Portability, Basis, and a Policy Assigned Eighteen Months Ago
Harold, 74, and Jean, 71, are married with a combined net worth of $16.2 million: S corporation stock worth $9 million (basis $600,000), joint brokerage accounts of $3.2 million (basis $1.1 million), Jean's traditional IRA of $1.4 million, a residence worth $1.6 million (basis $350,000), and a $1 million policy on Harold's life that he assigned to an irrevocable life insurance trust 18 months ago. Harold has early cognitive impairment; Jean is healthy and is the family's decision maker. Assume a $15,000,000 federal applicable exclusion per person, that portability is available and will be elected on a timely return, that there is no state estate tax, and that Harold's will leaves everything outright to Jean unless the executor elects otherwise.
1. Is the insurance trust included in Harold's estate? What planning does that require now, while he is still living?
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Likely included, at least contingently. Under IRC section 2035, if the decedent transferred an existing policy (as opposed to the trust purchasing a new one) within three years of death, the proceeds are pulled back into the gross estate. Harold assigned the policy 18 months ago, so for roughly the next 18 months the $1 million is exposed.
The trap: inclusion puts $1 million of value in the estate for tax purposes, but the trust, not the estate, is the beneficiary. The estate gets a tax liability without the cash to pay it, which is the exact opposite of why the trust was created.
What to do now:
- Do not attempt to unwind the assignment; that would restart the clock and add a gift.
- Build liquidity inside the estate from other sources, or plan for the trustee to purchase assets from the estate at fair market value or lend to the estate, which moves cash where it is needed without adverse income tax consequences if the trust is a grantor trust.
- Confirm the trust terms permit those purchases and loans, and confirm the trustee's discretion.
- Depending on the exclusion and the size of the estate at Harold's death, inclusion may consume little or no tax; quantify before doing anything expensive.
The general lesson: transfer existing policies early, and prefer having the trust apply for a new policy on a healthy insured, which never triggers section 2035.
2. At Harold's death, would you rely on portability, fund a credit shelter trust, or use a hybrid? Explain how basis affects the answer.
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Frame the trade-off. Portability means all assets pass through Jean's estate, so every asset gets a second basis step-up at her death. A credit shelter trust uses Harold's exclusion, but the assets inside it get no step-up at Jean's death and are taxed on sale. With a $9 million block of S corporation stock carrying a $600,000 basis, that forgone step-up is worth roughly $8.4 million of untaxed appreciation, potentially over $2 million of capital gains.
Size test. The estate is $16.2 million against a $15 million exclusion. Portability alone leaves very little headroom, and growth over Jean's remaining life will consume it. Something has to absorb appreciation.
Recommendation: a hybrid.
- Elect portability so no exclusion is wasted and the low-basis S corporation stock passes in a form that is included in Jean's estate, preserving the second step-up.
- Fund a credit shelter or QTIP-with-disclaimer trust with the high-basis assets (brokerage at $1.1 million basis, residence at $350,000) to the extent Harold's exclusion is available, capturing some transfer tax protection at modest basis cost.
- Use a Clayton or disclaimer structure so Jean can decide after Harold's death, when the numbers are known, rather than binding the outcome today.
Remember that portability provides no creditor protection, no control over ultimate disposition, and no protection if Jean remarries; a trust buys those things at the cost of basis. The correct mix depends on how much of the exclusion the future growth will consume.
3. How should the IRA beneficiary designations be coordinated with the rest of the plan?
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The IRA is income in respect of a decedent: every dollar is taxed as ordinary income to whoever receives it, and it receives no step-up. That makes it the worst asset to leave to individuals and the best asset to leave to charity.
If Harold predeceases Jean: a spousal rollover preserves deferral and lets Jean name her own beneficiaries, so Jean should be the primary beneficiary, not the estate and not a trust unless a see-through trust is properly drafted.
At Jean's death: adult children are non-eligible designated beneficiaries and must empty the account within ten years under the SECURE Act, likely at their peak earning years. On $1.4 million that is a substantial acceleration of tax.
Coordination:
- Name the children as IRA beneficiaries only for the amount Jean actually wants them to receive as income.
- If there is any charitable intent, satisfy it with the IRA: a charity pays no income tax, so a $250,000 charitable bequest from the IRA costs the family nothing, whereas the same $250,000 given from step-up-eligible stock costs the charity nothing but wastes a step-up the family could have used.
- Leave the low-basis S corporation stock and residence to the children so the step-up is preserved.
- Review the designations now, given Harold's cognitive decline; incapacity creates a window in which changes cannot be made.