The insurance industry's lobby is among the most powerful in Washington. Over the years it has created all kinds of tax breaks for insurance consumers, benefitting them and the insurance companies which sell them policies.
One such tax break is "inside buildup." The idea is that cash values growing within life insurance policies aren't subject to current income tax.
In recent years "variable" life insurance policies have been designed to make the most of the tax shelter's wealth accumulation possibilities. Simply put, the policyholder is invited to park some of her premium dollars in one or more investment "subaccounts," which look like mutual funds. Interest, dividends and capital gains completely escape current income tax.
People who market insurance products make a compelling case for their cost-efficiency when income taxes can be postponed until money is withdrawn from a policy. Better still, with proper planning, income taxes may never become due. The policyholder's investment and all it earns can be retrieved altogether free of tax through a combination of principal refunds and policy loans.
The whole strategy depends upon the policy's providing a death benefit which, at any given point in time, exceeds its cash value - a death benefit which, under ordinary circumstances, would eventually be includible in one's taxable estate. The planner's challenge becomes clear: to give the policyholder income tax-favored access to her cash value - without burdening her family with additional estate taxes when she dies.
One solution is a Spousal Lifetime Access Trust, or a "SLAT." A SLAT is an irrevocable trust which a grantor-insured creates for the benefit of her spouse. The trust owns the policy and can keep its proceeds out of the insured's taxable estate.
For a SLAT to work the way it's supposed to, its trustee must not be the insured, nor can she maintain an interest in the trust or any "incidents of ownership" in the policy it owns. But what can't be done directly can sometimes be achieved indirectly... so the insured's spouse can and often does serve as trustee.
As a general rule, policy payouts can also be kept out of the spouse's estate by limiting trust distributions in his favor to 5% of the trust's value each year or $5,000, whichever is greater; plus any other amounts required for his "health, education, support, or maintenance." Taken together, the "5 or 5" power and the funding of such basic living expenses can provide broad, but not unfettered, access to the trust's assets - while excluding policy proceeds from the estates of both the grantor-insured and her spouse.
Another design option is to appoint an independent trustee to oversee the trust. The "5 or 5" power and the "health, education, support or maintenance" limits won't apply, and there won't be any estate inclusion when the spouse dies. But the spouse beneficiary will run the risk that the trustee might not want to distribute cash when he asks for it.
Whoever serves as trustee, the distributions he or she makes will benefit from favorable income tax treatment: policy loans and withdrawals should be income tax-free when they're received by the spouse.
Where's the rub? The spouse - and not the insured - is the trust's beneficiary. So, if the spouse dies or if the couple divorces, the insured's indirect access to the policy's cash value may be placed at risk.
The SLAT, then, requires careful planning and careful drafting. It is a deservedly popular way to maximize the income tax benefits of life insurance - without suffering its estate tax costs.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.