My clients, Frank and Janelle, are dairy farmers in California. They have been married for 15 years and have three children: Jason, Katie and Fred. They milk roughly 3,000 head and farm 500 acres. Soon after they were married, they purchased life insurance on each other to provide survivor income – in other words, Janelle owns a policy on Frank’s life and vice versa. Since then, their wealth has increased significantly. Based on their net worth (around $15 million not including death benefits of the life insurance), there will be an estate tax due on the survivor’s death.

To allow the insurance policies to help solve their estate tax dilemma rather than exacerbate it, both Janelle and Frank want to remove the policies from their taxable estates.

Their conundrum: The estate tax exemption for 2012 may stay at $5.12 million per person ($10.24 million per couple) and a 35 percent tax rate.

However, Congress could let it reset to $1 million per person ($2 million per couple) and a 55 percent tax rate at the end of the year. It might go away for Frank and Janelle if the exemption amount sufficiently increases or their net worth decreases.

Now, they still want access to the cash values and death benefit on each other’s policies – can they accomplish this goal while getting these values out of both of their estates? Yes – by transferring the policies to a well-designed irrevocable trust that imitates their objective of outright ownership.


The first step to mimic outright ownership is to determine what it means to own property. Fundamentally, it means the right to control it, enjoy it and transfer it.

If Janelle owned the policy, she could control it – change the owner, change the beneficiary, select settlement options. She could enjoy it – use the cash values, through surrenders and loans, for her personal wants and needs. And she could obviously transfer it.

Can she maintain those same rights if an irrevocable trust owns the policy on Frank’s life? Basically, yes. She can control the policy if she is the trustee. She can enjoy the policy if she is a beneficiary.

She can be given the power to transfer the policy, known in legalese as a power of appointment. There does need to be some limit to Janelle’s rights, but those limits can still give her amazing flexibility.

Janelle’s right as trustee to make distributions to herself must be limited by an ascertainable standard relating to her health, education, maintenance and support. Courts have construed this standard broadly.

And the trust can allow for distributions to Janelle over and above this standard as long as those distributions are exclusively within the discretion of another trustee, which can be someone like Janelle’s mom, sister or friend – in other words, a person sympathetic to her and her needs.

Janelle’s ability to transfer the trust’s property also must be limited but, again, not very much. Janelle cannot have the unfettered power to transfer property to herself, her estate or the creditors of either.

So what the trust can do is give Janelle a limited power of appointment – a fancy way of saying she’ll have an unlimited power to transfer trust property to anyone in the world except the “forbidden four.”

In fact, because Frank is not one of the forbidden four, Janelle could even appoint the policy to him without tax consequences if, for example, the estate tax repeal becomes permanent. Hey, stranger things have happened.

The children also should be trust beneficiaries so if they need money, Janelle can make non-taxable distributions to them.

But the trust must limit Janelle’s ability to make these distributions because, under state law, while they are minors she has the obligation to support them. As to those support obligations, they become her creditors – one of the forbidden four.

The trust will provide that Janelle can only make distributions to the kids for non-support wants and needs.

By the way, the trust must not allow distributions to satisfy Frank’s obligations for the same reason. However, the sympathetic trustee (that is, not Janelle) could make support-based distributions to the kids after Frank’s death.

But how does Janelle get the policy into the trust? The simplest way is to have Janelle give it to the trust. The problem is if Janelle makes gifts to a trust over which she has the powers discussed above, the trust property will be in her gross estate.

Is there another way to get the policy into this trust? Janelle can sell the policy to the trust. Frank can give his separate property to the trust so it has sufficient funds to buy the policy from Janelle.

To avoid inclusion of the trust property in Janelle’s gross estate, the trust must pay full and adequate consideration – the policy’s fair market value.

If this is a policy that has been in force for some time yet still has premiums due, that value is generally the policy’s interpolated terminal reserve plus unused premiums minus any loan.

Usually that is about equal to the policy’s net cash value, which means Frank can give less to the trust to buy the policy if its net cash value is reduced. Janelle may be able to accomplish this by exercising policy provision before the sale.

Because Janelle is selling the policy to avoid estate inclusion, she is transferring life insurance for valuable consideration. The death benefit becomes potentially subject to income tax under the transfer-for-value rule. The reason it is potentially subject to income tax is because this rule has exceptions.

One of those exceptions is where the transferee’s (trust’s) basis is determined in whole or in part by reference to the transferrer’s (Janelle’s) basis.

As long as the trust is designed as a grantor trust for income tax purposes, the trust will get the benefit of that exception. If the trust is a grantor trust, it will be treated as its grantor (Frank) for income tax purposes.

The IRS will treat this sale as a sale from Janelle to Frank.

Sales between spouses are disregarded for income tax purposes – therefore, the trust will take a basis in the policy equal to Janelle’s basis. Or Janelle could give the policy back to Frank, who could sell it to the trust. If he sells, rather than gives the policy to the trust, the three-year rule will not be triggered.

Chances are, because this idea works so well, Frank will want to do the same thing – sell the policy he owns on Janelle to a trust that mimics his outright ownership.

They must be careful, however, because if the trusts are substantially identical, the trust property could be included in Frank’s and Janelle’s respective gross estates under the reciprocal trust doctrine. The solution to this problem is to design the trusts with sufficiently different provisions.

I have found that this concept can work remarkably well with clients who are asset-rich but cash-poor.

Sound like anyone you know? Sit down with your team of advisers (CPA, attorney and financial adviser) and see if this concept works for your particular situation (If you don’t have a team, get one that works together).

In other words, make sure the insurance agent isn’t telling you one thing and the CPA is telling you something different. Each team member plays a specific role and if they work together, you know what they say: “Three heads are better than one” – and the client wins. PD


Donald K. DeJonge
Financial Representative
Northwestern Mutual Financial Network