The Concern

Years ago, Joe and Mary engaged in some preliminary estate planning that allowed them to establish a credit shelter trust upon the death of the first spouse. Joe recently passed away and left an estate worth approximately $5 million. A portion of these assets will be used to fulfill Mary’s retirement lifestyle, while the remaining portion will be transferred to her children upon her death. Mary’s goal is to maximize the amount of wealth transferred to her children and reduce estate taxes as much as possible.

The Solution

One possible technique is the Leveraged Credit Shelter Trust. In this case, assets equal to the estate tax exempted by the applicable exclusion amount ($1,500,000 in 2005) are transferred to an irrevocable credit shelter trust estate tax free. The rest of the estate passes to Mary estate tax free because of the unlimited marital deduction for transfers to spouses. Since Mary will not need the $1 million in the credit shelter trust for income purposes, the trust purchases a life insurance policy on Mary using some or all of the trust’s assets. If properly structured, the life insurance cash value grows on a tax-deferred basis and the death benefit (which is free from income* and estate tax) may substantially increase the amount of wealth that will pass to Mary’s children.

The Benefits

• The use of life insurance can potentially leverage the amount of wealth transferred to beneficiaries
• Mary has access to policy cash values on a tax-free basis through the trustees. **
• The cash value of the life insurance policy grows tax-deferred which can potentially reduce the income tax burden on the trust.
• Provides Mary and her beneficiaries with protection from potential creditors, professional liabilities or other unseen losses
• Income tax benefits

How a Leveraged Credit Shelter Trust Works

1. Upon Joe’s death, the $1,000,000 applicable exclusion amount is transferred into an irrevocable credit shelter trust.
2. Mary’s children are appointed trustees of the trust. Since the trust will be purchasing an insurance policy on Mary’s life, Mary cannot act as trustee.
3. The trustees use some of the assets in the credit shelter trust to purchase a life insurance policy on Mary.
4. The policy’s death benefit will be paid to the trust and will pass to Mary’s children free from income* and estate tax.

*Proceeds from a life insurance policy paid because of the death of the insured are generally excludable from the beneficiary’s gross income for federal income tax purposes. IRC § 101(a)(1).

**Tax-free distributions assume that the life insurance policy is properly structured, is not a modified endowment contract (MEC) and distributions made are withdrawals up to the cost basis and policy loans thereafter. Distributions from the life insurance policy may reduce the policy death benefit. Should the policy lapse or be surrendered prior to the death of the insured, there may be tax consequences.