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OnTopic
NEWS AND EVENTS RELEVANT TO ADVANCED MARKETS
2014 – ISSUE 03
Certainty Beyond “Death and Taxes”
Benjamin Franklin’s efforts to arrange political and military support during the American Revolution as the U.S.
Ambassador to France are well known. Lesser known are his friendships with French scientists fostered by his interest in
electricity. One of these scientists was physicist Jean-Baptiste Leroy. Franklin wrote to his friend during the French
Revolution expressing his concern for Leroy’s safety, and discussing his hopes for the new U.S. Constitution. Franklin
wrote, “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world,
nothing is certain except death and taxes.”i
Though Benjamin Franklin believed taxation to be as inevitable as death, modern day financial planners know better.
While taxation is certain, there is no shortage of techniques taxpayers can use to reduce the amount the IRS wants us to
pay. In addition to the life insurance protection and providing retirement savings, life insurance and individual retirement
accounts (IRAs), provide a potential savings opportunities. In this issue of OnTopic we consider two strategies using these
tools – one familiar and one perhaps less so—that can help to reduce those painful tax bites.
Life Insurance Held in an Irrevocable Trust
Clients with a will and enough wealth to expect to pay estate tax are well advised not to overlook the tried-and-true
approach of using an ILIT to hold life insurance. Placing a life insurance policy in an irrevocable life insurance trust:
 provides liquidity to pay estate taxes on illiquid assets (e.g., a property or a business)
 allows wealth to pass to heirs outside the estate
 avoids estate taxation of life insurance proceeds
 provides for the income needs of survivors
 shelters property from creditors at death, and
 ensures a source of funds for charitable contributions.
In essence, an ILIT provides heirs with attractive flexibility when settling the estate. Without it, heirs might be forced to sell
real estate, stocks, or a family business to raisecash to pay final expenses, including taxes.ii
The grantor creates an ILIT by transferring a life insurance policy (usually on the grantor’s life, with family members as
beneficiaries) to the trust, retaining no rights to revoke, terminate or modify the trust. It is, of course, common practice for
grantors to use the annual gift tax exclusion ($14,000 per donee in 2014) to transfer tax-free funds to the trust to make
annual premium payments.
However, when the trust provides that death proceeds are to be held in trust at the insured’s death (rather than paid
immediately to a beneficiary), each transfer of a premium payment to the trust is considered a gift of a future interest.iii
Normally, the $14,000 annual gift tax exclusion is only available to shelter gifts of a present interest. To avoid this
unpleasant result, the grantor must provide Crummey powers to the beneficiaries. (Such an ILIT may be referred to as a
“Crummey trust” after a famous court case of the same name—Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968)).
The Crummey power enables gifts of premiums to an ILIT to be treated as gifts of a present interest by allowing trust
beneficiaries the right to immediately withdraw cash transfers to the trust. Naturally, the grantor hopes the beneficiaries
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won’t exercise this power, but the mere fact that they could may be sufficient to convert a future-interest gift into a
present-interest gift that qualifies for the gift tax annual exclusion.iv
Grantors must be careful when setting up this type of ILIT, as use of the Crummey power can become complex when
multiple beneficiaries are involved. To take just one example, the IRS considers the lapse of the withdrawal power by
one beneficiary to be a gift to the other beneficiaries under IRC Sec. 2514. It is essential for the grantor to engage a
knowledgeable planner when drafting these trusts.
Despite its potential for complexity, the ILIT’s advantages are powerful:
 assets owned by the ILIT are not considered part of the estate for estate tax purposes—heirs pay no estate or
inheritance taxes
 gifts made to the trust to pay insurance premiums are excluded from the estate through use of Crummey powers
and up to the annual gift tax exclusion
 death benefits paid to beneficiaries are not considered taxable income by the IRS
Contrast this result to an inherited individual retirement account (IRA) where assets must be withdrawn according to
required minimum distribution rules and the heirs have to pay ordinary income tax on the distributions.
Of course, it’s vital for a grantor to select a trustee with the knowledge and experience to keep the insurance policy in
force through the timely payment of premiums and to keep the beneficiaries informed of their rights and responsibilities.
WHAT TO DO
It’s important for producers to gain a thorough understanding of ILITs and the Crummy Power— the rules are quite
complex, especially where there are multiple beneficiaries. Discuss the potential benefits of ILITs with high net worth
clients, stressing the flexibility they offer in settling an estate. Remember, assets owned by the ILIT are not considered part
of the estate for estate tax purposes and heirs pay no estate or inheritance taxes.
WHERE TO LOOK
To access the Reference Library, click here. Choose “Estate Planning,” then “Trusts,” then “Irrevocable Life Insurance
Trusts.” For more information, please refer to Advanced Markets Portal or contact Advanced Markets directly (866323-6923 or [email protected]) or contact your American General representative.
Loaning IRA Assets to Charity
Like all good American celebrities, Ben Franklin had a charitable cause—abolishing slavery. In the years before his
death, Franklin freed his remaining two slaves and became a vocal abolitionist.v Many IRA owners have charitable
passions of their own, so let’s consider a possible tax-reduction strategy that could fit the needs of philanthropically
inclined IRA owners.
A simple, straightforward way to reduce tax on the money left in an IRA at death is, of course, to name a charity as the
beneficiary on a form provided by the IRA custodian. The charity receives the full value of the IRA tax free while the
estate is entitled to a full charitable deduction.vi
However, an IRA owner may not want to wait until death to make a charitable gift—the charity may need the money
right now, or the IRA owner may wish the pleasure of seeing the impact of the gift. One way to transfer assets to a
charity without taking a taxable distribution is known as a Charitable IRA or simply a CHIRA. With this strategy, an
individual loans IRA assets to a charity in exchange for a promissory note paying a specified amount of interest. The IRS
addressed this strategy in Private Letter Ruling (PLR) 200741016.vii
The donor in the PLR directed his IRA to lend money to a qualified charity in return for a 20-year promissory note paying
5% annually. The note provided for a balloon payment of the principal after 20 years (or upon death, if earlier). To
provide collateral for the note, the charity bought a life insurance policy on the life of the IRA holder, owned by the
charity, so that if the donor died prior to the full payment of the note, the death benefit would provide the remaining
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payments owed, and the rest would go to the charity. The loan payments from the charity to the IRA provided the cash
for the donor to take required minimum distributions from the IRA.
Example
Anna directs her IRA to lend $200,000 to her favorite charity. The charity allocates $100,000 to pay premiums on a
new policy on Anna’s life, and $60,000 to pay the required annual interest on the $200,000 loan. This leaves
$40,000 for the charity to use immediately. At Anna’s death, the charity receives $200,000, which it uses to pay off the
principal of the loan. Any excess remains with the charity. Since the charity makes the interest payments directly to the
IRA, they are considered tax-deferred gain. Anna’s spouse could then inherit the IRA when she dies and either maintain
it or roll the proceeds to another IRA in his own name.viii
While the use of the charitable IRA strategy has many advantages, it also requires the IRA owner to overcome important
hurdles:
 the loan cannot be made between the IRA and a “disqualified person”
 the promissory note must reflect a fair rate of return
 the loan must be considered a prudent investment
 the charity must have an insurable interest in the life of the IRA owner under state law
 the IRA cannot be considered an impermissible investment in life insurance
In the Private Letter Ruling, the IRS dealt with these issues and set the standard for those want to set up a CHIRA:
 The IRS found that an IRA owner may make a loan to a public nonprofit provided that it does not constitute a
transaction with a “disqualified person” under IRC §4975(c)(1)(B). IRC §4975(e)(2) lists disqualified
individuals as fiduciaries, employers, employer organizations, 50% owners of the equity or beneficial interests
in an entity. Provided the relationship between the donor and the nonprofit charity is appropriate under the
definition, the IRS will permit a loan to a public nonprofit organization.
 With respect to the interest rate, the IRS publishes a monthly revenue ruling listing the applicable federal rate
(AFR) for loans. Typically, a loan from an IRA to a nonprofit will be a long-term loan with annual payments;
therefore, the AFR for annual payment long-term duration loans should be the interest rate utilized for the
charitable IRA loan.
 If the loan to the charity bears a reasonable rate of interest, the IRS will deem it to be a prudent investment, even
though the IRA owner might have realized superior investment returns in other markets.
 Finally, since the IRA owner is a regular donor to the charity, under state law the charity has an insurable
interest in the life of the IRA owner. Because the charity owns and controls the insurance policy and is also the
beneficiary, the IRA is not making a prohibited life insurance investment under IRC §408(a)(3).ix
WHAT TO DO
The benefit of loaning IRA assets to a charity lies largely in the client’s desire to enjoy the act of giving during life; so this
strategy first requires an IRA owner with charitable intentions. In more complicated circumstances, a private IRS ruling
may be advisable. Despite these hurdles, insuring a CHIRA transaction could be a wise move for many charitably
minded clients.
WHERE TO LOOK
To access Reference Library, click here. Choose “Charitable Giving,” then “Charitable Giving and Retirement Assets,”
then “Strategies for Creating Lifetime Charitable Gifts with Retirement Assets.” For more information, please refer to
Advanced Markets Portal or contact Advanced Markets directly (866-323-6923 or [email protected]) or
contact your American General representative.
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It is certain that taxes will always accompany wealth, and the tax code reflects the political notion that higher income
earners should pay higher rates. Yet, with good planning, an individual can implement various techniques to postpone,
reduce or even eliminate the tax bite. Even a small tax reduction can have a big impact—after all, as Ben once said in
Poor Richard’s Almanac, “a penny saved is a penny earned.”x
i
http://en.wikipedia.org/wiki/Death_&_Taxes and http://www.encyclopedia.com/doc/1G2-2830902575.html.
The grantor should always consult an advisor regarding use of an ILIT to ensure coordination of the federal estate tax exclusion ($5,340,000 in
2014, or $10,680,000 for a married couple utilizing portability) with the applicable estate tax provisions of the state in which the grantor resides.
iii
The IRS ruled that an employer’s payment of monthly premiums for group term life insurance held in an employee’s irrevocable trust qualified for
the gift tax annual exclusion. The IRS considered the premiums a present interest because, under the terms of both the group insurance policy and
the trust, death proceeds were payable to the trust beneficiary immediately upon the death of the insured. Revenue Ruling 76-490, 1976-2 C.B.
300; see also General Counsel Memorandum 37451.
iv
The Crummey power for each holder is limited to the greater of $5,000, or 5% of principal. If the beneficiary’s annual right of withdrawal does
not exceed the “five-and-five” limits, the amount is generally excludable from the beneficiary’s gross estate. If the beneficiary’s right of withdrawal
exceeds the five-and-five limits, the excess amount will be includable in the beneficiary’s gross estate.
v
In 1789, Benjamin Franklin wrote, “Slavery is such an atrocious debasement of human nature, that its very extirpation, if not performed with
solicitous care, may sometimes open a source of serious evils.” http://memory.loc.gov/cgibin/query/r?ammem/rbpe:@field%28DOCID+@lit%28rbpe14701000%29%29
vi
IRC §2055(a).
vii
A PLR cannot be relied upon as authority by anyone other than the taxpayer to whom it was issued, but it does provide insight as to how the IRS
may view similar transactions.
viii
Non-spouse beneficiaries do not have the same options as surviving spouses.
ix
Another concern about the CHIRA arrangement is the potential for unrelated business taxable income (UBTI). In Mose and Garrison Siskin
Memorial Foundation, Inc., v. United States, 790 F.2d 480 (6th Cir. 1986), a charity owned 800 insurance policies and desired to increase total
return. Policy loans at 5½ percent interest were withdrawn and invested at approximately 10 percent, producing an annual profit of 4½ percent.
The court determined that because the loans were “acquisition indebtedness” under IRC §514(c), that profit was UBTI. Similarly, because a loan
from the IRA to the charity may be invested and produce income, there is a potential for UBTI on the debt-produced revenue. If all of the payments
from the owner are invested in the insurance policy, it is possible that the exception on proceeds of life insurance would eliminate the UBTI issue.
However, if there are any other earnings or capital gains during the life of the owner that can be traced to the investment of IRA loan proceeds,
then acquisition indebtedness and UBTI would apply.
x
Though earlier versions of the quote exist, the closest time the phrase “a penny saved is a penny earned” could be attributed to Benjamin Franklin
is after his death when it appeared in the Pall Mall Magazine. http://phrases.org.uk/meanings/a-penny-saved-is-a-penny-earned.html.
ii
FOR FINANCIAL PROFESSIONAL USE ONLY - NOT FOR PUBLIC DISTRIBUTION. Advanced Markets is a marketing unit of American General Life Insurance Company (AGL), a
member of American International Group, Inc. (AIG). No representation or warranty, express or implied, is made by AGL or its affiliates as to the completeness of the information
provided. All companies mentioned, their employees, financial professionals and other representatives are not authorized to give legal, tax or accounting advice. Applicable laws and
regulations are subject to change and individuals should consult an attorney, tax advisor or accountant. Any tax statements in this material are not intended to suggest the avoidance of
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U.S. federal, state or local tax penalties. 2014. All rights reserved. AGLC107893-003