The Income Protection Trust

The Income Protection Trust: Combining Nevada’s Domestic Asset Protection Trust with Life Insurance

Abstract: This article discusses the statutory requirements for an asset protection trust established pursuant to the Spendthrift Trust Act of Nevada. Trusts drafted under the Act are typically grantor trusts, do not result in taxable gifts upon funding, and do not remove assets from one’s estate. The typical trust is designed for asset protection and not tax minimization. The integration of life insurance products, preferably variable universal life (VUL), with a Nevada asset protection trust is proposed. Unlike a typical domestic asset protection trust, the income protection trust (IPT) holding VUL may achieve the following benefits: tax-deferred growth of the cash value, tax-free access to the cash value, creditor protection for the cash value, and exclusion from the estate of the insured.

Today, people play the “litigation” lottery. It is more lucrative and rewarding than playing a state lottery.
Historically, a person could protect himself or herself with adequate insurance coverage. However, premiums are becoming unaffordable as jury awards are increasing and often exceeding policy limits. Thus, we are forced to find more innovative strategies to protect our assets from potentially devastating creditor claims. Today we have another arrow in the quiver of asset protection. Combining life insurance with a domestic asset protection trust, as permitted by Alaska, Delaware, Rhode Island, and Nevada, allows an individual to secure the cash value of a life insurance contract from creditors’ claims. In addition, a properly drafted domestic asset protection trust could provide protected tax-free retirement income and exclude the death benefit from one’s estate for federal estate tax purposes.

Historically, restraints on alienation of property held in trust were strictly construed and viewed with skepticism by the judicial eye throughout the centuries. As a result, the common law of trusts evolved to prohibit, and continues to prohibit, self-settled spendthrift trusts.

A spendthrift trust is one that imposes a valid restraint on alienation; the restraint prevents a beneficiary of
a spendthrift trust from transferring his or her expectation of future income and/or principal. Thus, a beneficiary of a spendthrift trust may not voluntarily or involuntarily assign, give, transfer, or otherwise dispose of his or her right to future income and principal to satisfy a creditor’s claim. The corollary is that creditors cannot reach or attach the beneficiary’s interest in a spendthrift trust.

A self-settled spendthrift trust is one that attempts to impose a restraint on alienation of the settlor’s interest in the trust. The objective of such a trust is to protect the assets held by the trust from existing and future creditors of the settlor, while permitting the settlor to retain a beneficial interest in the trust. However, the common law has rejected such attempts. The common law generally permits creditors of the settlor to invade the income and corpus of the trust to the extent of the settlor’s retained interest. Furthermore, a creditor may reach the entire corpus in some instances and in some states as long as the settlor has retained some beneficial interest in the trust.

In the context of life insurance and irrevocable life insurance trusts (ILITs), the rule against self-settled spendthrift trusts translates into the mandate that the settlor relinquish all rights and ownership in the policy as well as forfeit any interest in the cash value. Such relinquishment and forfeiture are necessary to insure that the cash value and the death benefit are not available to satisfy the claims of the settlor’s creditors.

This restriction is also imposed by the federal estate tax. For the cash value and death benefit to be excluded from the settlor’s estate, and thus to escape federal estate taxation, the settlor may not be the owner of the policy and may not retain any incidents of ownership in the policy as defined in Internal Revenue Code (IRC) §2042 and the corresponding Treasury Regulations.

Since the inception of the ILIT, a perennial conflict for the settlor is the concern that he or she is relinquishing control over a policy and giving up access to a policy’s cash value in order to remove such assets from his or her taxable estate. But today, a resolution to the conflict exists. With the statutory creation of domestic asset protection trusts, a settlor may now establish an irrevocable trust designed to own life insurance and have indirect access to the cash value for retirement planning while excluding the accumulated cash and death benefits from the settlor’s estate.

This ability is especially important today with the uncertainty of the repeal of the federal estate tax. This type of planning would allow the settlor to keep the insurance in trust if needed for estate taxes or to access the cash value for his or her benefit if repeal occurs.

The era of the domestic asset protection trust began with the 1997 passage of asset protection statutes in Alaska and Delaware. Shortly thereafter, Nevada and Rhode Island enacted legislation authorizing the creation of asset protection trusts. Essentially, each of these states permits the establishment of an irrevocable trust in which the settlor may retain a beneficial interest while securing the assets owned by the trust from the settlor’s creditors.

Statutory Requirements
The legislation of each state mandates compliance with a specific set of statutory requisites in order to achieve the benefit of protection from creditors’ claims. This article focuses upon the Nevada Spendthrift Trust Act, Nevada Revised Statute (NRS) §166.010, et. seq. For a detailed comparison of the laws of Alaska, Delaware, Nevada, and Rhode Island, see Domestic Asset Protection Trusts Work – Should They?1

According to the statute, Nevada law shall apply to the construction, operation, and enforcement of all spendthrift trusts created in or outside Nevada if
•    all or part of the land, rents, issues, or profits affected are in Nevada,
•    all or part of the personal property, interest of money, dividends upon stock, and other produce
thereof affected are in Nevada,
•    the declared domicile of the creator of a spendthrift trust affecting personal property is in Nevada, or
•    at least one trustee, qualified pursuant to another section of the statute, has powers that include
maintaining records and preparing income tax returns for the trust, and all or part of the administration of the trust is performed in Nevada.2

Furthermore, no specific language is necessary for the creation of spendthrift trusts. The statute only requires that the settlor manifests an intention to create a spendthrift trust.3

However, the statute unambiguously sets forth the requirements necessary for the creation of an asset protection trust of which the settlor is a beneficiary.

First, the settlor must be competent by law to execute a will or deed. Second, the trust must be in writing. Oral trusts do not receive the protections afforded by the statute. Third, the writing must be irrevocable. Fourth, the writing cannot require that any part of the income or principal of the trust be distributed to the settlor. Fifth and finally, the trust must not be intended to hinder, delay, or defraud known creditors.4

Importantly, a trust established pursuant to NRS §166.010, et. seq. is irrevocable even if the settlor retains the power to prevent distributions (“veto power”), and/or the settlor retains a testamentary special power of appointment.5

Although a trust cannot “require” that a distribution be made to a settlor, he or she may receive distributions of both income and principal in the discretion of another person.

Finally, if the settlor retains a beneficial interest in the trust, at least one trustee of the spendthrift trust must be
•    a natural person who resides and has a domicile in Nevada,
•    a trust company that is organized under federal law or under the laws of Nevada or another state and maintains an office in Nevada for the transaction of business, or
•    a bank that is organized under federal law or under the laws of Nevada or another state, maintains an office in Nevada for the transaction of business, and possesses and exercises trust powers.6

Additionally, the trustee meeting the above-referenced requirements must have powers to maintain records and prepare income tax returns for the trust and must perform all or part of the administration of the trust.7

If these requirements are satisfied, creditors are barred from bringing an action with respect to a transfer of property to a spendthrift trust if either he or she is a creditor at the time of the transfer and fails to commence an action within two years after the transfer is made or within six months after the creditor discovers or reasonably should have discovered the transfer, whichever is later; or he or she becomes a creditor subsequent to the transfer and fails to commence an action within two years after the transfer is made.

Because of the statutory scheme, a spendthrift trust drafted pursuant to NRS §166.010, et. seq., referred to as the Nevada On-Shore Trust™ or NOST™8, has the following typical characteristics:

  1. Two trustees are appointed: a distribution trustee and an investment trustee.
  2. The distribution trustee authorizes distributions to the settlor.
  3. The investment trustee, most often the settlor(s), has managerial authority over the corpus.
  4. Numerous beneficiaries are named, including charitable beneficiaries.
  5. The settlor remains a permissible beneficiary.
  6. The settlor retains the power to veto distributions to any and all beneficiaries.
  7. The settlor has a special testamentary power of appointment.
  8. The trust provides for a trust consultant with the power to remove and replace trustees.
  9. The trust is a grantor trust under IRC §671, et. seq.9
  10. The funding of the NOST™ is not a completed gift for federal gift tax purposes because of the testamentary special power of appointment.
  11. The transfer of assets into the NOST™ does not remove such assets from the settlor’s gross estate for purposes of the federal estate tax as a result of the application of IRC §2036 and §2038.

Federal Tax Consequences

Income Taxation
As a result of the drafting of the NOST™, the trust is not a separate taxpayer for income tax purposes. The inclusion of the power to substitute assets insures that the trust will be a grantor trust under the Internal Revenue Code. Thus, all items of income, gain, loss, deduction, and credit are attributable to the settlor and shall be included in computing such settlor’s taxable income.

Gift Taxation
Additionally, the funding of or transferring assets into the NOST™ does not result in the imposition of the federal gift tax. The threshold question is whether a completed gift has been made. A completed gift results when a donor relinquishes such “dominion and control” over the property so that the donor is unable to change its disposition either for his or her benefit or for the benefit of another.10

The general rule is that if a settlor transfers assets to an irrevocable trust, retains a right to income only in the discretion of a trustee, and the settlors’ creditors cannot reach the assets of the trust in satisfaction of their claims under state law, the gift is complete because the settlor has not retained any interest in the property. Under NRS §166.010, et. seq., the settlor may remain a permissible beneficiary and after two years, the settlor’s creditors cannot reach the assets. Arguably, a taxable gift would occur upon expiration of the statutory period.

However, the retention of the special testamentary power of appointment by the settlor prevents a completed gift upon funding. The special testamentary power of appointment allows the settlor to change the dispositive provisions of the NOST™ by will. The settlor has the ability to direct the distribution of the corpus to any beneficiary upon his or her death. However, the settlor is not permitted to distribute corpus to himself or herself, his or her creditors, his or her estate, or creditors of the estate. A gift is incomplete if and to the extent a reserved power gives the donor (settlor) the power to name new beneficiaries or to change the interests of the beneficiaries between themselves unless the power is a fiduciary power limited to an ascertainable standard.11 The special testamentary power allows just that. The settlor may not only name new beneficiaries but also may change the interests among the named beneficiaries. Thus, the transfer of assets to a NOST™ does not result in a completed gift for federal gift tax purposes.

However, it is important to note that the distribution of any income and principal to a named beneficiary other than the settlor would result in a taxable gift.12

Estate Taxation
As a result of the funding of the NOST™ not being a completed gift, the assets owned by the NOST™ would be included in the settlor’s estate under IRC §2001, et. seq. The federal estate tax provisions of primary importance are §2036 and §2038.

IRC §2036(a) provides that:

“The value of the gross estate shall include the value of all property to the extent of any interest therein of which has at any time made a transfer…by trust or otherwise under which he has retained for his life…the possession or enjoyment of, or the right to income from the property13 or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”14

IRC §2036(a) requires that the decedent retain either the right to income or possession or enjoyment. The phrase “right to income” refers to both the right of the settlor to the income from the property held by a trust and the right to have the income used for the settlor’s benefit.

In circumstances similar to the establishment of a NOST™ in which the settlor creates an irrevocable trust with income and corpus ultimately payable to other beneficiaries but authorizes distributions to the settlor in the sole and absolute discretion of an independent trustee, the “right to income” phrase arguably does not apply. If the settlor has no legal right to income, the “income” phrase would not support inclusion under Section 2036.15 Under the terms of the NOST™, because the settlor is only a permissible beneficiary in the discretion of a trustee, the settlor has no legal right to the income. Thus, the mere fact that the settlor remains a beneficiary should not result in inclusion of the trust corpus in the estate of the settlor.

However, the right to have income used for the settlor’s benefit includes the use of any trust assets for the satisfaction of any legal obligation of the settlor. Is a creditor of the NOST™ able to access the assets owned by the trust in satisfaction of its claim? Any creditor may seek satisfaction of its claim from the assets held by the trust within two years of the date of transfer. If the settlor died within that period, the trust’s assets are arguably included in the settlor’s estate because such assets are available to creditors.
However, after the two-year period, creditors are prevented from recovering against the assets in the NOST™, and thus, the corpus should not be included in the settlor’s estate under IRC §2036(a)(1).

It is interesting to note that the other jurisdictions permitting self-settled spendthrift trusts carve out an exception to the general bar against creditors’ claims. The exception relates to child support. Creditors enforcing child support orders are able to satisfy such orders from assets held in domestic asset protection trusts governed by the spendthrift trust acts of Delaware, Rhode Island, and Alaska. As a result of the availability of trust assets for the satisfaction of child support, IRC §2036(a)(1) would require inclusion in a decedent’s estate of assets held by a trust established pursuant to the laws of those jurisdictions.

Furthermore, Section 2036(a) will result in inclusion if an express or implied arrangement exists between the trustee and the settlor by which the settlor retains the present use and enjoyment of the income and/or corpus of the trust. Thus, if the settlor of the NOST™ has a prearranged understanding with the distribution trustee that such trustee shall distribute income and principal to the settlor to the exclusion of other beneficiaries, estate exclusion is not possible.

Even if §2036(a)(1) may be avoided, IRC §2036(a)(2) very likely results in estate inclusion of assets owned by a NOST™ for federal estate tax purposes. That section includes the value of any assets in the gross estate in which the settlor has retained the right to designate the persons who shall possess or enjoy the property or income. The Spendthrift Trust Act of Nevada expressly gives the settlor veto power16, which is clearly within the scope of §2036(a)(2). This power allows the settlor to determine who may enjoy the transferred property or income therefrom by rejecting (or giving implied approval by not rejecting) any distribution to any beneficiary made by the trustee. As a result, if the settlor retains this power at his or her death, the trust assets should be included in the settlor’s estate for federal estate tax purposes.

Finally, the assets of a NOST™ should be included in a settlor’s estate pursuant to IRC §2038. Under §2038, a transfer in trust is included in the settlor’s gross estate if the settlor retains the right to alter or amend the enjoyment of the interests in the trust. Inclusion under §2038 results from the retention of a special testamentary power of appointment by the settlor. The special power of appointment retained by the settlor in a NOST™ allows the settlor to name the remainder beneficiaries of the trust, except for the settlor, his or her estate, his or her creditors, or the creditors of his or her estate, at the settlor’s death. This power subjects any transfer to a NOST™ to the settlor’s power to alter, amend, revoke, and terminate any interest of any beneficiary by the settlor’s last will and testament. Thus, IRC §2038(a)(1) applies, and the assets held by a NOST™ are includible in the settlor’s estate. Therefore, when estate tax exclusion is desired, the settlor must not retain a limited special power of appointment.

The Income Protection Trust (IPT)
The IPT is a NOST™ designed specifically to hold life insurance. The trust essentially operates the same way as an ILIT with some fundamentally important distinctions.

In order for the IPT to function like an ILIT, the IPT varies significantly from a typical NOST™, which is drafted exclusively to provide asset protection. Most notably, the settlor forgoes retaining the veto power over distributions and the special testamentary power of appointment, and Crummey language is inserted into the trust. However, and most importantly, unlike a traditional ILIT, the settlor still remains a permissible beneficiary under the IPT, as is permitted under Nevada law (NRS §166, et. seq.). Even though the settlor is a permissible beneficiary during life, his or her interest terminates at death.

Asset Protection
In the event of a lawsuit and subsequent judgment, the cash value of life insurance is protected only to the extent of the allowable state exemption. This exemption can be very minimal. For example, in Nevada, state law exempts “all money, benefits, privileges, or immunities accruing or in any manner growing out of any life insurance, if the annual premium does not exceed $1,000.”17 However, if the life insurance is owned by the IPT and the statutory waiting period expires, the existing cash value would be protected.

Tax Consequences
The IPT, like a typical NOST™, is a grantor trust. The settlor continues to be taxed at his or her personal income tax rates on all of the income, gains, losses, credits, and deductions of the trust.18

Because the settlor relinquishes the veto power and the special testamentary power of appointment, the settlor is unable to change the disposition of the property either for his or her own benefit or for another’s benefit once the property is transferred into the IPT. As such, the settlor parts with the requisite dominion and control of the property, and any contributions of property to the IPT is a completed gift.19 Depending upon the amount transferred into the IPT, a taxable gift may result, and a gift tax return may need to be filed.

However, the IPT provides that the distribution trustee has absolute discretion regarding distributions to any and all of the named beneficiaries. None of the beneficiaries has a current interest in the trust, i.e., an unrestricted right to immediate use, possession, or enjoyment of trust property or of income from such property.20 Thus, the funding of the trust results in a gift of a future interest. As a gift of a future interest, the funding does not qualify as a present interest gift, and the annual gift tax exclusion is inapplicable. The Internal Revenue Code provides that gifts of up to $11,000, other than gifts of future interests in property, made to any person other than a spouse are not taxable as gifts. Without the application of the annual exclusion, all property transferred to the IPT will be taxable gifts.

To qualify transfers under the annual exclusion, the IPT grants Crummey withdrawal rights to the beneficiaries.21 These powers permit the beneficiaries of a trust to presently demand income and/or principal from the trust. Generally, such powers are limited as to amount and duration. The ability of a beneficiary to presently demand payment transforms a gift of a future interest into a present interest for gift tax purposes. As such, if a gift is made to an irrevocable trust, and the beneficiaries have a right to withdraw that gift, then the transfer qualifies for the annual exclusion. If a beneficiary does not exercise the withdrawal right, then this right typically lapses. Of course, an amount transferred to the IPT that exceeds the annual exclusion amount will result in a taxable gift.

If the required funding exceeds $5,000 or 5 percent of the fair market value of the corpus per beneficiary (the “five-and-five” amount), then the Crummey beneficiaries must have “hanging” withdrawal powers. Hanging Crummey powers take advantage of the donor’s full annual gift tax exclusion per beneficiary but limit the lapse to the five-and-five amount. Any withdrawal right in excess of the five and five is said to hang, meaning the Crummey beneficiaries have a continuing right to withdrawal such excess. The hanging powers of withdrawal only lapse in future years when lapses for any given year do not equal the five-and five amount. This is important because any such excess amount may be subject to the creditors of a Crummey beneficiary and not the creditors of the settlor for as long as such excess remains subject to hanging Crummey powers that have not lapsed. The way to avoid this is to have a gift not exceed the fiveand-five amount.

Arguably, the federal estate tax consequences should be determined by reference to the two-year statutory period and the date of any transfer into the IPT. Pursuant to the Nevada statute, creditors of the settlor may reach the assets held by the IPT during the two years following a transfer. Assuming that upon the initial funding of the IPT the trustee subsequently purchases life insurance on the life of the settlor, such assets, i.e, the death benefit of a life insurance policy, should be included in the settlor’s gross estate pursuant to the “creditors’ rights” doctrine during the two years following such transfer and purchase.

Following the expiration of the two-year period, all or substantially all of the assets held by the trust should be excluded from the settlor’s estate. This exclusion results from (a) the transfer of funds being a completed gift, (b) the lack of a retained veto power by the settlor, and (c) the settlor not being granted a special testamentary power of appointment. Singularly or in combination, these characteristics remove the corpus from the reach of IRC §2036 and §2038. Under these provisions, the corpus and any accumulated income of the IPT should not be included in the estate of a deceased settlor for purposes of IRC §2031.

It is interesting to note that any subsequent annual gifts made by the settlor to the IPT for the payment of insurance premiums could be considered a new transfer under Nevada law. If this were the case, each annual gift would begin a new two-year statutory waiting period. As a result, creditors would be able to reach only those annual gifts transferred to the IPT within two years of such creditor’s claims. If the IPT were funded with annual gifts, the series of annual transfers would result in a bifurcated corpus; those assets transferred more than two years prior to any claim would be exempt from attachment in satisfaction of such claim; and those assets transferred within two years of any claim would not be exempt. For illustration, assume that the IPT was created in January 2002 and the trustee purchased a policy on the settlor in 2002 with funds transferred by the settlor. The settlor continues to fund the IPT with annual Crummey gifts beginning in 2003. In 2010, a settlor is subject to a creditor’s claim. Under Nevada Law, the only assets available for the satisfaction of that claim would be the annual gifts made in 2008 and 2009. The initial funding of the policy, the annual gifts made from 2003 through 2007, and the policy’s death benefit should be protected from such creditor’s claim.

According to this analysis and the creditor relegation theory, the death benefit and any accumulations occurring prior to the two years preceding death should escape inclusion in the settlor’s estate for federal estate tax purposes. Any funds transferred to the IPT within two years of the settlor’s death could arguably be included in his or her gross estate. This could mean that if annual Crummey gifts funded the IPT and such funds were used to pay premiums, a proportional amount of the death benefit could be included in the settlor’s gross estate. The proportional amount should be the ratio that the sum of the annual gifts made to the IPT within two years of the settlor’s death (that were utilized to pay insurance premiums) bears to the sum of all gifts made to the IPT that funded such insurance policy. The solution to this possible problem is to fund the insurance policy owned by the IPT with a single premium payment or utilize a “quick pay” premium schedule in order to have the two-year statutory waiting period expire as soon as possible.

However, what about the application of IRC §2042? Does the insured settlor retain any incidents of ownership? According to this section, life insurance proceeds payable to either the executor of a decedent’s estate22 or any other beneficiary are included in the decedent’s taxable estate if the decedent possessed, at the time of his or her death, any incidents of ownership in the policy.23

First, the IPT is drafted so that any life insurance proceeds are not payable to the executor of the insured settlor’s estate. The proceeds are retained in trust for the benefit of the insured’s spouse, children, and other named beneficiaries. Second, the insured settlor retains none of the prohibited incidents of ownership. As defined in the Treasury Regulations, the term “incidents of ownership” refers to the right of an insured or his or her estate to the economic benefits of the policy. Such incidents include the power to change beneficiaries, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy.24 Even though the settlor is a permissible beneficiary, the settlor retains none of the incidents of ownership enumerated in the Treasury Regulations by the terms of the IPT. The settlor is not able to (a) change the beneficiaries of the trusts, (b) change the time or manner of enjoyment of the proceeds or policy, (c) surrender the policy, (d) assign the policy, or (e) obtain from the insurance company a loan of the cash surrender value.

It may certainly be argued that the settlor possesses an economic benefit in the life insurance policy by remaining a permissible beneficiary of the IPT. However, under no circumstances may the insured settlor exercise any power relating to the life insurance policy on the settlor’s life for his or her own benefit. Furthermore, any benefit conferred upon the settlor would only result from an exercise of the independent trustee’s sole and absolute discretion.25

Incidents of ownership also include a reversionary interest in the policy or its proceeds, but only if the value of the reversionary interest immediately before death of the decedent exceeded five percent of the value of the policy. A reversionary interest includes a possibility that the policy or its proceeds may return to the decedent or his or her estate or may become subject to a power of disposition by the decedent.26 With the settlor as a permissible beneficiary of the IPT, a possibility exists that the policy, or more likely the proceeds, may return to the settlor. Thus, the settlor might be considered to have a reversionary interest, with the proceeds included in the settlor’s estate for federal estate tax purposes. However, pursuant to the regulations, a settlor is not deemed to have a reversionary interest if the power to obtain the cash surrender value is held by someone other than the settlor and such other person alone and in all events has the authority to exercise such power.27 Since the settlor is unable to access the cash surrender value, and only the distribution trustee in his or her sole and absolute discretion may access such value, the settlor should not be deemed to possess a reversionary interest.

In defining the scope of IRC §2042, the IRS has determined that powers held by an insured and exercisable only in a fiduciary capacity by such insured are deemed to be incidents of ownership over a life insurance policy on the life of the insured if the insured transferred the policy to the trust or transferred any funds to the trust to purchase or to pay the premiums on such policy.28 In other words, if the insured serves as one of the trustees of the IPT, e.g., as the investment trustee, and transfers the policy or any monies to fund the policy to the trust, any power held by such insured would be considered an incident of ownership over the policy, even if such power were only exercisable in a fiduciary capacity. Thus, if the insured is the trustee and has powers over the investments held by the trust, including the investment portion of a life insurance policy, then such powers are incidents of ownership. The result of the powers being deemed incidents of ownership is that the policy will be included in the settlor’s estate under IRC §2042. Therefore, the insured should not serve as either the investment or distribution trustee of the IPT. Consequently, the insured retains no powers, held individually or in a fiduciary capacity, that would be considered incidents of ownership. Therefore, the life insurance policy should escape inclusion in the settlor’s estate under IRC §2042.

Benefits of the IPT
The IPT is designed to hold various forms of life insurance. However, the authors foresee that variable universal life (VUL) insurance will become the vehicle of choice. VUL insurance is a form of permanent insurance offering substantial benefits that make it ideally suited for use in connection with the IPT.

As with all forms of permanent insurance, a VUL is comprised of both a death benefit and an investment benefit. The policy owner may select either a level or increasing death benefit. Regarding the payment of premiums, a VUL policy offers the policy owner the advantage of flexible premium schedules.

The investment element of a VUL, unlike a standard universal life policy, is held in a separate account by an insurance company and does not become commingled with such insurance company’s general funds or assets. By maintaining the monies in a separate account, the insurance company is permitted to shift (and has shifted) investment control and decision making to the policy owner. By shifting investment control to the policy owner, the insurance company shifts investment risk and reward from itself to the policy owner. Additionally, this shift provides the policy owner with more investment flexibility and allows the owner to invest pursuant to his or her own risk tolerance. However, the investment options are limited to a group of investments or funds selected by the insurance company. In other words, even though the choice of investment lies with the policy owner, such owner may only choose among predetermined sets of investments.

The benefits afforded by VUL insurance include tax-deferred growth of the investment element, potential tax-free access to the cash value via loans or partial withdrawals, and like all insurance policies, the death benefits may be received free of federal income tax.29

The increase in the cash value of any VUL insurance escapes federal income taxation as long as the cash value and any appreciation remains in the policy. Under the Internal Revenue Code, gross income only includes amounts received as an annuity under an annuity, endowment, or life insurance contract.30 The corollary of this rule is that gross income does not include any amount not received as an annuity under a life insurance contract. Accumulations of cash value within a life insurance policy are not amounts received as an annuity. An annuity is any amount payable at a fixed rate or amount for a period certain or during one or more lives.31 Thus, the accumulations are not included in the gross income, and as a result, escape current income taxation. Additionally, tax deferral allows the cash value to grow much more rapidly and results in substantially higher rates of return on investments than the same investments made with aftertax dollars.

Partial withdrawals or loans of cash value to the policy owners that do not exceed the basis in the policy will occur tax free. A policy owner may access the cash value of a VUL without the imposition of any income tax. The tax effect of a partial withdrawal or a loan is governed by IRC §72(e). The analysis hinges upon determining the amount received, the investment in the contract or basis, and the gain. First, any amount received must not be an annuity.32 Partial withdrawals and loans are not amounts payable at a fixed rate or amount for a period certain or during one or more lives. Thus, they are not annuities, and section 72(e) applies. Second, the investment in the contract must be determined. As set forth in the Code, it means the aggregate amount of premiums paid for the contract minus the aggregate amounts received under the contract which were excluded from gross income.33 The statutory formula is the aggregate premiums paid minus nontaxable distributions, including dividends that reduce basis and nontaxable withdrawals. Such dividends include those received in cash, those left in the policy to accumulate interest, and those used to purchase riders.34

Third and finally, gain is any difference between the cash value and the investment in the contract or basis.

Once the above amounts have been calculated, the statutory rules provide that
•    amounts allocated to income equal the excess of the cash value over the investment in the contract,35
•    amounts allocable to the investment in the contract are any amounts not allocated to income,36 and
•    amounts allocable to the investment in the contract are not included in gross income.37

Thus, the tax consequences of a partial loan or withdrawal are:
•    The proceeds will not be included in gross income as long as they do not exceed the amount allocable to the investment in the contract.
•    Gross income will include any proceeds in excess of the investment in the contract up to the cash value.

In addition to the above benefits, the combination of a VUL insurance policy and a NOST™ may allow access to the cash value for retirement funding while removing the death benefits from one’s estate. In this vein, the IPT is a more attractive planning strategy than the spousal ILIT. Under the IPT, the settlor is a named beneficiary and his or her own ability to benefit from the cash value does not hinge upon the settlor’s successful marriage to the spouse-beneficiary of the spousal ILIT. Another benefit of the IPT is that the cash value is protected from claims of the settlor’s creditors after the expiration of the two-year statutory period. Finally, the IPT permits the settlor to take a “wait and see” approach to retirement and estate planning in today’s very uncertain legal landscape. If the estate tax is ultimately repealed, the settlor may access the cash buildup for retirement and reduce the corresponding death benefit; however, if the estate tax is not repealed, the policy may be preserved for estate liquidity needs without having the death benefit included in the settlor’s estate.

Ideal Vehicle for Private Placement VULs

A typical VUL insurance policy is a “plain vanilla” registered product. Such products are sold “as is,” with very little or no customization based upon the client’s wants and desires, are offered as simply another product of an insurance company, and are registered with the Securities and Exchange Commission and state insurance commissioners.38 Essential components like investment choices, investment managers, and fee structures are nonnegotiable. However, if an investor is willing to invest at least $500,000 in a VUL policy, the buyer may qualify for a private placement product.39

A private placement product is unregistered and is only available to purchasers who are accredited investors and qualified purchasers. An accredited investor is one with a net worth in excess of $1 million or a yearly income greater than $200,000.40 Similarly a qualified purchaser must own at least $5 million in investments.41

Because a private placement product is unregistered, it may be tailored to each client. The greatest aspect of customization is the ability of the investor to continue to utilize the services of his or her existing money manager. The investor does not have to forfeit any trusted relationship simply because the investor opts to invest in a VUL product. Once a particular money manager passes the insurance company’s due diligence screening and creates a fund dedicated to the insurance company’s separate private placement products, then a fund controlled by that money manager may become a selection among the various investment options offered by the insurance company regarding its private placement VUL products.42 Thus, an investor has the ability to recommend to the insurance company a particular money manager, and if the manager passes the due diligence screening, the investor may continue to use that money manager.

In this regard it is worth noting that substantial limitations are imposed upon the policy owner’s ability to control the policy. First, investments in the separate account must be adequately diversified.43 Second, any separate account must be under the ownership of the insurance company and not the insured or the policy owner.44 Third, control over the investment decisions must lie with the insurer and not the owner. However, a policy owner may direct the broad allocation among the funds.45

Additional benefits include the ability to negotiate for lower or eliminated sales loads, broker commissions, asset charges, and surrender charges. Also, the private placement products often have lower internal charges, e.g., mortality and expense charges.46

When combined with an IPT, institutionally priced private placement VUL products offer the benefits set forth above plus the ability to invest with a money manager of the investor’s choosing at reduced costs.

With the advent of domestic asset protection trusts, particularly the NOST™, an ideal estate planning vehicle now exists.

In summation, a properly drafted IPT that owns a VUL insurance policy should achieve
•    the tax-deferred accumulation of wealth,
•    the tax-free access to cash values for retirement,
•    the protection of cash values from creditors’ claims, and
•    the exclusion of death benefit proceeds from the settlor’s estate.

Copyright © 2002, Society of Financial Service Professionals.

(1) Richard Bacon, Esq., and John Terrill II, Esq., “Domestic Asset Protection Trusts Work – Should They?” Tax Management Estates,
Gifts, and Trusts Journal 26, No. 3 (May 10, 2001): 123.
(2) NRS §166.025(1).
(3) NRS §166.050.
(4) NRS §166.040.
(5) NRS §166.040(2)(a)
(6) NRS §166.025(2).
May 2002 Journal, The Income Protection Trust: Combining Nevada’s Domestic Asset Protection Trust with Life Insurance[11/11/2011 11:00:38 AM]
(7) NRS §166.025(1)(d).
(8) The Firm of Jeffrey L. Burr & Associates has copyrighted and trademarked the terms “Nevada On-Shore Trust” and “NOST.”
(9) The document provides that the settlor retains the power to reacquire corpus by substituting other property of equivalent value,
exercisable in nonfiduciary capacity without the consent or approval of any person in a fiduciary capacity. IRC §675(4).
(10) Treas. Reg. §25.2511-2(b).
(11) Treas. Reg. §25.2511-2(c).
(12) Treas. Reg. §25.2511-2(f).
(13) IRC §2036(a)(1).
(14) IRC §2036(a)(2).
(15) Richard Stephens, et. al., Federal Estate and Gift Taxation, 6th ed. (Boston, MA: Warren, Gorham & Lamont, 1991): 4.08[4][c].
(16) NRS §166.040(2)(a).
(17) NRS §21.090(k).
(18) IRC §671, et. seq.
(19) IRC §2511; Treas. Reg. §25.2511-2.
(20) Treas. Reg. §25.2503-3(b).
(21) Crummey v. Commissioner , 397 F2d 92 (9th Cir. 1968).
(22) IRC§2042(1).
(23) IRC §2042(2).
(24) Treas. Reg. §20.2042-1(c)(2).
(25) See e.g., Treas. Reg. §20.2042-1(c)(3).
(26) Treas. Reg. §20.2042-1(c)(3).
(27) Id.
(28) Revenue Ruling 84-179, 1984-2 C.B. 195.
(29) IRC §102.
(30) IRC §72(a), emphasis added.
(31) Id.
(32) IRC §72(e)(1)(A).
(33) IRC §72(e)(6).
(34) BNA Portfolio.
(35) IRC §72(e)(3)(A).
(36) IRC§72(e)(3)(B).
(37) IRC §72(e)(2)(A)(ii).
(38) Charles Ratner, “Private Placement Life Products: Domestic, Offshore or Atoll? The Reality Check Please,” Trusts and Estates
(July 2001): 48, 52.
(39) Id.
(40) Id., p. 53.
May 2002 Journal, The Income Protection Trust: Combining Nevada’s Domestic Asset Protection Trust with Life Insurance[11/11/2011 11:00:38 AM]
(41) Id.
(42) Id., p. 54.
(43) Id. See IRC.§817(h)
(44) Id.
(45) Id.
(46) Id.