Avoiding the Generation-Skipping Transfer Tax on Life Insurance Proceeds

If certain requirements are met, a transfer to an irrevocable life insurance trust can qualify for the annual exclusion (and thus avoid the generation-skipping transfer tax). A nontaxable gift, which is a direct skip, has an inclusion ratio of zero (i.e., it is not subject to GST tax). Nontaxable gifts are defined as gifts eligible for the annual exclusion (doubled if gifts are split between spouses), as well as certain transfers for educational or medical expenses. However, with respect to transfers after March 31, 1988, the nontaxable gift that is a direct skip to a trust for the benefit of an individual has an inclusion ratio of zero only if (1) during the life of such individual no portion of the trust corpus or income may be distributed to or for the benefit of any other person, and (2) the trust would be included in such individual's estate if the trust did not terminate before such individual died. Thus, separate shares or separate trusts, as described in the preceding sentence, must be created for each such individual if premium payments are to be covered by the annual exclusion for GST tax purposes

How can the generation-skipping transfer (GST) tax exemption be leveraged using an irrevocable life insurance trust?

Leveraging of the GST tax exemption can be accomplished by allocating the exemption against the discounted dollars that the premiums represent when compared with the ultimate value of the insurance proceeds. However, in the case of inter vivos transfers in trust, allocation of the GST exemption is postponed until the end of an estate tax inclusion period (ETIP). In general, an ETIP would not end until the termination of the last interest held by either the transferor or the spouse of the transferor during the period in which the property being transferred would have been included in either spouse's estate if that spouse died.

Of course, the transferor should be given no interest that would cause the trust property to be included in the transferor's estate. Furthermore, the transferor's spouse should be given no interest that would cause the trust property to be included in the transferor spouse's estate if the transferor spouse were to die.

The property is not considered as includable in the estate of the spouse of the transferor by reason of a withdrawal power limited to the greater of $5,000 or 5 percent of the trust corpus if the withdrawal power terminates no later than sixty days after the transfer to the trust. Also, the property is not considered as includable in the estate of the transferor or the spouse of the transferor if the possibility of inclusion is so remote as to be negligible (i.e., less than a 5 percent actuarial probability). Furthermore, the ETIP rules do not apply if a reverse qualified terminable interest property (QTIP) election is made. Otherwise, if proceeds are received during the ETIP, the allocation of the GST exemption must be made against proceeds rather than premiums and the advantage of leveraging is lost.

Example 1.  G creates a trust for the benefit of his children and grandchildren. Each year he transfers to the trust $50,000 (to be used to make premium payments on a $2 million insurance policy on his life) and allocates $50,000 of his GST exemption to each transfer. Assuming G makes no other allocations of his GST exemption, the trust will have a zero inclusion ratio (i.e., it is not subject to GST tax) during its first twenty years. At the end of twenty years, G will have used up his GST exemption and the trust's inclusion ratio will increase slowly with each additional transfer of $50,000 to the trust. If G died during the twenty-year period, the insurance proceeds of $2 million would not be subject to GST tax. Part of the $2 million proceeds may be subject to GST tax if G died in a later year. To ensure that the trust has a zero inclusion ratio, use of a policy that becomes paid-up before the transfers to trust exceed the GST exemption may be indicated.

Example 2. Same facts as in Example 1, except that the trust is created for G's spouse, S, during her lifetime, and then, to benefit children and grandchildren. If the trust is intended to qualify for the marital deduction (apparently, other than if a reverse QTIP election is used), the valuation of property for purpose of the ETIP rule is generally delayed until G or S dies because the property would have been included in S's estate if she died during the ETIP. Consequently, if the $2 million insurance proceeds are received during the wife's lifetime, the GST exemption is allocated against the $2 million proceeds, and a substantial amount of GST tax may be due upon subsequent taxable distributions and taxable terminations from the trust. Because allocation of the exemption must be made against the proceeds if they are received during the ETIP, the advantage of leveraging enjoyed in Example 1 is lost.

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