FOR FINANCIAL PROFESSIONAL USE ONLY. NOT TO BE USED WITH THE PUBLIC. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston,

FOR FINANCIAL PROFESSIONAL USE ONLY. NOT TO BE USED WITH THE PUBLIC.

Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, MA 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595.

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Life Insurance Planning with “Defective Trusts”Only the Name is “Crummey” or “Defective”

Randy Zipse, JD, CPAVice President & Senior CounselThe Advanced Markets GroupJohn Hancock Financial Services MLINY09280911598 CL DOLU092809


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What is an Intentionally Defective Trust?

• Trust is Respected for Transfer Tax Purposes

• Trust is Ignored for Income Tax Purposes


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Grantor Pays Taxes Attributable to Trust

• Do I want to pay my kids’ tax bill?– No, but it CAN be a good thing.– But, be sure the client UNDERSTANDS this is how it

works.

• Rev. Rul. 2004-64, 2004-27 I.R.B. 7– Discretionary payment of taxes by grantor NOT

additional gift to the trust.• Trust should expressly prohibit the mandatory

reimbursement by the trust for grantor’s tax payments. • Failure to make the repayment subject to the trustee’s

discretion invites inclusion under Sect. 2036.


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Things Change

• Many of Our Clients Have Learned a Valuable Lesson in the Past Few Years…

– Consider a provision in the trust authorizing a termination of the “defective” characteristic.

– Some advisors comfortable with allowing an independent trustee to have discretion to reimburse for taxes.


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Is it Totally Defective?

• Sometimes I Find “Defective Trusts” to Not Be Totally Defective – Just a Little Bit Off

– Be careful that the trust is defective as to income AND principal.


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Defective Trust Powers

• Premium Payment Power (Sect. 677(a)(3))

– Grantor or a nonadverse party or both MAY apply trust income to the payment of premiums on policies of insurance on life of the grantor or grantor’s spouse.

• This power or actual payment does not cause estate tax inclusion (See PLR 8118051 & PLR 8126047)

• WARNING!!!

> See Iversen v. Commissioner, 3 TC 756 (1944); Weil v. Commissioner, 3 TC 579 (1944), acq. 1944 C.B. 29.

> These old cases held that only that part of the trust with respect to which income was ACTUALLY needed to pay premiums was a grantor trust.


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• Power to Borrow Without Adequate Security (Sect. 675(2)&(3))

– A Grantor borrows funds from a trust without adequate security.

• The absence of security should not cause 2036 or 2038 powers if the trust is required to charge adequate interest.

• WARNING!!!

> See Benson v. Commissioner, 76 TC 1040 (1981)

> Bennett v. Commissioner, 79 TC 470 (1982)

> Only grantor trust as to that portion of trust borrowed – not entire trust.


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• NonAdverse Trustee’s Sprinkling Power (Sect. 674)

– Grantor treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the income or corpus therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party or both.

• WARNING: The grantor needs to be careful not to directly or indirectly control decisions of the trustee or 2036 could cause estate inclusion. This power is sometimes limited to trust income – thus not making the trust a grantor trust as to corpus.


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• NonAdverse Trustee’s Power to Add Beneficiaries (Sect. 674(b)(5)&(6))

– Grantor treated as the owner of a trust for income tax purposes if a nonadverse trustee has the power to add beneficiaries (other than after-born or adopted children).

– See PLR 200030018 (Power to Add Charitable Beneficiary)

– Seems safe enough – if you trust the trustee!

– WARNING: What about beneficiary/trustee?


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• Right to Substitute Assets (Sect. 675(4))

– Retention of the right, in a non-fiduciary capacity, to reacquire trust assets by substituting property of equivalent value.

– WARNING: What about Sect. 2042 Incident of Ownership when the trust owns life insurance?

• See Rev. Rul. 2008-22 (Silent as to Sect. 2042)• What if the Sect. 675(4) carves out life insurance? • What if the power is given to the grantor’s spouse instead

of the grantor? (Sect. 672(e)(1)(1))


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• Payment of Trust Income to the Grantor’s Spouse (Sect. 677(a))

– Grantor treated as the owner of a trust for income tax purposes if a nonadverse trustee may pay trust income to the grantor’s spouse.

• WARNING: Grantor trust status seems to end on death of spouse.

• ADDITIONAL WARNING: Does this only make it grantor trust as to income and not principal?

• FURTHER WARNING: Does this discharge a support obligation of the grantor causing it to be a deemed distribution to the grantor? Triggering 2036 Inclusion?



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Uses of Defective Trusts

Case Study—Mr. and Mrs. Brady


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Assumptions

• Mr. and Mrs. Brady are ages 70 and 68, respectively

• They are both non-smoker standard risks

• Gross Estate $40,000,000

• Need $15,000,000 of survivorship life insurance

• They have approximately $20,000,000 of cash and cash equivalents

• They have an S corporation worth $10,000,000– 8% net cash flow, growing by 2% per year– 3% underlying growth in stock

The data shown is taken from a hypothetical calculation. It assumes a hypothetical rate of return and may not be used to project or predict investment results.


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The Problem

• How to pay life insurance premiums without making taxable gifts.

• How to transfer assets outside of taxable estate in a tax efficient manner.


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The SolutionsRanked by Net to Heirs

Strategy RankSale of Assets to a Grantor Trust

(15 Year Note – Long-Term AFR, May 2009 - 3.58%)1

Private Split Dollar (Non-Equity Collateral Assignment)

2

Private Financing Lump-Sum Loan(9 Year Note – Mid-Term AFR, May 2009 - 2.05%)

3

Private Financing GRAT Exit Strategy(9 Year Note - Mid-Term AFR, May 2009 - 2.05%)

4

Gifting Assets to an ILIT 5

Dual Loan Approach(10 Year Note – Loan-Term AFR, May 2009 – 3.58%)

6

Gifting Premiums to an ILIT 7

Commercial Premium Financing (10 Year Note – Loan Interest Rate 7%)

8

DO NOTHING 9


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The Planning Tool BoxThe Tools

• Flexible Irrevocable Life Insurance Trusts

• Irrevocable Grantor Trust

• Grantor Retained Annuity Trust (GRAT)


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The Planning Tool Box The Techniques

• Leveraging Annual Exclusions

• Gifting Lifetime Exemption

• Private Split Dollar

• Private Financing

• Third Party Premium Financing

• Dual Loan

• Sale to a Grantor Trust

• Exit Strategies


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Grantor Trust

• Gifts to the trust are complete for gift and estate tax purposes (“Effective”)

• Grantor’s payment of income taxes is not a further gift to the trust– Rev. Rul. 2004-64

• Permits “leveraging” of trust income

• Payment of trust income can provide tax bracket arbitrage– Reduces grantor’s estate at income tax rates (35%)

rather than gift/estate tax rates (45%)


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Grantor Trust

• Gifts to the trust are complete for gift and estate tax purposes (“Effective”)

• Grantor’s payment of income taxes is not a further gift to the trust– Rev. Rul. 2004-64

• Permits “leveraging” of trust income

• Payment of trust income can provide tax bracket arbitrage– Reduces grantor’s estate at income tax rates (35%)

rather than gift/estate tax rates (45%)


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Grantor Retained Annuity Trust (GRAT)

• Estate Freeze technique – in low interest rate environment

• Grantor contributes property to an irrevocable trust and retains an annuity for a period of years

• At the end of the GRAT term, the remaining GRAT assets pass to the remainder beneficiaries (usually the grantor’s children or a trust for the grantor’s children)

• Goal is to completely "zero-out" the GRAT using actuarial assumptions (Walton Case)

• Set present value of the grantor’s retained annuity equal to the fair market value of the assets contributed to the GRAT using IRS formulas

• Arbitrage Sect. 7520 rates– 120% of the mid-term AFR– 3.2% in Oct 2009


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ZEROED-OUTZEROED-OUTGRATGRAT

ZEROED-OUTZEROED-OUTGRATGRAT

Initial Contribution(Psychological)•Discounts•Increasing Annuity

Rate of Return(Asset Choice)•High Income/No Growth•Good Cash Flow/Good Growth•All Growth/No Income

Length of GRAT Term(Age of Client/Life Expectancy)

Zeroed-Out GRAT Decision Triangle


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Current Trends: Low Interest Rates

LIBOR

AFR

The AFR for an obligation is the applicable federal rate in effect under IRC Sec. 1274(d) for the day on which the obligation is issued, as published by Internal Revenue Bulletin

October AFR:

2.66% Mid-Term4.10% Long Term


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Private Split Dollar

• Non-equity Collateral Assignment Split Dollar (NECASD) Arrangement

• Between Donor and Defective ILIT

• Very favorable economic benefit rates based on Table 2001

• Need to roll out before equity (gain in the policy) or first death

• Exit strategy


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Private Financing

• Use “Family Bank” - Donor lends money to ILIT

• Use current low interest applicable federal rate (AFRs)

• ILIT can either:– Use money to fund premiums– Invest funds and use returns to pay premiums

• Interest– can be accrued and paid at death or – can be paid by investment returns

• Trust income taxes paid by grantor

• Need to pay off loan before interest cost gets too high

• Exit Strategy


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Premium Financing Summary

• Loan to purchase life insurance

• Non-amortizing loan (interest only)

• Leverages insurance assets

• Many different options for third party lenders

• Dual Loan


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Premium Financing Summary

• Interest in advance (beginning of year)

• Interest in arrears (end of year)

• Deferred interest (in limited cases)

• Interest rates may be adjusted annually or may be a fixed rate

• Size of premium usually impacts spread on interest rate


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Sale to Intentionally Defective Grantor Trust (IDIT)

• Donor sells property to an IDIT

• Use current low interest long-term applicable federal rate (AFR)

• Sale ignored for income tax purposes

• No gift for gift taxes (except liquidity seed)

• Estate Freeze

• Valuation discounts available

• But no Step-up in basis at death


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• Sale is ignored for income tax purposes– Loan payments are non-taxable– Loan payments can be used by grantor to pay income

tax liability– No step-up in basis at death

• Income taxes paid by grantor – No additional gift– All income from business can be used to pay premium– Any excess income can be used to pay interest or

“amortize” note


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• Need for liquidity Seed– Rule of thumb is 10% – 20% of sale value– Gift of business interests (with discount) or cash– Use available “unified credit” to shelter gift

• Valuation discounts available– FLP/LLC discounts– Minority interest discounts– S Corporation recaps– Pending legislation may reduce availability of minority

interest discounts


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Grantor Retained Annuity Trust (GRAT)

• Assume GRAT investments will outperform Section 7520 rate

• GRAT remainder is transferred gift-tax free or at minimal gift tax cost

• Valuation Discounts further enhance gift-tax leverage

• Remainder can be used to fund rollout strategy.

• Caveat – NOT a GOOD GST Leverage Technique– Cannot apply GST exemption until the GRAT term expires– ETIP rules



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Private Financing with a Lump Sum Loan


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Private Financing – With Lump-SumHow It Works

ILIT

John Hancock Life Insurance

Company

Grantor loans Lump-Sum Amount

Grantor

ILIT repays loan note

ILIT Pays Premiums

Heirs receive ILIT proceeds

Heirs

ILIT receives death proceeds


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How It Works

Net To The HeirsNet To The Heirs$19,337,661$19,337,661

The Brady The Brady FamilyFamily

Outstanding Loan inYr. 10$31,962,230

Total Loan Amount = $25,236,303

Total Premiums$7,886,655

InitialInitialLife Insurance Life Insurance Death BenefitDeath Benefit

$15,481,962$15,481,962

ILITILIT

Note & Loan Interest Payments

Death Benefit in Yr. 10$19,337,661

Total Trust Total Trust Assets Assets in Yr. 15in Yr. 15

$19,337,661$19,337,661

Total ILIT in Yr. 10$19,337,661

Total Gifts to ILIT = $0

This is a supplemental illustration. Not all benefits and values are guaranteed. The assumptions on which the non-guaranteed elements are based are subject to change by the insurer. Actual results may be more or less favorable.



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Private Financing with a GRAT Exit Strategy

(Annual Loans)


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Private Financing – With GRATHow It Works

ILIT

John Hancock Life Insurance

Company

Grantor Creates GRAT

Grantor loans premiums

Insured makes gifts to ILIT to pay loan interest

GrantorILIT pays loan interest

ILIT Pays Premiums

Heirs receive ILIT proceeds

Heirs

ILIT receives death proceeds

GRAT

Remainder Interest from GRAT at the end of the term used to repay

note & future Premiums, if any


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How It Works With GRAT as an Exit Strategy

Net To The HeirsNet To The Heirs$19,337,661$19,337,661

The Brady The Brady FamilyFamily

Outstanding Loan inYr. 10$9,013,563

Total Loan to ILIT = $7,886,657

Total Premiums$6,164,624

Life Insurance Life Insurance Death BenefitDeath Benefit

$19,337,661$19,337,661

ILITILIT

Note & Loan Interest Payments

Death Benefit in Yr. 10$19,337,661

Total ILIT Assets in Yr. 10

$19,337,661

Total Trust Total Trust Assets Assets in Yr. 10in Yr. 10

$28,351,224$28,351,224

Total Gifts to ILIT = $0

GRAT Remainder

Interest in Yr. 9

$9,013,563This is a supplemental illustration. Not all benefits and values are guaranteed. The assumptions on which the non-guaranteed elements are based are subject to change by the insurer. Actual results may be more or less favorable.



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Sale to a Grantor Trust


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Sale to a Grantor TrustHow It Works

Grantor

GrantorTrust

Life Insurance Policy

Sales Assets & Gifts

Trust Pays Insurance Premiums

Receives InterestPayment on Note


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Current Situation

$8,291,845$8,291,845of Capital Assets

and Gifts Held in Estate

$8,291,845$8,291,845of Capital Assets

and Gifts Held in Estate

Net Value to Heirs$12,627,300

IRSIRS

Estimated TaxesPaid by Grantor

$12,627,300

Value of Capital Assets and Gifts Year 18

$25,254,600$25,254,600

Value of Capital Assets and Gifts Year 18

$25,254,600$25,254,600

The data shown is taken from a hypothetical calculation. It assumes a hypothetical rate of return and may not be used to project or predict investment results.


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Proposed Plan – Year 18

Mr. Brady & Mrs. Brady Grantor Trust

$8,000,000 of Capital Assets Transferred to Grantor Trust

Value of Capital Assets and Gifts To Heirs$14,906,788

Interest Payments to Grantor = $3,903,200

Death Benefit$15,000,000

Total InsurancePremiums Paid

$5,253,216

Total Netto Heirs

$31,572,265$31,572,265

Promissory Note$5,600,000

Note Repayment @ Beg. of Year 18 $5,600,000 John Hancock

Estimated Net Estimated Net Cash Flow To Cash Flow To

Grantor’s EstateGrantor’s Estate(EOY 17)(EOY 17)

($2,030,239)($2,030,239)

Cash Gifts to Grantor Trust = $291,845

Net Cash Flow from Estate$1,665,477

This is a supplemental illustration. Not all benefits and values are guaranteed. The assumptions on which the non-guaranteed elements are based are subject to change by the insurer. Actual results may be more or less favorable.



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Glossary of Terms


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Glossary

• Annual Exclusion Gifts– Under the federal gift tax, the annual exclusion is the amount that a donor can give

any individual each year without incurring a gift tax. If properly structured, these gifts are in addition to the Gift Tax Lifetime Exclusion Amount. This amount is adjusted each year by inflation and is per individual. For 2009, the annual exclusion amount is set at $13,000. If a donor’s spouse agrees to be treated as having made one-half of the gift (so-called gift-splitting) a donor can give up to $26,000 (or double annual exclusion amount). A husband and wife, however, cannot give an individual more than $26,000 during in any calendar year under the annual exclusion.

• Applicable Federal Rate (AFR)– The AFR is used to determined whether a loan between related parties provides for

sufficient interest under Section 7872 of the Internal Revenue Code. AFR rates vary depending on the term of the loan chosen. These rates are determined under Section 274(d) of the Code and are published monthly by the Internal Revenue Service and Treasury Department.


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Glossary

• Generation-Skipping Transfer Tax (GST Tax)– The Generation-Skipping Transfer Tax (GST Tax) is federal tax imposed on a donor’s

estate when assets are transferred to lineal descendants of the donor who are two generations (or more) below the donor or to individuals who are not the donor’s lineal descendants but are at least 37.5 years younger than the donor. This tax is designed to make sure that property is taxed once in each generation (i.e., to prevent donors from “skipping” generations to avoid the federal estate tax that would otherwise apply at each generation). Planning to avoid or minimize the GST tax is a vital component of many estate plans for wealthy donors.

• Gift Tax Lifetime Exclusion Amount– Under the federal gift tax, a donor can give away a certain amount of property during

life without incurring a gift tax. This amount is know as the lifetime exclusion amount. Currently this amount is fixed at $1,000,000. If a donor’s spouse agrees to be treated as having made one-half of the gift (so-called gift-splitting) a donor can give up to $2,000,000 (or double the lifetime exclusion amount). A husband and wife, however, cannot give more than $2,000,000 during their joint lifetimes.


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Glossary

• Grantor Retained Annuity Trust (GRAT)– A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust created by a donor. The donor

transfers property to an irrevocable trust, and retains a annuity interest generally for a term of years (the retained interest). The annuity is either a fixed dollar amount or fixed percentage multiplied by the initial fair market value of the trust's assets. Once calculated, the annuity amount generally remains the same throughout the term of the trust. When the trust term expires, the retained interest ends, and the trust property (the remainder interest) passes outright to the trust beneficiaries or is held for their benefit in the trust.

• Grantor Trust/IDIT/Defective Trust– A Grantor Trust is special type of trust under Sections 671-678 of the Internal Revenue Code.

Pursuant to these provisions, the trust is ignored for federal income tax purposes and is treated as the donor’s alter ego. As a result, the donor is required to pay income taxes on the income earned by a the trust and transactions between the donor and the trust are not recognized for federal income tax purposes. In other words, a donor cannot enter into a taxable transaction with his or her grantor trust. The trust is, however, recognized for federal gift, estate, and GST tax purposes. Usually such a trust is irrevocable and contains special provisions to make it a Grantor Trust. The term Grantor Trust is the name given to such a trust by the Code; however, such a trust is also know as an Intentionally Defective Irrevocable Trust (an IDIT) or simply as a Defective Trust. An ILIT can be structured as a Grantor Trust.


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Glossary

• Irrevocable Life Insurance Trust (ILIT)– An ILIT is an irrevocable trust created during life that is designed to hold one or more

life insurance policies. An ILIT is designed to keep the proceeds from a life insurance policy out of the donor’s taxable estate and provide beneficiaries with the means to pay estate taxes or replace estate assets consumed by estate taxes.

• Irrevocable Trust– An irrevocable trust is a trust that generally cannot be revoked or amended by the

donor (the person who creates the trust). An irrevocable trust can be used to minimize or eliminate gift, estate and GST taxes. An irrevocable trust can be established during the lifetime of the donor or upon the donor’s death pursuant to the donor’s will.

• Liquidity Seed– A liquidity seed is a gift to a Grantor Trust that is designed to show that the trust has

sufficient assets prior to the donor entering into a sale to a grantor trust for a note transaction with the trust. There is no explicit requirement that a trust be seeded, but many practitioners do so nevertheless as a precautionary step. A rule of thumb is that a seed gift should be 10% - 20% of the expected sale price.


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Glossary

• Premium Financing– A premium financing transaction is generally a loan transaction between an ILIT and

third party lender, such as a bank. The ILIT borrows funds from the lender to pay premiums on one or more life insurance policies owned by the trust. The life insurance policy(ies) serve as collateral for the loans. Generally, the lender will charge interest only during the loan term, with the principal to be repaid from the life insurance death proceeds at death.

• Private Financing– A private financing transaction is a loan transaction between a donor and his or her

ILIT. The ILIT is generally structured as a Grantor Trust so that the loan will be ignored for income tax purposes but respected for gift, estate, and GST tax purposes. The donor lends the ILIT cash with which to pay premiums on one or more insurance policies held by the ILIT. The donor charges the ILIT AFR interest. A Private financing transaction is designed to minimize or eliminate federal gift taxes in a situation where the donor cannot shelter premiums with available lifetime gift tax exemption and/or annual exclusions gifts.


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Glossary

• Private Split Dollar– A Private Split Dollar transaction is special type of arrangement between a donor and an ILIT. The

donor pays the premium on one or more life insurance policies owned by the trust. In return for paying the premiums, the donor or the donor’s estate is entitled to the greater of the cash surrender value of the policy(ies) or the total amount of premiums paid by the donor, whichever is greater. Under a Private Split Dollar arrangement, the donor is generally deemed to have made a gift to the trust each year of the so-called economic benefit cost of the policy(ies). This value is determined by tables and represents the Internal Revenue Service’s estimate of the value of the life insurance protection provided to the trust each year by the donor’s premium payments. Generally speaking, these values are very favorable as compared to AFR loan interest rates. Thus, a private split dollar arrangement can provide significant gift-tax leverage for a donor who has very limited gifting ability and wants to avoid a private financing arrangement.

• Valuation Discounting– The value of an interest in a closely held corporation, a partnership, or other asset, may qualify for a

valuation discount to reflect one or more discounts, such as a minority interest discount and a lack of marketability discount. Total valuation discounts can range from 25%-40% of the underlying value of the assets. Consequently, maximum leverage can be achieved with the transfer of such interests in a gifting program.


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Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including the generation-skipping tax). Failure to do so could result in adverse tax treatment of trust proceeds.

All examples used herein are hypothetical examples based upon hypothetical rates of return and are not indicative of past or future results. The charts and graphs used herein are supplemental illustrations. Benefits and values are not guaranteed; the assumptions on which they are based are subject to change by the insurer. Actual results may be more or less favorable. Unless otherwise indicated, all values are derived from JH Illustrator and/or JH Solutions software systems. Products illustrated are Protection SUL-G (Form: 05PR0SULG), Protection UL-G 07 and JH Survivorship UL-G.

Insurance policies and/or associated riders and features may not be available in all states.


All product features may not be available or may vary by state. Product availability is subject to state approval.

This material does not constitute tax, legal, or accounting advice and neither John Hancock nor any of its agents, employees registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any tax payer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors.

© 2009 John Hancock. All rights reserved.

Disclosures


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Thank-you for Thank-you for attending!attending!

Documents

FOR FINANCIAL PROFESSIONAL USE ONLY. NOT TO BE USED WITH THE PUBLIC. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston,