The Investment Scientist

Saving Estate Taxes with Trust and Life Insurance Policy

Posted on: June 25, 2012

Multi-generational families

A business owner came to me for help in untangling a “dynasty trust” he has regretted setting up.

I sat down with him for a discovery meeting.

Now I am no expert in trust law and estate tax matters.

Still, after asking a few pointed questions, I found the trust arrangement problematic.

Here is a record of the question and answer session I held with him.

Q: Why did you want to set up this “dynasty trust”?

A: The attorney (referred by an insurance agent) told me I don’t have to pay estate taxes, my children won’t pay estate taxes, and their children also won’t pay estate taxes.

Q: What is your total net worth?

A: About $4 million.

Q: How will you fund the trust?

A: I will fund the trust with a permanent life insurance policy. First-year premium of the insurance policy is $250k, so I am taking out a home equity line of credit to pay for that. After that, it’s about $25k a year.

Let me explain why I think this is problematic: The current federal estate tax exemption is $5mm, well over the $4mm net worth this business owner has. Why set up a complicated irrevocable trust to save a tax from which you are exempt anyway?!

Granted the state estate tax exemption is lower. Using a much simpler A/B trust and annual gifting to heirs, this businessman could substantially reduce his state estate tax liability.

Why worry about your children’s and grandchildren’s estate taxes? Tax law changes every other year; who knows what the tax law will look like when they die. Why create a document that will be defunct anyway?

Note that this simpler and more sensible approach to estate planning does not involve an expensive life insurance policy. No wonder he was not even told such an option existed.

Boston Law School Professor Ray Madoff recently commented about dynasty trusts: “Bankers are using these trusts as a decoy to line their own pockets.” In this businessman’s case, those who benefit from his trust will not be his heirs, but the insurance agent, the lawyer, and the mortgage banker.

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4 Responses to "Saving Estate Taxes with Trust and Life Insurance Policy"

I have lost any respect for these documents. Here’s why. My father established a marital trust. Irrevocable after his death. At the time he constructed the trust, 1987, it saved him some tax money. He and his wife divorced and continued to live together for lower income tax. When his attorney learned of the divorce he informed Dad “for a marital trust to work there has to be a marriage”. So, they remarried; even though at the time of the second marriage the tax law had changed and all of his simple estate would have been exempt from federal estate tax.
Secondly, to save operating expense, Dad named his second wife “Successor Trustee”, which put a benficiary of the trust in charge of the trust. This is a conflict of interest.
As it turned out, the successor beneficiary sued the trust and the heirs, using trust funds to pay attorney fees, on the grounds that all of the chief purposes of the trust had been fullfilled and the bulk of the trust should be distributed. (She received nothing at Dad’s death, and was upset. Even his life insurance went to the trust). After about 3 years of wrangling, the trust was disolved with about the same distribution of assets as if there were no will.

Conditions change, laws change, family dynamics change. As proven by this experience a fiduciary document written in 1987 was inappropriate for it’s chief purpose (taxes), and in this case secondary and tertiary elements were ill concieved as well.

I could go on about an attorney that was following the money rather than the best choice for the client. That would be a different topic. However, we go to attorneys for their advice. How can we know they are helping us? Or are they positioning themselves for future fees that never or seldom come to an end?

My mother was sold a life insurance policy to “protect your estate from taxes”. She never had enough money to go over the estate taxable level, then or now. She paid for the policy without talking with me first, and dropped it upon renewal. That was about 20 years ago. I have despised insurance sales-weasels ever since. (Yes, I buy insurance policies, but only term.)

In retrospect, the tax money saved was totally not worth it.

Jerry, thanks for the comment. I share your disdain for people who have to screw their unknowing clients for bucks.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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