"Wait and see" GST tax planning.

• Author: O'Connell, Frank J., Jr.
• Position: Generation skipping transfer

If an irrevocable life insurance trust (ILIT) holds only term insurance (i.e., with no cash surrender value (CSV)), it is possible (and often recommended) not to allocate any generation-skipping transfer (GST) tax exemption to the trust until after the insured dies. Although this technique is extremely effective if a client is "cooperative enough" to the relatively suddenly, this plan can be a trap if the client develops health problems in the calendar year before death.

Background

Generally, the overall goal is for the ILIT to be fully exempt from the GST tax, while using as little as possible of the donor's lifetime GST exemption. There are two ways to make the trust fully exempt. One method is relatively simple, but ultimately uses more of the exemption. The other requires more planning, but can achieve a zero inclusion ratio without using as much of the GST exemption.

The two methods involve allocating a GST exemption either (1) to the trust on an annual basis equal to each trust contribution or (2) against the trust's fair market value (FMV) at the time of the allocation. If the latter is used, then after a GST allocation is made against the net value (which has the effect of "catching up" for prior years in which no exemption was allocated against the premiums), the GST exemption needs to be allocated (dollar-for-dollar) against all subsequent trust contributions to maintain the trust's exempt status.

For most ILITs that hold either whole life or universal life policies, the policy's FMV will be smaller than the premiums paid during the first few policy years. Thus, the best way to achieve exempt status while using the least amount of GST exemption is to not allocate any GST exemption against the premiums when they are contributed to the trust, but rather to allocate an exemption at a later date against the (then-lower) value of the trust at that time. Before the allocation date, the trust would be fully subject to the GST tax; once the GST exemption is allocated against the current FMV, the trust would become exempt.

Example 1: An ILIT holding a whole life insurance policy receives a $10,000 premium each year, but the CSV at the beginning of year 10 is only $30,000. If $10,000 of GST exemption had been allocated against the trust each year, the $100,000 total would have made the trust fully exempt at all times. Alternatively, exempt status can be achieved by waiting until year 10 to make a "late allocation" of $40,000 of GST...