The American Taxpayer Relief Act of 2012 (ATRA) forever changes the face of insurance and estate planning. The permanent $5 million (adjusted for inflation) exemption amount and portability, coupled with the higher marginal income take rates, have profound implications. Estimates are that only 3,000 to 4,000 estate tax returns will be filed each year that owe estate tax (the actual number of total returns will be very high, as surviving spouses seek to secure the benefits of portability). So, for the vast majority of Americans who may be viewed as “wealthy,” the federal estate tax will be irrelevant. Instead, these new higher income taxes will result in the income tax becoming the new estate tax; thus, it’s the focal point of estate planning. Maximizing basis adjustments on death to minimize the now higher capital gains tax will be more important to the planning process than ever before.
In sharp contrast, ultra-high-net-worth (UHNW) families will face a significant estate tax that will remain the focus of their planning. More than ever before, estate planning for the UHNW will differ dramatically in focus and technique from that for the “merely” wealthy. (See “Integrating Life Insurance Into Planning for Ultra-High-Net-Worth Individuals,” by Melvin A. Warshaw, p. 51.) Insurance and estate planning for UHNW clients will continue, to a large extent, in the manner of planning pre-ATRA. However, given the potential risk of proposals to restrict/modify grantor trusts, allocation of generation-skipping transfer (GST) tax exemption, transfer-for-value and other rules, practitioners should implement planning on an urgent basis for the UHNW client.
Because of the post-ATRA environment of higher income taxes, the special income tax treatment afforded life insurance will have increased importance. For the wealthy client unconcerned about federal estate taxes, the favorable income tax attributes of life insurance may outweigh the former estate tax benefits.
Unless improperly transferred, the death benefit isn’t subject to income tax. This is especially significant for clients with existing large insurance policies, so they may wish to restructure the ownership of those policies in light of the ATRA changes. Also, many clients may be tempted to liquidate family limited partnerships (FLPs) or limited liability companies (LLCs) because the discounts they afforded may no longer be relevant. Moreover, FLPs and LLCs may be counterproductive in the new search for tax basis. However, those same FLPs and LLCs may prove essential to avoiding the transfer-for-value rules if clients decide to change the ownership of large insurance policies. Additionally, many FLPs and LLCs can continue to provide control, asset protection and other benefits. However, practitioners should caution clients to evaluate these constructs’ usefulness in mitigating the harsh impact of the transfer-for-value rules before they pursue liquidation.
There have been proposals to modify or restrict the transfer-for-value rules, which could adversely affect this benefit. And, even without any changes, the current transfer-for-value rules can present income traps for the unwary.
The most significant benefit of permanent life insurance is the tax-free build-up inside of the policy. Unless a policy is characterized as a modified endowment contract (MEC), if the policy isn’t surrendered and withdrawals don’t exceed a client’s tax basis in the policy, the excess of cash value above basis isn’t subject to income tax. This limitation can also be simply addressed to access the income tax-advantaged build-up inside a policy. The client can avoid income tax when withdrawing money from the policy if the withdrawals are limited to an amount not in excess of the income tax basis, and thereafter, cash is withdrawn in the form of loans taken out for the excess above basis. This benefit will be discussed below in the context of a multi-purpose irrevocable life insurance trust (MILIT). If the insured dies with a policy in force, any cash value above the income tax basis not previously withdrawn isn’t subject to income tax, even if the policy is characterized as a MEC.
Life insurance also supplies leverage that can be used to further enhance planning. Insurance leverage can come in a number of forms:
• Annual premiums are a very small fraction of the death benefit most policies afford.
• The death benefit is paid in full regardless of how many or how few premiums have been paid prior to death (leaving aside an issue of contestability).
• If life insurance is owned by an irrevocable life insurance trust (ILIT), the death benefits can be kept outside of the transfer tax system.
• Only cash or property gifted to the ILIT is subject to gift (and possibly GST) tax. However, with the substantial inflation-adjusted exemption amounts, there will be no gift (or GST) tax concerns for the vast majority of wealthy taxpayers. (Connecticut residents may be an exception because of the state gift tax.) This can simplify planning to transfer assets to fund premium payments to ILITs, eliminating a barrier that had been significant in prior years to holding insurance in ILIT format.
• There are other special rules allowing for greater leverage.
Investment and Income Tax Planning
The higher income tax rates ATRA imposes enhance the use of permanent life insurance as a savings vehicle. The long-term returns on a properly structured traditional cash value life insurance policy are attractive. Life insurance companies, by law, are required to keep substantial reserves. The reserves are low risk. The average life insurance company has more than 50 percent of its assets in high quality bonds. Fear of the carnage of the recent recession, burned into the psyche of many wealthy clients, makes consideration of insurance as a ballast to a client’s investment portfolio appealing to many. With the additional income and Medicare taxes, because of the tax advantages of life insurance and the risk-averse nature of the insurance companies’ investments, the return is even more attractive.
Private placement life insurance (PPLI) and private placement variable annuities are special products for use by very affluent people, trusts and family offices (that is, those with $5 million or more in assets). The investment options in these policies aren’t those available to the general public and include hedge funds and specially managed accounts. They have the same tax benefits as other insurance or annuity products. Because of the higher taxes as a result of ATRA, PPLIs look more attractive than they have in the past by providing a protective envelope from income taxes.
With the new income tax rates, the relative advantage of an S corporation is diminished as compared to a C corporation. Coupled with the threshold levels for the additional taxes, C corporations are more attractive, especially if funding qualified and non-qualified benefits for owner-employees. Through regulations in the Internal Revenue Code, the corporation can loan money at low interest rates to be used by an employee to pay for life insurance.
The use of pre-tax retirement plan dollars to fund life insurance purchases was impeded for many years because of the concern over estate tax inclusion of policy proceeds. This was especially worrisome after the concept of a pension sub-trust fell into disfavor. Now, however, with a permanent high inflation-adjusted exemption, many clients can use pre-tax pension dollars to fund insurance premiums with little concern of ever being subject to a federal estate tax. Those wealthy clients looking for an income tax advantage may see a resurgence in pension ownership of life insurance. For clients subject to state estate tax, it may be preferable to have an ILIT own the policy to avoid state estate tax, but now, for the first time, the current income tax benefits may outweigh the future state estate tax cost of this type of arrangement.
Regardless of the status of the estate tax, life insurance remains the key and most flexible asset that becomes cash when an insured dies. Even if a buy-sell agreement provides for the buyout of equity in a closely held business or investment, those payments are often deferred or subject to risks that an insurance policy isn’t. Therefore, life insurance use for traditional estate liquidity needs will continue unimpeded by ATRA. However, the calculus of liquidity needs may change, suggesting an adjustment of existing coverage purchased primarily for this purpose. For some clients, federal estate tax will no longer be a component of the liquidity analysis. For UHNW clients, the higher rate might require a reassessment of insurance needs.
If there’s no liquidity in the estate, and the insurance is owned by an ILIT, a Graegin loan can be used to provide liquidity while reducing the taxable estate. (Named for Estate of Cecil Graegin, T.C. Memo. 1988-477, a Graegin loan can be made to an estate that doesn’t have enough liquid assets to pay estate taxes. The value of the liability becomes a reduction in the taxable estate, reducing estate tax liability.) However, the Internal Revenue Service has recently seemed to take a harsher position toward some Graegin transactions. Subject to that risk, a Graegin loan may be a preferable approach for many wealthy clients to other planning options. Given the higher income tax rates, it may be more advantageous to structure a plan for an estate with highly appreciated assets, for example, a closely held business, by leaving the business interests in the estate to gain a step-up in tax basis on death. Instead of transferring the business interests to remove post-transfer appreciation from the estate, insurance in an ILIT and a Graegin loan can be used to pay the estate tax, leaving the appreciation in the estate to be eliminated at death by a step-up in basis.
Asset Value and Business Protection
Very few people die “at the right time.” Insurance can be used to fund the costs of an untimely death. This could include the death of a family wage earner before sufficient savings are accumulated or the death of a key employee or business owner before the business has the resources to fund the loss.
In a down stock or real estate market, the value of investments may be insufficient to fund lifestyle expenses and other needs. Using permanent insurance as a bridge for these market troughs seems to be growing in importance as volatility remains common and investors skittish.
A forced sale of a business will rarely generate the terms that a more properly timed sale can garner. Again, insurance can, in part, help address this risk. If there isn’t liquidity elsewhere, some of those investments may have to be sold or the business disposed of at an unattractive price. Life insurance can provide the liquidity to realize good value or obviate the need to sell the business.
State Estate and Inheritance Taxes
As noted above, permanent life insurance may grow in use as a simple solution to the state estate tax cost faced by clients domiciled in decoupled states. Regardless of the federal estate tax, more than 20 states have decoupled from the federal estate tax system, and many have exemption amounts much lower than the federal level.
In New York, with portability, it’s possible to have an estate of $10.5 million without a federal estate tax. However, the New York estate tax would be $1,146,800. Any amount higher than $10.5 million would be taxed at 16 percent.
Many individuals might want insurance to cover the state death tax, even if there’s no estate tax. In New York, the state estate tax after a $1 million exemption starts at 5.085 percent. An estate worth $5 million in New York would owe $391,600. Taking into account that the state tax is a deduction from the estate subject to federal taxation, any amount that’s subject to both taxes would have a combined effective rate of 49.6 percent. The amounts, even for estates safely under the federal exemption amount, are significant. The practical issue is to what degree clients with wealth levels that will never be subject to federal estate tax will be willing to accept (for many, “tolerate” may be a more apt description) the cost and complexity of sophisticated estate planning, if the only savings will be state estate tax. Their hesitancy to do so will be compounded by the fact that successful estate planning that shifts assets outside the state taxable estate will be offset to some degree, perhaps to the point of generating negative overall tax consequences, by a loss in basis step-up because assets are removed from the estate. With capital gains tax rates higher than state estate tax rates, this will be a significant issue for many.
Portability vs. Bypass Trusts
Many clients may opt to avoid the decision of whether to use portability or a bypass trust and the myriad of ancillary decisions by looking for an insurance answer to the state estate tax. When that answer is enhanced by the ability to rely on portability for a full basis step-up, and the pre-death income tax advantages of the tax-free build-up inside the policy, insurance may become a more common estate-planning tool for wealthy clients under the federal exemption amount than it had been prior to ATRA. What might occur is that pre-existing survivorship insurance policies that were purchased to pay an estate tax on the second spouse’s death may give way to cash-rich permanent policies purchased on each spouse’s life, held in spousal lifetime access trusts (SLATs), which maximize tax-free build-up inside the policy and leave sufficient death benefits to cover state estate taxes.
In some situations, when estates hold a lot of illiquid assets (such as land or mineral rights) that produce little or no income, other estate-planning techniques, such as grantor retained annuity trusts (GRATs) or sales to grantor trusts won’t work. Using loans and life insurance, it’s possible to accomplish the goal of transferring assets on a favorable basis. GRATs are time sensitive because, if a GRAT is still in existence when the grantor dies, it’s likely that whatever value remains in the GRAT will be taxable in the grantor’s estate. Life insurance (usually term) in an ILIT can ensure the success of the GRAT, even if the grantor dies during the GRAT term. If the Greenbook proposal of a 10-year minimum term for GRATs is enacted in a future cliff legislation, the use of life insurance to backstop GRATs will become de rigueur. Again, if the client already has a MILIT in place (discussed below), that same trust can be used in this context, thus simplifying the addition of term policies used in tandem with GRATs.
As an alternative to GRATs, insurance may grow in importance. GRATs, in and of themselves, can’t be used to pass assets down more than one generation without incurring substantial tax. Although there are some creative approaches that have been advocated to using GRATs to create multi-generational planning, these are complex, and not all practitioners are comfortable with them. Life insurance can be structured in such a way that doesn’t have that disadvantage and can still be done as a zeroed-out transaction. In the quest for simplicity post-ATRA, this latter approach may become more common.
For the vast majority of wealthy clients, the federal estate tax will be academic. While state estate taxes remain an issue, as explained above, many clients won’t find taxes to be an incentive to hire an estate planner to develop a comprehensive plan. While non-estate tax planning, like asset protection, succession planning and other topics, is and will continue to be important, the main thrust of planning for most wealthy clients, and hence the nature of practice for most attorneys, will change. Planners will have to offer more flexible, creative and cost-effective options to attract and serve clients. One such option is the MILIT.
Here’s how a MILIT can serve numerous planning goals and, thereby, minimize the number of trusts a client needs and simplify the planning process:
• Many wealthy clients already have ILITs, so they’re familiar with the concept. That’s an important plus, from the perspective of simplicity, in making the ILIT the focal point of planning.
• Most clients find the use of bypass trusts complex and uncomfortable and reluctantly had agreed to such planning to save what they had perceived to be a significant federal estate tax. That issue is moot for most, and in many decoupled states, the low state exemption amount has only a modest impact on reducing state estate tax on the second death. Inter vivos transfers (in all states except Connecticut, which has a gift tax) may afford much better
opportunities to reduce aggregate state estate taxes.
• If the ILIT is structured to serve multiple purposes, the client will view it as a more cost-effective planning option. An ILIT designed to serve as a SLAT, and, in particular, a non-reciprocal SLAT, can provide an ideal receptacle to grow assets outside the reach of the state estate tax without the restrictive limit of a state exemption amount (for example, $675,000 in New Jersey, which on an estate of $5 million or more is only a modest reduction in overall state estate taxes). This application of the SLAT/ILIT can also provide far better asset protection for the client, a benefit often attributed to a bypass trust. With many bypass trusts limited to a state exemption amount and all formed on death when, in many instances, the clients are retired and in less need of asset protection, bypass trusts were never a particularly optimal asset protection tool for most clients. A SLAT, or non-reciprocal SLAT, non-limited by a state exemption and funded while clients are younger and employed, so that liability concerns are greater, offers a far more protective approach.
• With an increased focus on the income tax implications of estate planning for many clients, a MILIT can provide income tax savings on many levels. While the client is alive, the tax-free growth inside the life insurance policy can continue and even be used. Because the MILIT will be structured as a grantor trust, assets can be swapped out before death to achieve a step-up in tax basis. Following the death of the grantor, the MILIT will be taxed as a complex trust, which can be structured to permit sprinkling of income so that the trustee can distribute income to heirs in the lowest tax bracket, thereby minimizing the impact of the new higher marginal income tax rates and the
3.8 percent Medicare tax on passive investment income.
A MILIT can provide the desired simplicity clients will seek with greater fervor post-ATRA in several ways:
• The MILIT can serve as a traditional ILIT, SLAT and bypass trust. One trust, instead of multiple trusts, is both simpler and more cost effective.
• Instead of using traditional Crummey powers, the MILIT, for clients who will never be subject to federal estate tax, may opt for a simpler annual demand power with a one-time initial written Crummey notice, rather than the annual routine most clients find a complex frustration. While practitioners previously may not have been comfortable with such an approach, for the vast majority of wealthy clients who will never be subject to a federal estate tax, why not let the client opt to accept the incremental risk of a one-time Crummey power and commitment to make verbal communications in the future? If the client will never be subject to federal estate tax, what risk is there? While some practitioners might be concerned that if the exemption is lowered with hindsight a riskier annual demand procedure may prove inadvisable, this is a risk of which the client can be apprised.
• One of the major drawbacks to a bypass trust, especially a disclaimer bypass trust, was that the surviving spouse had to deal with the complexity and decision making after the loss of a spouse. With a MILIT, the trust is established while the client is alive and the couple/family can “kick the tires” and get comfortable with the planning before a major negative life event.
Other post-ATRA uses and benefits of MILITs are:
• Holding term life insurance policies from time to time, paired with a transfer to GRATs if the 10-year minimum term restriction for GRATs is enacted.
• Serving as the receptacle for annual gifts of the inflation-adjusted exemption amount.