Estate Tax, GST Tax and Funding Issues

Estate Tax

The "full and adequate consideration" test under Section 2512 (see Gift Tax above) is also paralleled in the estate tax inclusion section under Sections 2036 and 2038.  Since there have been many recent tax court cases dealing with retained interests and control [see F.N. 39 ante.], the estate planner must carefully structure ownership of the captive.  If payment of premiums to the captive are for full and adequate consideration, then Sections 2036 and 2038 should not apply.

Generation-Skipping Transfer Tax

A transfer of property is subject to generation-skipping transfer tax ("GST Tax") if there is either a direct skip, a taxable distribution, or a taxable termination [Treas. Reg. Section 26.2611.1].  The latter two events deal with transfers in trust and would not apply to the captive arrangement.  A direct skip is a transfer to a skip person (i.e. a transfer that skips at least one generation that is subject to either the gift tax or estate tax [Treas. Reg. Section 2612-1(a)].

If there is no gift for gift tax purposes and there is no inclusion in the taxable estate for estate tax purposes arising from payment of insurance premiums, then there is no transfer for GST Tax purposes.  Thus, the value that is created from ownership of shares in the captive and distributions from the captive may be made to a skip person or a GST Tax-exempt trust that may never be subject to GST Tax.

Funding Issues

If the captive is owned by or in trust for the business owner's children or grandchildren, and if the business owner provides the capital (see Capitalization Requirements), this will constitute a gift for gift and generation-skipping tax purposes [IRC Section 2511].

Alternatively, to avoid a gift, the capital could be provided as loans to the captive owners, who in turn make the capital contributions to the captive.  There also may be other sources of capital available based on prior estate planning for many clients.

The best practice may be to form an irrevocable trust for the benefit of the children and/or grandchildren, then make a gift of cash to the trust in the amount necessary to capitalize the captive and own all the stock, or alternatively, multiple trusts could own all the stock.  This avoids potential issues with valuation of the capital insurance company stock if the client transferred stock to the trust after formation of the captive, rather than cash with which the trust made its original capital contribution.  The trust can be drafted so that no future estate tax applies to the trust and the client's GST Tax exemption can be allocated to this transfer on a federal gift tax return to ensure that no future GST Tax applies to the trust.