A Tax Marriage Made in Heaven

I often write separate articles about the tax magic of irrevocable life-insurance trusts (ILITs) and intentionally defective trusts (IDTs). Now get ready for the wedding ceremony joining ILITs and IDTs.

An ILIT allows the death benefits of the life insurance it purchases to be received tax-free—no income tax and estate tax. A fly in the ointment: Necessary gifts each year by the trust creator to pay premiums kicks up a gift-tax problem. Marrying an ILIT to an IDT eliminates the problem, and also creates a host of tax-free and wealth-building opportunities.

An IDT—also irrevocable—is defective only for income-tax purposes. In all other respects, it is the same as any other irrevocable trust. An IDT is the perfect strategy to transfer income-producing assets such as a family business or real estate from parents to children, and the transfer is tax-free. For example, when transferring a closely held business, the tax savings run about $200,000 per $1 million of the stock value.

Before we tie the knot between ILIT and IDT, let’s discuss the concept of arbitrage—the purchase and sale of the same or equivalent security in different markets in order to profit from the price discrepancies, profit being the key concept here. What makes the marriage work? Anyone that owns an asset earning a rate of return exceeding today’s low interest rates can use the arbitrage profit to pay insurance premiums, creating tax-free wealth while avoiding any losses to the IRS.

Crazy American tax law provides for various discounts, such as a discount for lack of marketability and a discount for minority interest, that reduce the real market value of an asset in the 30- to 40-percent range for tax purposes, increase the arbitrage profit and make the tax-savings a slam dunk.

Here’s how to initiate and complete an arbitrage ILIT.

Step 1. Create the arbitrage ILIT. A lawyer must create the trust defective for income purposes, combining the ILIT an IDT in one document. Joe, our tax hero in this example, will be responsible for personally paying the income tax due on all trust earnings, because the trust is ignored for income-tax purposes. The basic facts: Joe is married to Mary, and both are 65 and in good health. An insurance consultant quotes the cost of a second-to-die policy at $11,832 per $1 million of death benefit. Joe owns Success Co. (an S corporation worth $6 million), run by his son Sam. Joe and Mary want Sam to own Success Co. A major concern is how to treat their two nonbusiness kids equally—aside from Success Co., they have $5 million of other assets; about one-half is liquid.

Step 2. Select the asset to sell to the ILIT. Typically, the creator of the ILIT will sell one of three types of assets to the ILIT: 1) Stock of a closely held business; 2) An interest in a FLIP (family limited partnership), which owns real estate and/or securities; or 3) an interest in an LLC (usually holding real estate). Regardless of the asset selected, the transaction is arranged so Joe keeps absolute control of the asset for as long as he lives, even though the asset is out of his estate.

Joe decides to sell all of the nonvoting stock (10,000 shares) he owns in Success Co. to the ILIT, keeping all 100 shares of the voting stock. So, Joe gets Success Co. out of his estate while keeping control.