Gift tax planning: Divide and cope with a split-dollar arrangement
Looking into ways to cope with future gift tax liability is a good idea — especially this year: The present $5.12 million gift tax exemption is scheduled to drop down to just $1 million in 2013. One strategy to consider: a split-dollar insurance arrangement. This article examines how establishing an irrevocable life insurance trust (ILIT) to buy and hold a life insurance policy can set the table for a split-dollar arrangement that helps transfer wealth effectively.
Have gift taxes been on your mind? If not, perhaps they should be. For 2012, the gift tax exemption is $5.12 million. But, as of this writing, it’s scheduled to drop down to just $1 million in 2013. So looking into ways to cope with future gift tax liability is a good idea. One strategy to consider: a split-dollar insurance arrangement.
Start with an ILIT
A life insurance policy can do many good things. But there are risks. One is that, upon your death, its death benefit could be includible in your estate and subject to estate taxes. A common means of avoiding this — and setting the table for a split-dollar arrangement — is establishing an irrevocable life insurance trust (ILIT) to buy and hold a life insurance policy.
This will keep the death benefit out of your estate while still allowing your heirs to receive the proceeds. You fund the ILIT by making periodic contributions, which will be considered gifts to the ILIT beneficiaries.
But you can’t hold any “incidents of ownership” in the insurance policy. For example, you may not retain the right to change beneficiaries or borrow against the cash value of the coverage.
Split it up
Although an ILIT will likely shield policy proceeds from estate taxes, it could still spur gift taxes if your available annual gift tax exclusions and lifetime exemption don’t sufficiently shelter your contributions. This is where a split-dollar concept comes into play.
Under this arrangement, you set up an ILIT that purchases a second-to-die policy on you and your spouse. You make contributions equal to 100% of the premiums. Following the second spouse’s death, the insurance proceeds will be split between that spouse’s estate and the ILIT’s beneficiaries.
In a properly designed and executed split-dollar arrangement, the gift tax value of contributions will be estimated by the IRS based on the “economic benefit” received by the ILIT. The agency uses its own tables to measure the current cost of life insurance, and the result is usually only a small percentage of the total premium.
Think it through
Don’t let the brevity of this article mislead you as to the complexity of the split-dollar arrangement: It’s a sophisticated vehicle that brings risks along with potential rewards.
Although such an arrangement can help you transfer wealth effectively, it could miss the mark if not set up and maintained correctly. Or worse, it could invite an IRS challenge. Ask your financial advisor for guidance in determining whether a split-dollar arrangement is the right move for your family.
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