Life insurance is a key ingredient not just in financial plans, but also in estate plans. While many estate planners are generally aware of this, many aren't aware of a little-known method for using life insurance to benefit illiquid estates, including those containing a family business or those composed largely of real estate.

This method hinges on what is called the Graegin technique, named after a 1988 court case concerning the estate of Cecil Graegin (56 TCM 387 (1988)). The Graegin estate had a whopping tax bill and lacked the cash to pay the government because it was composed of illiquid assets.

The decedent didn't have much life insurance, so the heirs had a family business lend the estate money to pay the tax. Thus far, this sounds fairly pedestrian, right? Well, that's where the mundane aspects of this precedent-setting case end. For Graegin has a twist that even Chubby Checker would be proud of. Administrators of the estate reasoned that, if the loan could not be prepaid, they could justify adding up all of the future interest payments due over the term of the loan and deducting them as an expense on the estate tax return.

Remarkably, these future interest payments weren't even discounted to the present value at the date of death or the date of filing the estate tax return. So these aggregated interest payments amounted to a dollar-for- dollar reduction of the estate tax due. If the Graegin estate had been in a 50% marginal tax bracket—a reasonable estimated rate for an estate paying both federal and state tax—then this deduction would have provided atax savings of 50%.

A sweet move, to be sure. Equally sweet are some ways you can use this move in plans for estates that don't hinge on any family businesses making loans.

Prepayment Prohibited

Before the benefactor's death, if appropriate to the plan, set up an irrevocable life insurance trust (ILIT) and arrange for this trust to buy the client's life insurance policy. After the benefactor dies, the trust collects the proceeds estate tax free and then lends them to the estate under terms of a loan agreement that absolutely prohibits prepayment. As it did in Graegin, this maneuver may generate a substantial administrative deduction.

How substantial? If the trust gets $2 million in insurance proceeds and then lends this money to the estate at 6% interest for 10 years, that comes to $1.2 million in interest and, it follows, a $1.2 million deduction.

Using an insurance trust keeps the entire $2 million in proceeds out of the reach of the estate tax and beyond the clutches of any ex-spouses, creditors or malpractice plaintiffs. The estate tax savings alone is about $1 million. What's more, using Graegin for the loan from the insurance trust might generate another $600,000 in tax benefits.

Who Owns the Insurance?

Because of Graegin, using life insurance strategically can be even more highly beneficial to clients faced with daunting tax bills on illiquid estates than is typically realized. If clients are to benefit, there are some key points they should keep in mind.

One is to determine whether the client owns the life insurance directly. If that's the case, the proceeds would become part of the estate, adding to the tax burden. The client may transfer to an ILIT ownership of an existing policy that he or she had purchased directly. But the client must survive for three years if proceeds are to be excluded from the estate.

So the preferable course for executing any ILIT, including situations involving the Graegin technique, is to have the trust purchase insurance directly. This way, the trust may use the tax-exempt proceeds to lend money to or purchase assets from the estate. Either way, the estate gets cash to pay its tax.

Contrary to what clients may believe, the trust cannot simply pay the estate tax. This is because the trust is a separate entity and hence cannot have the estate's tax liability. If the trust's documents are written in a way that requires it to pay the insured's estate tax, this would render the proceeds taxable, defeating the purpose of using the trust.

Key Points

If advisors are to oversee successful Graegin solutions, they must be aware of some key points that estate planners should address. Among these:

• Trusts should include provisions that will characterize them as grantor trusts for income tax purposes. A grantor trust is one whose income is taxed to the grantor—usually the insured person forming the trust. This status can be helpful if the trust engages in transfers with other trusts.
• If the grantor is married and is transferring existing life insurance into the trust, planners should use a marital savings clause to counteract the three-year waiting period that applies to life policy transfers to trusts. This clause enables the transfer of such tainted insurance proceeds into a marital deduction, thus avoiding tax liability for the proceeds upon the grantor's death (assuming, of course, that there is a surviving spouse).
• Most insurance trusts include an annual demand power, or Crummey power. Crummey can apply to gift-tax situations. For example, a client can gift $12,000 to anyone without any gift-tax implications. However, to qualify for this benefit, the gift must be a "present interest." Gifts to a trust generally won't qualify because they don't represent a present interest. To garner this benefit for the grantor's gift to a trust, the beneficiaries should be given written notice of a gift made and of their right to withdraw it for 30 days after the gift is made. The beneficiaries should acknowledge receipt in writing.
• The client's accountant should determine whether a gift-tax return should be filed and what, if anything, should be done to address the generation-skipping transfer (GST) tax. This is a highly complex area that the accountant should address carefully. Your role as an advisor should involve input as to the likelihood of the insurance being held until death, as lapse rates (the percentage of policies that are never paid) are substantial.