The Role of Life Insurance in GRATs, IDGTs, QPRTs, CRUTs, and Other Four-Letter Words

1. The Role of Life Insurance inGRATs, IDGTs, QPRTs, CRUTs, and Other Four-Letter Words Sponsored by: Presented by: Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver Road, 10th Floor Troy, Michigan 48084 (248) 457-7200 jhg@disinherit-irs.com www.disinherit-irs.com

2. IRS Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this presentation is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

3. Preface • The federal estate tax is only vulnerable to lifetime gifting. • And there are generally three types of gifts clients can make: • Gifts of life insurance. • Gifts that shift or reduce value. • Gifts to charity.

4. Estate, Gift, and GST Taxes • 1 The Tax Relief Act of 2010: • For individuals who died in 2010: • Tax the decedent’s assets at 35%, after estate tax exemption of $5 million and receive a “stepped up” income tax basis equal to fair market value at death. • Alternatively, elect out of the estate tax regime, no estate tax is assessed and modified carryover basis rules apply in determining recipients’ income tax basis in the assets. • 2 Beginning in 2011, introduction of the portability of the estate tax exemption between married couples (Note: not applicable to GST tax exemption). • 3 Estate, GST, and gift tax exemptions are indexed for inflation in 2012. • 4 Indexed for inflation ($1.4M estimate).

5. Wealth Transfer Strategies Over Lifetime Annually Transfer of wealthexcluded fromany gift tax Transfer of wealththrough GST, estate,and gift tax exemptions Transfer of wealth utilizing discount strategies Transfer of wealth utilizing freeze strategies(appreciation-only gifts) Transfer of wealththroughtaxable gifts • $13,000 per individual ($26,000 gift splitting with spouse) per donee • Direct payments to educational institutions and health care providers1 • Irrevocable life insurance trusts (ILIT)2 • Gift tax exemption of up to $5M per individual • GST and estate tax exemptions of $5M per individual3 • Generation-skipping transfer trust (GST) • Family limited partnership (FLP) • Family limited liability company (FLLC) • Non-voting shares in family corporation (C or S corporation) • Grantor retained annuity trust (GRAT) • Intentionally defective grantor trust (IDGT) • Qualified personal residence trust (QPRT) • Intra-family loan • Statutory freeze partnership (FLP or FLLC)4 • Pay gift tax now rather than paying estate tax later • Converting traditional IRA to Roth IRA5 Charitable planning: CRTs and CLTs. 1 To qualify for exclusion, gifts (a) of tuition must be made directly to the educational institution; and (b) for medical expenses must be made directly to the health care provider. 2 Often can be structured to use annual exclusion gifting. 3 In 2011, an estate is taxed at a top rate of 35% with a $5 million estate tax exemption and a $5 million GST tax exemption. 4 Can serve to both utilize discount and transfer wealth utilizing freeze strategies. 5 Paying the income tax in converting a traditional IRA to a Roth IRA is essentially a gift tax-free gift.

6. Dynasty Trust – Overview of Technique Dynasty Trust Grantor No transfer tax paid. Discretionary Distributions to Children for Life • Advantages • Creditor protection • Divorce protection • Estate tax protection • Dispositive plan protection • Spendthrift protection • Consolidation of capital No transfer tax paid. Discretionary Distributions to Grandchildren for Life No transfer tax paid. Discretionary Distributions to Great-Grandchildren for Life Gift should take advantage of any remaining lifetime gift exclusion and lifetime GST exclusion No transfer tax paid. Future Generations

7. Non-Dynasty Trust Dynasty Trust Children’s Inheritance $10,000,000 Children’s Inheritance $10,000,000 Grandchildren’s Inheritance $21,082,083 Grandchildren’s Inheritance $32,433,975 Great-Grandchildren’s Inheritance $44,445,424 Great-Grandchildren’s Inheritance $105,196,274 Dynasty Trusts 1. Value of estate is $10,000,000. 3. One generation = 30 years. 2. After-tax growth rate of 4%. 4. Federal Estate Tax = 35%.

8. Dynasty Trust vs. 35% Estate Tax Every 30 Years

9. ILITs • Life Insurance trusts remain a key planning tool. • Increased exemptions provide additional opportunities. • ILIT will typically be designed as both a grantor trust and a generation-skipping trust.

10. ILITs • Large premium cases: • ILIT may not have enough Crummey beneficiaries to cover premiums. • Grantor may not have any unused gift tax exemption to cover premiums. • What is the exit strategy for: • Split-dollar plans. • Premium financing arrangements.

11. ILITs: Leveraging the GST Exemption Dynasty Trust Children’s Inheritance $28,000,000 • Amount of life insurance is $20 million. • Total premiums paid = $2 million. • Grantor allocates $2 million of his/her $10 million GST exemption. • This leaves Grantor with $8 million of GST exemption remaining. • Growth rate after taxes is 4% annually. • One generation = 30 years. Grandchildren’s Inheritance $90,815,130 Great-Grandchildren’s Inheritance $294,549,567 Great-Great-Grandchildren’s Inheritance $955,341,332

12. FLLC Family Limited Liability Company(“FLLC”)

13. FLLC • Donor can maintain control and management of investment assets (by retaining the voting membership interests). • Creates otherwise unavailable minority and marketability discounts for estate and gift tax purposes. • Protects investment assets from creditors or ex-spouses of members because “charging order” is sole remedy of creditors.

14. FLLC FLLC Governed by Operating Agreement Receive Voting Interests & Non-Voting Interests Contribute Assets Parents (Members & Managers) ILIT (Member) Gift/Sell Non-Voting Interests

15. FLLC FLLC FLLC’s assets protected from claims against individual members Income retained in FLLC or allocated among members based on percentage interests. Parents/Managers Gifts are easily made; reduce parent’s estate; and may qualify for valuation discounts. ILIT

16. GRAT Grantor RetainedAnnuity Trust(“GRAT”)

17. How Does a GRAT Work? • Grantor transfers assets to an irrevocable trust. • Annual annuity paid to Grantor for a term of years (in cash or in kind). • With zeroed-out GRAT, the value of the annuity = the value of the initial gift. • Assets remaining at end of term pass – tax free – to remainder beneficiary.

18. What are the Advantages of a GRAT? • Statutory technique. • Suitable for persons with substantial estates and growth assets. • Remainder beneficiary can be an ILIT.

19. What are the Advantages of a GRAT? • Permits tax-free gifts to beneficiaries. • Tax-free gift of appreciation in excess of IRC Section 7520 rate. • Grantor’s payment of GRAT’s income taxes is a tax-free gift to the beneficiaries. • No risk of unintended gift tax.

20. GRAT: 10-year term Grantor (age 65): $5 million Gift = $3.21 GRAT Value:$5 million Contribution of Assets Annual Annuity Distributions (12.5%) Remainder transferred to ILIT:Assumptions: 12% return: $4,545,224 10% return: $2,993,239 8% return: $1,727,268Section 7520 Rate = 2.4% Remainder after10 years Children or ILIT

21. GRAT Drawbacks • Grantor must survive the GRAT term. • Use an ILIT to “bullet proof” a GRAT. • Assets must outperform the IRC Section 7520 rate. • Cannot allocate GST exemption until end of GRAT term. • Congress may eliminate short-term GRATs. • Practical downside is transaction costs only.

22. IDGT Installment Sale toIntentionally-DefectiveGrantor Trust(“IDGT”)

23. IDGT • An IDGT is a type of trust where all income earned by the trust is taxed to the grantor because the trust is considered “defective” for income tax purposes, but “effective” for estate and gift tax purposes. • Defective nature of trust also allows for a “tax-free” gift to the trust’s beneficiaries when grantor pays income taxes otherwise attributable to the trust or its beneficiaries.

24. Installment Sale to an IDGT – Summary of Technique • Grantor sells an appreciating asset to an IDGT in exchange for an installment note. • For estate tax purposes the grantor should make an initial gift (at least 10% of the total transfer value) to the trust. • To the extent that the growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note, the “excess” is passed on to the trust beneficiaries free of any gift, estate and/or GST tax.

25. Installment Sale to an IDGT – Summary of Technique • No capital gains tax is due on the installment sale to the trust because the trust is “defective” for income tax purposes. • IDGT’s basis in the assets is Grantor’s carry-over basis. • Interest income on installment note is not taxable to the grantor because the trust is “defective” for income tax purposes.

26. Sale to an IDGT 1. Gifts $5M of LLC Non-Voting Interests 5. Excess Cash Flow / Premiums Grantor/ Insured IDGT Life Insurance Company 2. Sells $45M of LLC Non-Voting Interests (No Capital Gain Tax) 6. Death Proceeds (Income and Estate Tax Free / Leverages GST Exemption) 3. $45M Note to Grantor Balloon Payment in 9 Years 4. $1,098,000 annual interest (Interest Rate 2.44%) • Advantages: • Value of assets sold frozen at 2.44% for nine years (assumed mid-term AFR). • Grantor’s estate further reduced by the income taxes paid on behalf of the trust. • The trust property escapes estate taxation for as long as permitted under state law. • Possible valuation discounts for non-voting interests.

27. Low Interest Rate Loan to IDGT 1. Gifts $5M 5. Excess Cash Flow / Premiums Grantor/ Insured IDGT Life Insurance Company 2. Loans $45M 6. Death Proceeds (Income and Estate Tax Free / Leverages GST Exemption) 3. $45M Note to Grantor Balloon Payment in 9 Years 4. $1,098,000annual interest (Interest Rate 2.44%) • Advantages: • Value of loan proceeds frozen at 2.44% for nine years (assumed mid-term AFR). • Grantor’s estate further reduced by the income taxes paid on behalf of the trust. • The trust property escapes estate taxation for as long as permitted under state law. • Possible valuation discounts for promissory note in grantor’s estate.

28. Grantor Trust vs. Non-Grantor Trust

29. Installment Sales to an IDGT - Example Amount passing to beneficiaries free of estate and gift tax And income tax on trust income is paid by grantor as additional “gift” without gift tax

30. IDGT vs. GRAT • No mortality risk with IDGT. • Can allocate GST exemption to seed gift. • Mid-term AFR is less than Section 7520 rate. • Back-loading (i.e., interest only with balloon payment vs. level annuity payment). • Not a statutory technique. • Possibility of unintended gift tax, which may be mitigated by using a “defined value” clause.

31. QPRT Qualified PersonalResidence Trust(“QPRT”)

32. QPRTs • Increased popularity in light of enhanced gift tax exemption and reduced fair market value of residential real estate. • Potential for large estate tax savings. • Very low tax risk: statutory technique. • Relatively easy to implement and administer.

33. QPRT: Personal Residence • Primary residence. • Vacation residence. • Fractional interest in a residence. • No more than 2 residences at a time. • Rental property or commercial use not permitted. • Mortgaged property complicates the planning. • Some surrounding land permitted, but not too much.

34. How Does a QPRT Work? • Grantor makes a gift of the residence to a trust. • Grantor retains right to occupy the residence during the QPRT term.

35. How Does a QPRT Work? • Grantor is entitled to 2 key discounts to current FMV: • Cost of waiting: Beneficiaries must wait to receive the residence (when the QPRT term expires). • Possibility of reversion: Grantor retains the “right to get the residence back if he/she dies before the QPRT term ends. • These discounts can result in substantial reductions to current FMV.

36. How Does a QPRT Work? • Grantor can continue to occupy the residence following the QPRT term, though the Grantor will have to pay FMV rent. • Grantor continues to receive tax deductions for property taxes and remains eligible for exclusion from gains tax on resale (if primary residence).

37. QPRT: Tax Benefits • No gift tax consequences unless Grantor has already used up his/her $5 million lifetime gift tax exemption. • All appreciation is out of the Grantor’s estate for estate tax purposes. • Any rent the Grantor pays after the QPRT term is out of his/her estate for estate tax purposes.

38. QPRT: Tax Benefits • If residence in a grantor trust at end of term, the rent payments will not be subject to income taxes. • There could be property transfer tax consequences at end of QPRT term.

39. QPRT: Drawbacks • Grantor must survive the QPRT term. • Use an ILIT to “bullet proof” a QPRT. • The QPRT is an irrevocable trust – there may be no commutation. • May use some or all of Grantor’s lifetime gift tax exemption. • Grantor may have to rent the property back at end of QPRT term. • Cannot allocate GST exemption until end of QPRT term

40. QPRT Residence Grantor QPRT Rent Free Right of Use of Residence for 15 Years After Expiration of Selected Term of Years Grantor’s Age 70 FMV of Residence $1,000,000 FMV in 15 years at 5% growth $2,079,000Term of QPRT 15 Years Initial Gift $295,820 FET Savings (35%) $624,088 §7520 Rate 3% ASSUMPTIONS: Grantor Childrenor ILIT Pays RESULTS: Rent

41. CRUTs Charitable Remainder Unitrusts(“CRUTs”)

42. CRUTs: Common Features • Grantor transfers assets to an irrevocable trust. • No capital gains tax on the sale of appreciated assets by the trust. • Grantor and spouse are lifetime beneficiaries of the trust.

43. CRUTs: Common Features • Charities named by grantor are remainder beneficiaries of trust. • Grantor and/or grantor’s spouse can be the trustees of the trust.

44. CRUTs: Common Features • Trustee can control timing and amount of income distributions to grantor and grantor’s spouse. • Trust assets are protected from creditors. • Grantor receives a charitable income tax deduction (of at least 10%) based on the present value of the remainder interest.

45. CRUTs: Common Features • Assets in trust are excluded from grantor’s and grantor’s spouse’s gross estates. • Life insurance “replaces” the assets passing to charity with premiums paid for out of the tax savings.

46. CRUTs: Common Uses • To diversify low basis/low yield investments. • To sell an asset without a capital gains tax.

47. CRUT Diagram $1,000,000 Property$100,000 Cost Basis Donor (Age 70) CRUT2% growth / 6% income Charity At Donor’s Death (14 years)Remainder to Charity$1,513,600 5% Unitrust Income tax deduction $529,380 Gain not taxed $900,000 First year payment $50,000 Total Payments (14 yrs) $854,600 IRC Section 7520 Rate 3.4%

48. CRUTWealth Replacement with Insurance GRANTOR Annual Gifts Life Insurance / Dynasty Trust for benefit of heirs Tax savings from income tax deduction; and increased cash flow from not paying capital gains taxes.

49. NIM-CRUTs • A Net Income with Makeup Charitable Remainder Trust or NIM-CRUT is a type of CRUT where a fixed percentage (minimum of 5%) of the annual value of trust assets is credited to the income beneficiary. • If the net income is less than the fixed percentage, then any deficiencies are "made up" in later years when trust income exceeds the required set percentage amounts for such years.

50. NIM-CRUTs • If there is insufficient income to meet the payout, the income beneficiary must wait until sufficient income exists. • Until such time however, the income beneficiary's "make-up account" will continue to build. • Once income is sufficient, the income beneficiary will be entitled to the entire buildup in the "make-up account."