bypass trust" arrangement is designed to eliminate all estate tax on the death of the first to die and also shield considerable assets from tax on the surviving spouse's estate. Where a couple has a large estate, however, substantial estate taxes still may be due on the surviving spouse's estate, at a marginal estate tax rate that can be as high as 55 percent. By contrast, if the otherwise nontaxable estate of the first spouse to die were increased, the marginal tax rates applicable would begin at 37 percent. Thus, if an asset that would otherwise be taxed in the surviving spouse's estate is instead taxed in the estate of the first spouse to die (and is not taxed again in the surviving spouse's estate), the tax rate applicable to that asset would be roughly 37 percent rather than as high as 55 percent. Assuming that the asset were worth $200,000, that the "blended" tax rate applicable to it in the first estate were 40 percent, and that a 55 percent rate were applicable to it in the second estate, the tax saving from having the asset taxed in the first estate rather than the second would be $30,000. Accordingly, the trusts used in conjunction with a "bypass trust" produce tax savings by causing assets that would be taxed at high rates in the surviving spouse's estate under a basic "bypass trust" arrangement to be taxed at lower rates in the estate of the first spouse to die. 11 With this brief description of the way in which the trusts used in conjunction with a "bypass trust" can produce tax savings, let us now turn to consideration of the specific types of trust typically used for this purpose. 1. A "Bypass Tïust" for More Than the $600,000 "Unified Credit Exemption Equivalent" One option an option that does not involve creation of a separate new trust is simply to increase the size of the "bypass trust" beyond the $600,000 "unified credit exemption equivalent" amount. For couples with large estates, this generally will result in an overall tax saving for the reason explained above. Another tax objective also can be accomplished by increasing the 11 The tax savings produced in this way will in most cases be increased substantially as a result of appreciation in the value of the couple's assets from the date of the first spouse's death until the survivor's death. That is so because the appreciation on the assets taxed in the first spouse's estate also will escape taxation in the surviving spouse's estate. 7

9 amount of the "bypass trust." There now exists a so-called "generationskipping transfer tax" (the "GST tax") that is designed to prevent property from being passed through several generations tax free. In essence, a GST tax is imposed on property when it "skips" a generation and is not subject to estate tax. For example, if a wealthy parent set up a trust for a child for the child's lifetime and the trust property was not includable in the child's taxable estate at death, no estate tax would be due on the trust property upon the child's death, but the property would, unless shielded from tax by an exemption, be subject to the GST tax. I will not discuss the GST tax in detail here because the statutes setting forth the tax are quite complicated and because any savings in GST tax often will occur far into the future, making the present-dollar value of the savings relatively small as compared to estate tax savings. There is, however, one aspect of the GST tax statutes that is both simple and important for people with substantial estates. This is a $1 million exemption from the GST tax available to every taxpayer. As is the case with the "unified credit exemption equivalent," the portion of the $1 million exemption "used up" by a particular transfer generally is measured when the transfer takes place. Thus, if a parent set up a $1 million trust for a child's lifetime with the remainder to go to grandchildren, then all the trust property, including accumulated income and appreciation, would be shielded from GST tax upon the child's death, when the trust might have grown to several million dollars. 12 In such a case, proper use of the GST tax exemption can result in worthwhile savings even though those savings may not be realized for some time. If a "bypass trust" is to continue for the lifetime of children after the death of the surviving spouse, application of part of the $1 million GST exemption to the "bypass trust" might well be the most advisable use of the exemption. And if that is the case, it might also be advisable, in large estates, to increase the size of the "bypass trust" above $600,000 so that more property can be shielded from GST tax by application of the $1 million exemption to the trust. The optimum amount to put in the "bypass trust," at least for GST tax purposes, appears to be an amount that will produce a $1 million trust after the estate tax on the first spouse's estate has been paid. However, given the fact that GST tax savings typically will occur only far in the future, this amount should not be added to the "bypass trust" unless this step also makes sense from an estate tax standpoint. Thus, increasing the size of the "bypass trust" can produce both estate 12 The property would have to be retained in the trust, rather than distributed to the child, to qualify for the exemption. 8

10 and GST tax savings. A problem with this approach, however, is that it does not allow the decision whether and to what extent to have property taxed in the estate of the first spouse to die to be made at the time of that spouse's death, which the following two alternatives do allow. Accordingly, increasing the size of the "bypass trust" is a worthwhile alternative for couples who are confident that their total estate will be large enough that they will definitely want to incur estate tax on the death of the first spouse to die, but others may want the flexibility of the following two approaches. 2. A "Qualified Terminable Interest Property" Trust In the Economic Recovery Tax Act of 1981, Congress authorized use of a "qualified terminable interest property" trust as a means of qualifying for the marital deduction. Before, property could qualify for the marital deduction only if it went to a surviving spouse outright or passed into a trust that the surviving spouse had power of disposition over or that went to his or her estate at death. Under a "QTIP trust," however, the surviving spouse does not have to have complete power of disposition and the trust property does not have to go to his or her estate at death. The only requirements are that all the income of the trust must be paid to the surviving spouse during his or her lifetime and that neither income nor principal can be paid to anyone other than the surviving spouse during his or her lifetime. The property in a "QTIP trust" does not qualify automatically for the marital deduction. Instead, the trust property can be qualified for the deduction, in whole or in part, by the executor of that spouse's estate. To the extent the trust property is qualified for the marital deduction, it is not subject to estate tax on the death of the first spouse to die, but is subject to estate tax in the surviving spouse's estate. To the extent the trust property is not qualified for the marital deduction, it is taxed in the first spouse's estate but is not then subject to estate tax in the survivor's estate. 13 Use of a "QTIP trust" thus allows the decision whether to have property taxed in the estate of the first spouse to die, and if so, how much, to be made following the death of the first to die, when the value of the first spouse's estate and other critical facts are available. To the extent a "QTIP trust" is not qualified for the marital deduction, it functions much as an addition to a $600,000 "bypass trust," being taxed in the estate of the first 13 This decision whether or not to qualify the trust property for the marital deduction, called the "QTIP election," must be made on a timely filed Federal estate tax return. That return is due 9 months after a decedent's death, although in proper circumstances a 6- month extension of time to file can be obtained, and a "QTIP election" made on a return for which an extension has been granted qualifies. 9

11 spouse to die but not in the surviving spouse's estate. 14 In this respect, therefore, the "QTIP trust" approach allows more flexibility than the approach of simply increasing the size of the "bypass trust." On the other hand, a disadvantage of a "QTIP trust" is that it is less flexible in terms of the distributions that can be made than a "bypass trust" As indicated above, all the income of the trust must be paid to the surviving spouse and no payments can be made to any other beneficiary during the surviving spouse's lifetime. These requirements may be inconsistent with estate planning objectives. The requirement that all income be paid to the surviving spouse is, moreover, inconsistent with tax saving objectives. As explained above in the discussion of "bypass trusts," where a trust will not be included in the surviving spouse's estate, it is advisable to accumulate the income in the trust if the surviving spouse's income and assets are sufficient to meet his or her needs. Otherwise the trust income effectively will be going from an entity that will pass tax-free at the surviving spouse's death to one that will be taxed the surviving spouse's estate. A simple example will illustrate the estate tax savings that can result through the accumulation of income possible with an increased "bypass trust" (and the "disclaimer trust" alternative discussed below), but not possible with a "QTIP trust." Assume that after estate taxes on the first spouse's death, there is a "bypass trust" of $1 million $400,000 over the "basic" amount of $600,000. If the additional $400,000 in assets earned 4 percent in after-tax income until the surviving spouse's death and his or her death occurred 10 years after the first spouse's death, the accumulated income would total $192,080. The estate tax savings on the surviving spouse's death resulting from the accumulation of income, as compared to the taxes on the surviving spouse's estate if instead there had been a $400,000 "QTIP trust" of which the income was required to be paid to the surviving spouse, would be $96,040 if the marginal tax rate applicable to the surviving spouse's estate were 50 percent. Thus, the tax savings possible through the accumulation of income that is possible with a "bypass trust" (and a "disclaimer trust"), but not with a "QTIP trust," can be significant (The disadvantage of a "QTIP trust" that income must be distributed can be mitigated somewhat by investing the trust funds primarily in long-term growth assets that produce little income.) 14 It is, in fact, possible for a couple to provide that all of the property of the first spouse to die will go into one "QTIP trust," and then have the executor of that estate decide what part of the trust should be qualified for the marital deduction and what part should not. However, because the "bypass trust" is more flexible in terms of permissible distributions from the trust than a "QTIP trust," as explained in the following paragraph of the text, it generally is advisable to have a separate "bypass trust" even when a "QTIP trust" also is used. 10

12 Thus, there is a trade-off between the use of a "QTIP trust" in conjunction with a $600,000 "bypass trust*' as compared to simply enlarging the "bypass trust." The "QTIP trust" alternative provides more flexibility in making the decision whether property should be taxed in the estate of the first spouse to die and, if so, how much. However, an enlarged "bypass trust" allows more flexibility in terms of the distributions that can be made after the trust is established, and this flexibility can be valuable for both estate planning and tax purposes A "Disclaimer Trust" The third type of trust that can in appropriate circumstances be used with a "bypass trust" is a so-called "disclaimer trust." Under the Internal Revenue Code, a beneficiary under a will can within 9 months of a decedent's death disclaim part or all of the property left to him or her under the decedent's will. Moreover, where the person disclaiming is a surviving spouse, the property can go to a trust that can be used for the benefit of the surviving spouse, as well as others, if that is desired, during the surviving spouse's lifetime. However, the surviving spouse cannot himself or herself set up such a "disclaimer trust"; it must be included in the will of the first spouse to die, and that will must provide that any property left outright to the surviving spouse that he or she disclaims will pass to the "disclaimer trust." Thus, a couple can in their wills provide that upon the death of the first of them to die, a $600,000 "bypass trust" will be established and the balance of the estate will pass outright to the survivor, and they can further provide that in the event the surviving spouse disclaims any property that would otherwise pass outright to him or her, that property would pass to a "disclaimer trust." Where such provisions are included in wills but the surviving spouse does not disclaim any property, no "disclaimer trust" will be established. A "disclaimer trust" arrangement operates like a "QTIP trust" arrangement to the extent it allows the decision concerning the taxation of property in the first spouse's estate to be made following the first spouse's death. One difference between the two arrangements is that under the "disclaimer trust" alternative this decision is made by the surviving spouse, while under the "QTIP trust" alternative it is made by the executor of the first spouse's estate (who can be the surviving spouse). Another difference is that a "disclaimer trust" is in some respects more flexible than a "QTIP trust." 15 A "QTIP trust" can be qualified in whole or in part for the $1 million exemption from the GST tax, and while a "bypass trust" is a slightly more advisable entity for use of this exemption, this slight difference between the two generally should not in itself be the basis for choosing an enlarged "bypass trust" instead of a "QTIP trust" in conjunction with a $600,000 "bypass trust." 11

13 Under a "disclaimer trust," there can be beneficiaries other than the surviving spouse during the surviving spouse's lifetime, and not all the income has to be paid automatically to the surviving spouse. This difference can favor the "disclaimer trust" not just for estate planning reasons but also for the taxreasonthat income can beretainedin trust so that it will pass tax-free on the surviving spouse's death. As discussed above in connection with "bypass trusts," the option of accumulating income can be used to produce valuable estate tax savings on the surviving spouse's death. Thus, the decision whether to use a "QTIP trust" or a "disclaimer trust" in conjunction with a "bypass trust" depends upon (1) who the person drafting the will wants to have make the decision concerning taxation of property in the estate of the first spouse to die, and (2) what trust provisions that person wants. A "QTIP trust" sometimes is preferable in "second marriage" situations in which a person wants decisions made that, in the event the person predeceases his or her spouse, will maximize the property that will go to children of his or her first marriage. That is so because then a third party can be named as executor to make the decision as to whether and to what extent to have property taxed in the estate of the first spouse to die. A surviving spouse has a financial interest somewhat contrary to having property taxed in the estate of the first spouse to die because that would reduce the property available for distribution to the surviving spouse during his or her lifetime by the amount of the taxes due on the first spouse's death. In situations other than a "second marriage" situation, however, a "disclaimer trust" often is preferable because it allows accumulated trust income to pass free of estate tax on the surviving spouse's death. As between a "disclaimer trust" arrangement and an increased "bypass trust," the choice generally should turn on whether the married couple has a large enough estate and stable enough circumstances to be sure they want considerable property taxed in the estate of the first spouse to die. When that is the case, an expanded "bypass trust" often will be advisable. When that is not the case, a "disclaimer trust" (or, particularly in "second marriage" situations, a "QTIP trust") probably will be the best option. 16 One final, very important point about a "disclaimer trust" is that it can and very often should be used by a married couple even if they do not have a "bypass trust" arrangement in their wills. If a couple believes that their total estate probably will not exceed the $600,000 "unified credit exemp- 16 The $1 million GST tax exemption can be applied to property disclaimed into a "disclaimer trust," and this can be an advantageous use of the exemption. In most cases, however, this should not provide a basis for using a "disclaimer trust" if there is an otherwise preferable alternative. 12

14 tion equivalent" and therefore provide for all the property of the first to die to pass to the survivor, the couple still might want to include provisions in their wills for a "disclaimer trust" to give them something of a fallback position. Then, if the couple's estate increased substantially in value and they did not get around to revising their wills before the death of the first of them to die, the surviving spouse could disclaim property into the "disclaimer trust" to use the "unified credit exemption equivalent" available to the first spouse's estate. The property passing to the "disclaimer trust," if it is less than the $600,000 "unified credit exemption equivalent," will not be taxed in the first spouse's estate, and it will not be included in the surviving spouse's taxable estate, as it would if it had passed outright to the surviving spouse. And since no "disclaimer trust" will come into effect unless the surviving spouse does disclaim property, there is no reason not to include the "disclaimer trust" provisions to provide for the contingency that it may turn out to be advisable to make use of the "unified credit exemption equivalent" of the first spouse to die A cautionary note concerning the entire discussion in this section of "bypass trusts" and other trusts for a surviving spouse: if one spouse is not a U.S. citizen, very different rules apply concerning the types of gifts that will qualify for the marital deduction and concerning certain other matters. Accordingly, married couples in which one spouse is a nonçitizen need to learn the special rules applicable to their circumstances. 13

15 n. CHARITABLE REMAINDER UNITRUSTS AND POOLED INCOME FUNDS IN this section, I first discuss charitable remainder unitrusts and pooled income funds and show the basic ways in which these trusts produce tax savings. I then demonstrate how these valuable estate planning tools can be used to accomplish a variety of other tax and nontax objectives. A. The Basics of Charitable Remainder Unitrusts and Pooled Income Funds An outright gift to a charity qualifies for a deduction from gift and income taxes if made during lifetime and for an estate tax deduction if made at death. Likewise, certain so-called "split-interest" gifts gifts divided between individuals and a charity can qualify for a charitable deduction. However, "split-interest" gifts can qualify for a charitable deduction only if they meet strict requirements in the Internal Revenue Code. In other words, a person cannot simply "make up" his own "splitinterest" gift giving certain rights in property to certain individuals and other rights to a particular charity and have the interest given to charity qualify for a charitable deduction from gift, income, or estate tax. Of the "split-interest" gifts qualifying for charitable deduction treatment, the most useful are "charitable remainder unitrusts" and "pooled income funds." A "charitable remainder unitrust" is a trust under which in each year during the lifetime of one or more individuals or for a fixed period of years, a specified percentage (which must be at least 5 percent) of the current value of the trust property is paid to the individual beneficiary or beneficiaries. After the interests of the individual beneficiary or beneficiaries have expired, the remainder is paid to charity. There can be concurrent, consecutive, and contingent individual beneficiaries, and an individual beneficiary's interest can terminate at death, after a period of years, or upon the occurrence of an earlier contingency, such as remarriage. The value of the remainder interest in a charitable remainder unitrust, as determined by IRS tables, qualifies for a charitable deduction from gift and income taxes or from estate taxes "Charitable remainder unitrusts" generally are considered preferable to another type of charitable remainder trust explained in "Basic Estate Tax Planning" "charitable remainder annuity trusts." That is so because under a "charitable remainder unitrust," the payments to individual beneficiaries increase with increases in the underlying assets, while with a "charitable remainder annuity trust," the amount of the annual payments throughout the life of the trust is fixed when the trust is established. Another advantage of "charitable 14

16 A "pooled income fund" is an investment fund operated by a charitable entity for its donors. The percentage of the income of the fund that is attributable to a donor's contribution is distributed to the donor or other individual beneficiary or beneficiaries the donor selects, and upon the termination of all individual beneficiaries' interests, the property in the fund attributable to the donor's contribution goes to the charitable entity. As with charitable remainder unitrusts, there can be concurrent, consecutive, and contingent individual beneficiaries, and IRS tables are used to determine the charitable deduction from gift and income taxes or from estate taxes for the remainder interest eventually passing to charity. 19 A lifetime gift to a charitable remainder unitrust or a pooled income fund can be particularly useful because it will produce income, gift, and estate tax benefits. As explained above, the remainder interest passing to charity under such a gift will qualify for a charitable deduction from income and gift taxes. In addition, the property of the gift and any appreciation earned on the gift from the date it is made to the donor's death also will be removed from the donor's taxable estate. If the donor were not an individual beneficiary of the charitable remainder unitrust or pooled income fund, no income on the gift property from the date of the gift would be included in or increase his or her taxable estate. AIER administers both charitable remainder unitrusts, which it calls "CRUs," and pooled income funds, which it calls "Reserved Life Income Funds" or "RLIs." Each CRU has a separate portfolio and is individually managed by AIER as trustee. 20 AIER administers two "RLIs": the RLI Stock Fund II, which is invested primarily in "Blue Chip" common stocks, in common stocks of gold companies, and in Swiss franc and Deutsche mark denominated bonds, and the RLI Current Income Fund, which is invested in short-term U.S. Government obligations and U.S. Government-backed or insured obligations. When a gift is made to an RLI, the current income beneficiary selected by the donor is assigned a number of "units of participation" determined by dividing the fair market value of the donor's gift by the fair market value of a unit in the RLI at the time of remainder unitrusts" over "charitable remainder annuity trusts" is that contributions can be made to the former over a period of years but not to the latter. For another advantage of "charitable remainder unitrusts" as compared to "charitable remainder annuity trusts," see Chapter III, Subsection B. 19 Another advantage of a pooled income fund is that if the income interest in such a fund is given to a surviving spouse, that income interest will qualify as an interest in a "QTIP trust." Thus, the executor of the first spouse to die can decide, based upon the circumstances existing following the first spouse's death, whether or not to qualify that interest for the marital deduction. 20 AIER's standard form of CRU agreement has been expressly held by the IRS to meet the tax requirements for a charitable remainder unitrust. 15

17 the gift. The net income of the RLI is distributed quarterly among income beneficiaries according to their respective units of participation. Thus, charitable remainder unitrusts and pooled income funds, including AIER's CRUs and RLIs, can be used to assist a favored charity while at the same time obtaining reductions in gift, income, and estate taxes. As described in the following subsection, these extremely valuable estate planning tools also can be used, at the same time, to accomplish other important tax and nontax objectives. B. Other Valuable Tax and Nontax Uses of Charitable Remainder Unitrusts and Pooled Income Funds 1. Shielding Capital Gains from Tax while Producing an "Unreduced" Stream of Income and an "Unreduced" Charitable Deduction Often a person does not need additional current income but anticipates that he or she will need a supplemental stream of income at some point in the future for college costs or retirement or some other purpose. In such a situation, a fairly standard investment approach is for the person to invest primarily in growth assets until shortly before the stream of income is needed, then reinvest in assets that will produce a high rate of income. There is, however, something of a hitch to this proposed scenario. It is that when the "growth" assets are converted into assets with a high income yield, income taxes will have to be paid on the capital gains required to be recognized in that transaction, and now these capital gains will be taxed at "ordinary income" rates up to 28 percent. Charitable remainder unitrusts and pooled income funds provide a way to eliminate the hitch in the above scenario and to avoid recognition of capital gains in other situations. That is so because when an appreciated asset that has been held at least 1 year is transferred to a charitable remainder unitrust or a pooled income fund, the difference between its original cost and its value when added to the charitable remainder unitrust or pooled income fund does not have to be recognized by the person making the transfer. Nor does the person making the transfer have to recognize gains if and when the asset subsequently is sold by the charitable remainder unitrust or pooled income fund. And this is the case even though the charitable deduction for the value of the remainder interests is computed based on the full fair market value of the asset when it is added to the charitable remainder unitrust or pooled income fund Two minor caveats should be mentioned. First, certain benefits discussed above are not available if the donated asset is tangible personal property. Second, although a deduction based on the full fair market value of property transferred to the charitable remainder 16

18 Thus, a person can transfer highly appreciated assets to a charitable remainder unitrust or a pooled income fund without paying any capital gains tax and without any reduction in (1) the stream of income the assets can be used to produce at their appreciated value or (2) the charitable deduction available to the donor. 22 An example will illustrate how extremely valuable such a transfer can be. Assume that a person retiring at age 65 with stock holdings worth $500,000 for which he paid a total of $100,000 wants to sell the stock and diversify his investment portfolio. If he sells the stock, however, he will have to recognize $400,000 of capital gains and will incur taxes of $112,000 (28 percent $400,000) on such gains, leaving him with only $388,000 to invest. At an 8 percent return, he would earn $31,040 annually on the net assets remaining after payment of capital gains taxes. On the other hand, if the person transfers the stock to a charitable remainder unitrust, designating himself as the life beneficiary of an 8 percent unitrust payment, the unitrust could sell the stock and invest the full $500,000 of proceeds in other investments. The person would receive a unitrust payment of $40,000 annually for his lifetime assuming no depreciation in the value of the trust principal, and this amount would increase if, as is more likely, the trust property appreciates in value. In addition, he would have avoided payment of capital gains taxes of $112,000 (and since the unitrust is tax exempt, no capital gains tax would be paid by it either). Moreover, the person would be entitled to a charitable deduction of $171,480 (using current interest factors) for the value of the remainder interest going to charity. 23 And the $500,000 added to the unitrust also would escape gift and estate taxation. This example shows how a charitable remainder unitrust can be used to meet the retirement planning objectives of an individual while at the same unitrust or pooled income fund is allowed for regular income tax purposes, the appreciation component of the deduction is treated as a tax preference for alternative minimum tax purposes. In some cases, this could trigger an alternative minimum tax liability, but this would occur only in unusual cases involving very large gifts. 22 These tax benefits also will result from use of a "charitable remainder annuity trust," but as indicated above, the payments to beneficiaries under such a trust will not increase with appreciation in the trust property, as is the case under a charitable remainder unitrust. 23 The unitrust payments will be deemed, however, to have been paid first out of current and prior year ordinary income and capital gains of the trust even if the trust invests in taxexempt bonds. Nevertheless, in contrast to the first scenario, the tax on the gain will be spread over several years and the total $500,000 of proceeds will be available for investment by the trust. To the extent that the deduction exceeds 30 percent of the person's adjusted gross income, the excess may not be deducted currently, but may be carried over and treated as a charitable contribution of capital gain property in each of the 5 succeeding tax years until fully deducted. 17

19 time providing benefits to a charity whose purposes the individual wants to support. A charitable remainder unitrust could be used in a similar fashion to pay for college costs by, for example, limiting the trust to a term of years and providing a higher unitrust payment. Moreover, the tax savings from the charitable deduction, the additional income realized during the person's lifetime, and the shielding of the $500,000 from any gift or estate tax liability will offset to a very significant extent, if not entirely, the diminution in the total value of his or her assets resulting from the transfer of stock to the unitrust. Thus, where a person has invested assets for growth and would now like to produce a stream of income to provide for retirement or pay college costs, a charitable remainder unitrust or pooled income fund can be used so that the stream of income produced will not be reduced, at the very outset, by significant capital gains taxes, and a charitable deduction based on the full, appreciated value of the donated property also can be obtained. These split-interest gifts also can be very valuable in other situations in which it would be useful to convert growth assets without recognizing capital gain. For example, many investors now hold stocks that appreciated greatly during the bull market of the 1980's but that may not be advisable investments in today's uncertain times. A number of these investors would like to divest themselves of these assets, but the large capital gains taxes they would have to recognize, at "ordinary income" rates, dissuade them from doing so. Charitable remainder unitrusts and pooled income funds provide vehicles they could use to convert their highly appreciated stock into a stream of income without recognizing capital gains, and they would get a valuable charitable deduction to boot. Depending upon the particular objectives and strategies, of course, the numerical comparison illustrated above will vary from case to case. 2. Use of a Charitable Remainder Unitrust as the Vehicle to Produce Both Growth and an Enhanced Stream of Income As indicated above, a common investment approach is to invest for growth for a period, when additional current income is not needed, then convert the appreciated assets into a stream of income when additional current income will be needed for college costs or retirement or some other purpose. In the preceding subsection, I showed that charitable remainder unitrusts can be a very effective tool for converting appreciated assets acquired during the "growth cycle" under such an approach into a stream of income. It also is noteworthy that because of a special characteristic of charitable remainder unitrusts, these unitrusts also can be used effectively to produce both growth and then an enhanced stream of income. It is possible to provide in a charitable remainder unitrust that only the 18

20 income of the unitrust will be paid to the beneficiary or beneficiaries in any year in which the income is less than the otherwise required percentage distribution. 24 Where the unitrust so provides, then in any subsequent year in which the income exceeds the otherwise required percentage distribution, the excess is to be paid to the beneficiary or beneficiaries until the shortfall from prior years is made up. Such a charitable remainder unitrust provides a unique means for producing first growth and then a stream of income. If a person established this kind of charitable remainder unitrust and invested primarily in growth assets for a period of years, the payments to the person in those years would be limited to the unitrust income, which would be low because the unitrust assets had been invested for growth. Then in subsequent years, after the assets of the trust had appreciated substantially, those assets could be converted into assets producing a high current yield. Neither the donor nor the unitrust would have to recognize any gain on the conversion. The donor would not have to recognize any gain because the assets would have been held throughout by the charitable remainder unitrust, not by him, and the unitrust would not have to recognize any gain because it is tax exempt. And the donor would receive not just the specified percentage of the appreciated assets; he also would receive the excess of the enhanced income over that percentage to "make up" for the low payments of income made during the "growth cycle" of the unitrust. Thus, a charitable remainder unitrust can be used in this unique way to produce first growth and then an enhanced stream of income that would not be reduced by capital gains. 25 C. Use of a Charitable Remainder Unitrust or Pooled Income Fund in Conjunction with a Life Insurance Arrangement In the above examples of worthwhile uses of charitable remainder unitrusts and pooled income funds, although the use of such a unitrust or fund would produce an overall economic benefit, the underlying assets of the unitrust or fund ultimately would go to the designated charity. However, by combining a life insurance arrangement with a charitable remainder unitrust or a pooled income fund, it is possible to have funds equal to the likely value of the underlying assets of the unitrust or fund pass to family members or other individual beneficiaries, if that is desired. Thus, if a donor made a gift to a charitable remainder unitrust or pooled 24 This is not possible with respect to a "charitable remainder annuity trust." 25 Because of this capability, a charitable remainder unitrust can in some circumstances be an advisable alternative to an IRA, a Keogh plan, or a corporate qualified retirement plan. See Hicks, "Charitable Remainder Trust May Be More Advantageous Than a Qualified Plan," Estate Planning (May/June 1990). 19

21 income fund and named himself or herself as sole individual beneficiary of the unitrust or the interest in the fund, the donor could use a portion of the payments received from the fund to purchase insurance on his or her life. Likewise, if a married couple were to be the individual beneficiaries of a charitable remainder unitrust or pooled income fund, they could use payments from the unitrust or fund to purchase so-called "second death*' insurance on their lives payable on the death of the survivor of them. 26 Then at the time the underlying assets of the unitrust or fund interest passed to charity, insurance proceeds equivalent to the value of those assets would be payable to family members in the next generation or to other individual beneficiaries. Moreover, if the insurance had been held in an irrevocable insurance trust another important type of tax saving trust discussed in the following chapter of this booklet the insurance proceeds would not be reduced by any estate taxes. Of course, the fact that part of the annual payments from the charitable remainder unitrust or pooled income fund were used to purchase life insurance would reduce the funds available to the individual beneficiaries of the unitrust or fund. However, the cost of insurance equivalent to the value of the underlying assets might not significantly reduce the annual payments from the unitrust or fund, particularly where "second death" insurance, which has a relatively low annual cost, is involved. Where that is the case, combining an insurance arrangement, particularly an irrevocable insurance trust, with a charitable remainder unitrust or pooled income fund can increase the economic benefits obtainable through use of such a unitrust or fund. Moreover, combining an insurance arrangement with a charitable remainder unitrust or pooled income fund also provides a hedge against the possibility that the individual beneficiaries of the unitrust or fund will not live as long as expected, which would mean that the anticipated economic benefits to the individual beneficiaries would not be realized. 27 D. Structuring a Charitable Remainder Unitrust or a Pooled Income Fund Gift to Make Economical Use of the "Unified Credit Exemption Equivalent" In appropriate circumstances, a charitable remainder unitrust or pooled income fund also can be a useful means of taking optimum advantage of the "unified credit exemption equivalent." Assume that a person has an estate considerably in excess of the $600,000 "unified credit exemption equivalent" and that one of the person's 26 "Second death" insurance is discussed further in the following subsection of this booklet. 27 For further discussion of this planning technique a discussion that is in some respects quite technical see Mering, "Combination of Charitable Remainder and Insurance Trust Can Increase Health," Estate Planning (Nov./Dec. 1990). 20

22 primary estate planning objectives is to provide a stream of income for life for a particular beneficiary (other than a surviving spouse) or for a particular class of beneficiaries. If that person established a conventional trust under which lifetime payments would be made after his or her death to the chosen beneficiary or beneficiaries, everything added to that trust would "count against" the person's "unified credit exemption equivalent" and might well completely use up that exemption. By contrast, if the person used a charitable remainder unitrust or pooled income fund to provide a stream of lifetime income for his or her chosen beneficiary or beneficiaries upon his or her death, only a fraction of the property added to the trust would "count against" the "unified credit exemption equivalent." The balance of that exemption would then be available to shield other property from estate tax. Of course, in the process the person also would assist the charity he or she chose to receive the remainder interest. Now let us take the above example a little further. Suppose that the person hypothesized above established the charitable remainder unitrust or pooled income fund interest to provide lifetime payments for one or more beneficiaries while the person was alive, rather than upon his or her death. Once again, only part of the property added to the trust the part attributable to the individual beneficiaries' lifetime interests would "count against" the donor's $600,000 "unified credit exemption equivalent." 28 The donor also would get a valuable income tax deduction. Moreover, income and appreciation earned on the trust property from the date of the gift to the date of the donor's death, as well as the trust property itself, would be removed from the donor's taxable estate. And if the donor used appreciated property to make the split-interest gift, he would not have to recognize capital gains on that gift and yet there would be no reduction in the stream of income produced or in the charitable deduction obtained. The above example thus shows not only how a charitable remainder unitrust or pooled income fund can be an advisable means of using the "unified credit exemption equivalent" economically, but also how in a single situation such a unitrust or fund can accomplish a variety of estate planning purposes. * * * In sum, charitable remainder unitrusts and pooled income funds can be used to accomplish a number of important estate planning objectives. You should accordingly consider whether these valuable tools can be helpful in accomplishing your estate planning objectives. 28 Moreover, the annual exclusion would be available to shield part of the individual beneficiaries' interests from tax. 21

23 m. IRREVOCABLE INSURANCE TRUSTS IN my practice, I have found that the best way to explain irrevocable insurance trusts the significant savings they can produce, the estate planning considerations involved in their drafting, the somewhat gimmicky way in which they operate is to take clients through the basic decisions involved in determining whether they should have an irrevocable insurance trust and, if so, how it should be implemented. General explanations of such trusts and how they operate usually produce glassy eyes, so I cut the generalities short and move quickly to the decisions to be made. Accordingly, here I will take readers through the basic decisions involved in establishing and implementing an irrevocable insurance trust as a means of explaining such trusts to them in concrete terms. To provide a basis for our decision-making, we need a set of hypothetical facts about a particular individual or particular individuals who might want to consider establishing an irrevocable insurance trust. For this purpose, let us hypothesize a couple, Tom and Carmen Jones, both of them in their fifties, with two children in college. Tom and Carmen have a total estate of $3 million and they have made arrangements so that a $600,000 "bypass trust" will be set up upon the death of the first of them to die. They are, however, concerned because their estate planning attorney has told them that the estate of the survivor still will be heavily taxed, incurring estate taxes in the range of $750,000. For this reason, they want to consider acquiring insurance to meet this estate tax liability and establishing a trust to hold the insurance. Now with these basic facts, let us proceed to advise them about the decisions they need to make. A. Should Insurance Be Acquired, and an Irrevocable Insurance Trust Established, to Meet Needs with "Untaxed" Funds? Of course, the basic benefit of insurance is that it provides funds to meet needs such as a surviving spouse's living expenses, the education of children, the payment of estate taxes even in the event of an untimely death. An irrevocable insurance trust greatly increases the benefits obtainable from insurance because it allows the insurance proceeds to be available to meet such needs without having those insurance proceeds reduced by estate taxes. This is accomplished by having the insurance held in a trust that will not be included in the estate of the insured or, in the case of a couple, in either spouse's estate. To do this, the trust must be irrevocable and the powers and interests that the insured or the 22

24 couple have concerning the trust must be limited in other respects as well. 29 The threshold question for the Joneses, then, is whether they have a need or needs that could advantageously be met through the acquisition of insurance and the establishment of an irrevocable insurance trust. Their children appear to have completed most of their schooling and there appear to be ample funds to pay for the remainder. Likewise, there appear to be sufficient funds to provide for the survivor of Tom and Carmen if something untoward should happen to either of them. However, their total estate, and the amount they can pass "down the line" to their children, will be reduced by estate taxes of roughly $750,000 on the death of the survivor of them. The Joneses believe that if there were a way economically to pay part or all of these taxes through insurance, thereby increasing the net amount they could pass to their children, they would do so. If the Joneses were to purchase a traditional insurance product on one of their lives and have the insured own that insurance, it probably would not be worthwhile for them to purchase insurance to meet the estate tax liabilities on the survivor's estate, given the cost of that insurance and the fact it would be reduced by estate taxes. However, two additional factors might well make the purchase of insurance economically advisable for them. One is, of course, the fact that by putting the insurance into an irrevocable insurance trust, the Joneses can make the insurance available to pay estate taxes and yet not have the insurance proceeds reduced by estate taxes. 30 The other is that because under current law estate taxes generally are due only on the death of the survivor of a couple, the insurance industry has come up with a product, called "second death" insurance, that pays out proceeds only upon a surviving spouse's death. Because this insurance is payable only upon the termination of two lives rather than one, the annual cost of the insurance generally is much less than that of traditional insurance on a single insured. This reduced annual cost, plus the tax savings resulting from the use of an irrevocable insur- 29 The limitations that must apply to the insured or the couple are derived from the Internal Revenue Code and regulations, rulings, and cases interpreting them, and these authorities must be followed very carefully for the trust to achieve its tax saving purpose. For this and several other reasons, a lay person certainly should not attempt to establish an irrevocable insurance trust on his or her own. 30 It is important to emphasize that the provisions in an irrevocable insurance trust making the proceeds available to pay estate taxes must be very carefully written. Most importantly, those provisions should not direct that the insurance proceeds be used to pay estate taxes on the insured's death. Such a direction, by requiring that the proceeds be paid for the benefit of the insured's estate, would cause the proceeds to be included in the insured's taxable estate, so the tax savings that were the principal reason for establishing the trust would not be obtained. 23

25 ance trust, might well make it advisable for the Joneses to purchase "second death" insurance and put it in such a trust. 31 In other situations, the decision whether to establish an irrevocable insurance trust may be much easier. For example, many executives receive substantial insurance as a fringe benefit of their employment. In such situations, where the insurance already is in place and will be added to the taxable estate unless steps are taken to prevent that, an irrevocable insurance trust (or a comparable arrangement) is desirable. 32 Similarly, in other situations in which insurance already has been obtained or is needed, it often will be advisable to establish an irrevocable insurance trust. B. Does an Irrevocable Insurance Trust Make Sense from a Basic Estate Planning Standpoint? No matter what tax savings may be obtainable through an irrevocable insurance trust, such a trust usually should not be established unless it also makes sense from a basic estate tax standpoint. Take for example, a case in which the persons who would be the beneficiaries of the trust are minor children and there is no family member or other individual or entity who the person interested in establishing the trust would feel comfortable having serve as trustee and make decisions on payments to the children. In 31 Another option for people like the Joneses would be to establish an irrevocable trust and fund it with assets other than insurance. The basic principle applicable concerning taxation of an irrevocable insurance trust that if the interests and powers of the insured couple involved are properly limited, the trust will not be subject to estate taxation also applies with respect to other irrevocable trusts. Thus, an irrevocable trust could be established with other assets, and accumulated income and appreciation on those assets would then be shielded from estate tax. In my experience, however, most people prefer to put insurance in such a trust. There primarily are two reasons for this. One is the fact that in the event of an untimely death or untimely deaths, the insurance will produce a greater yield than assets added to such a trust that are designed to grow through accumulated income and appreciation. The second is that if, notwithstanding the planning that goes into establishment of an irrevocable trust and deciding on its terms, the person or persons establishing the trust subsequently decide it does not suit his, her, or their needs or desires, the trust can in many cases be eliminated by not making future premium payments to it. If, by contrast, other assets had been added to the trust, the disposition of those assets would continue to be controlled by the trust even if the person or persons establishing the trust had decided that that was not wanted. For individuals with large estates and stable family situations, however, an irrevocable trust for assets other than insurance may be useful either instead of, or in addition to, an irrevocable insurance trust. 32 In some situations, a feasible alternative method of shielding insurance from estate tax is to make periodic gifts to the children or other persons who areto be the beneficiaries of the insurance to allow them to acquire the policy and pay the premiums and then have them own the policy outright. This alternative generally is only advisable where the children or other beneficiaries are adult and have stable lives, and even then certain steps need to be taken to ensure the insurance proceeds will pass as intended without adverse consequences. 24

26 such a case, it is very questionable whether such a trust which is, after all, an irrevocable arrangement that frequently will control the disposition of hundreds of thousands of dollars or more should be established. A better approach might well be to wait until the children have grown and matured to some extent or until the person considering the irrevocable insurance trust has found someone he or she would be confident naming as trustee. Even where the intended beneficiaries of the trust are mature and their circumstances are stable and a reliable trustee is available, the irrevocability aspect of an insurance trust often counsels in favor of building flexibility into the trust. For example, if a trust were to be established for adult children that the person establishing the trust considered mature and able to handle money on their own, it might nonetheless be advisable to provide that the proceeds would continue to be held in trust after the insured's death, with broad discretion in the trustee to pay out at any time all of the proceeds or any lesser amount he or she deemed appropriate. Such a provision might be advisable because by the time of the insured's death, events might have occurred a business setback to one child that resulted in his or her bankruptcy, a pending divorce of another child that made it undesirable to have the proceeds paid outright to the beneficiaries. Because the trust's dispositive provisions cannot be changed after establishment of the trust, such possibilities need to be anticipated when the trust is written and sufficiently flexible provisions included to deal with them. C. Can the Payments Used to Acquire the Insurance Initially and Pay Continuing Premiums Feasibly Be Shielded from Gift Tax? The total savings obtainable from establishment of an irrevocable insurance trust will be reduced if the initial transfer of funds necessary to acquire insurance (or the transfer to the trustee of the insurance, if it was acquired by the person establishing the insurance trust sometime in the past) and nature transfers of funds sufficient to pay the premiums on the insurance constitute taxable gifts. 33 If these transfers are not shielded from gift tax, the $600,000 "unified credit exemption equivalent" available to the person establishing the trust effectively will be reduced by the amount of each transfer. 34 If an irrevocable insurance trust is in existence for a 33 If insurance is to be acquired at the time the irrevocable insurance trust is to be established, it generally makes sense for the person establishing the trust to give the trustee under the trust the funds necessary to purchase the insurance, not acquire the insurance himself or herself and transfer it to the trustee. This is so for a fairly complex reason relating to the estate taxation of the trust and the insurance in it. 34 Gift and estate taxes now are "unified." This means that taxable gifts effectively "count against" the $600,000 "unified credit exemption equivalent" until the "exemption equivalent" is exhausted. After that, gift taxes have to be paid on any taxable gifts. 25

27 number of years and the cost of the insurance runs to several thousand dollars a year, this would result in a substantial reduction in the "unified credit exemption equivalent'* available at death to the person establishing the insurance trust. There is, as many readers undoubtedly know, an "annual exclusion" from the gift tax. This exclusion generally shields gifts from any gift or estate tax liability if no more than $10,000 ($20,000 in the case of a married couple) is given to a particular donee in a particular year. In other words, a donor usually can give up to $10,000 ($20,000 where a married couple are the donors) to as many different donees as he or she wants in a year without any gift or estate tax liability. The "annual exclusion" is, however, limited in an important way: a gift of a "future interest" a gift over which the donee does not have either immediate enjoyment or immediate power of disposition does not qualify for the "annual exclusion." And gifts of property to a trust are almost by definition gifts of future interests, since the beneficiary almost always does not have immediate enjoyment of or power of disposition over the gift property. Accordingly, the original transfer of funds or insurance to the trustee of an irrevocable insurance trust and the subsequent transfer to the trustee of funds to pay annual premiums (or the direct payment of these premiums to the insurance company) would, if nothing more were done, constitute gifts of future interests that would not qualify for the "annual exclusion" from the gift tax. Those transfers can, however, be qualified for the "annual exclusion" by giving the beneficiaries the power to withdraw property transferred to the trust for a short period, such as a month, after a transfer has been made. Such a withdrawal power gives the beneficiaries an immediate power of disposition over the transfers to the trust and thus qualifies those transfers for the "annual exclusion." The withdrawal powers must be real, however: the beneficiaries must be given notice of the powers whenever property is transferred to the trust, there can be no agreement with them that they will not exercise the powers, and if they do exercise them, the property subject to the powers must be transferred to them. If the withdrawal powers are not exercised, which is the desired result, then the funds transferred can be used to pay premiums or for other trust purposes. Let's now see how withdrawal powers could be used effectively in the Jones's situation. Assume that the annual premiums on "second death" insurance for the two of them of $750,000 the approximate amount of estate taxes due on the survivor's death would be $6,000. If so, the Joneses could provide in the irrevocable insurance trust that each of their children would have the right to withdraw one-half of each payment to the 26

28 trust for a month after the payment was made. This would qualify the $6,000 annual transfers to the trust to pay premiums for the "annual exclusion/' Such withdrawal powers can be used to qualify amounts needed to pay premiums for the "annual exclusion" even if the beneficiaries to whom withdrawal powers are given are minors or disabled. Under certain IRS rulings, it also appears possible to use withdrawal powers to qualify premium payments for the "annual exclusion" even where the premium payments do not pass through the trust, as typically is the case under an employer's group term life insurance policy, where the premium payments usually are paid by the employer directly to the insurance company. In such a situation, however, the most recent authorities should be reviewed for possible new developments in the law before the trust is established, and great care needs to be taken in implementing the withdrawal powers. Because withdrawal powers will prevent a reduction in the tax savings obtainable through an irrevocable insurance trust, they generally should be used in connection with insurance trusts. However, they need to be drafted and implemented carefully, with the assistance of a qualified estate planning attorney. * * * For many people, like the Joneses, it will be advisable for them to purchase insurance, establish an irrevocable trust for it, and use withdrawal powers to shield the amounts needed to pay premiums from gift and estate tax. For others who have existing insurance and an estate that will be subject to substantial taxes at death, the decision to establish and implement an irrevocable insurance trust (or a comparable arrangement, such as a gift of the insurance to children) often will be even easier because the insurance already is in place. 27

29 IV. PICKING THE TAX SAVING TRUST ARRANGEMENT FOR YOU THE "bottom line" question for you is, of course, "Which of these tax saving trusts, or which combination of them, is appropriate for me?" A brief review of those aspects of the earlier discussion that bear most directly on this question should, therefore, make a useful summary. A "bypass trust" should be used by married couples in virtually every situation in which estate tax is likely to be due on the death of the surviving spouse. As explained above, it is very unlikely that any disadvantage will result from the use of the trust in such circumstances, and that being the case, there is no reason not to obtain the tax savings possible through the use of the trust. Most married couples, even those who leave everything outright to each other and thus do not provide for "bypass trusts" in their wills, also should include "disclaimer trust" provisions in their wills. In virtually all cases, there is no reason not to include such provisions, since the trust will not come into existence at all unless the surviving spouse decides to disclaim property into it. And having the trust provisions there can turn out to be quite advantageous, as explained above. Married couples with total estates of roughly $2 million or more also should consider using one of the alternatives to a "disclaimer trust" an expanded "bypass trust" or a "QTIP trust" as a means of having property taxed at lower marginal rates in the estate of the first to die. If couples with estates of this size find one of these alternatives preferable to a "disclaimer trust" arrangement, they might well want to include that alternative in their wills. With respect to charitable remainder unitrusts and pooled income funds, single individuals who will have estates in excess of $600,000, as well as couples who will have a taxable estate upon the survivor's death even though a "bypass trust" arrangement is used, should consider these trusts both as a means of saving taxes and as a means of accomplishing basic estate planning objectives. As indicated above, these multi-purpose trusts can obtain the following tax and nontax benefits, among others, in addition to financially assisting a particular charity: Produce a charitable deduction available against the gift or estate tax and, if the transfer is made during lifetime, a separate charitable deduction against the income tax. 28

30 Provide a stream of income for retirement, for a surviving spouse, or for the education of a child or grandchild. Shield from income tax the appreciation on appreciated property added to the trust without reducing either the stream of income for individual beneficiaries or the charitable deduction for the remainder interest passing to charity. Make optimum use of the "unified credit exemption equivalent" where a primary estate planning objective is to provide funds for the lifetime of a specific beneficiary or specific beneficiaries. As for irrevocable insurance trusts, these trusts (or gifts of insurance to individual beneficiaries) should be used in most cases where there is substantial existing insurance and, notwithstanding the use of other appropriate tax-saving measures, estate tax will be incurred on the insured's death. Where there are needs that beneficially could be met by insurance, at least if the insurance proceeds themselves were shielded from estate tax, it also may be advisable to acquire new insurance and add it to an irrevocable insurance trust. These, then, are some of the most valuable tax saving trusts and how you can put them to work for you. I urge you to do so. 29

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