To the surprise of most, Congress, by its inaction, allowed federal taxes on estate, gift and generation skipping transfers (GST) to expire at midnight Dec. 31, 2009, pursuant to the sunset provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). While we wait for Congress to hopefully resolve the future of the estate tax, there are several planning steps advisors and clients should consider.
Current law
For the rest of 2010, unless Congress acts, there is no estate or GST tax and the gift tax rate drops to 35% (with a $1 million lifetime exemption). The basis step-up is eliminated and replaced by a modified carry-over basis regime. In 2011, unless Congress acts, the law defaults to pre-EGTRRA rules with a $1 million estate and gift tax exemption, a $1 million GST exemption, a top estate and gift tax rate of 55% and restoration of the basis step-up.
Even though permanent estate tax repeal appears unlikely given current budget issues, most observers now believe the existing political equation makes it extremely difficult to predict when Congress will act or what path it might choose. Resolution could occur next week but might not happen until next year. Meanwhile clients and their advisors are left with more questions than answers.
What not to do
First and foremost, clients should be counseled not to make impulsive decisions based on circumstances almost certain to be temporary. Even in the unlikely event of permanent repeal of the federal estate tax, much existing planning will continue to make sense to promote orderly wealth transfer, asset protection and business succession.
For example, though living trusts typically include estate tax planning provisions, terminating the trust would deprive a client of its many non-tax benefits such as protection against incapacity, a potentially smoother probate and a comprehensive distribution scheme.
Similarly, life insurance purchased to provide liquidity for federal estate tax purposes can also be useful for business succession planning, survivor income protection, estate equalization and to offset state death taxes as well as potentially higher capital gains taxes if the basis step-up is eliminated. Before cancelling a policy that may be irreplaceable, clients should consider other potential needs and be certain that estate tax needs have been addressed.
Life insurance purchased for estate tax liquidity is often owned in an irrevocable life insurance trust (ILIT) in order to exclude the proceeds from the taxable estate.
Regardless of estate taxes, ILITs may continue to be used for large policies because they can be drafted to protect policy proceeds (as well as any other trust assets) from a beneficiary's creditor problems, divorce or even simply from irresponsible beneficiaries who, without the protection of a trustee, might make bad spending and investment decisions.
Proactive communication to educate clients who may be confused given the uncertainty of the situation may avert reckless decisions.
Planning steps
Many commentators have written about the potential transfer tax opportunities created by this presumably temporary repeal of the federal estate tax. While such opportunities may exist, it is likely that those planning strategies will generally be suitable only for aggressive, sophisticated clients who are fully advised of the risks and uncertainties.
More broadly, most clients should review with counsel their wills and/or trusts in light of current circumstances and address major gaps. For example, marital and family shares defined with respect to a federal estate tax that does not exist, may allocate assets in unexpected ways and leave a surviving spouse with less money than intended or set up conflicts with co-beneficiaries of the family trust. Likewise, similarly defined charitable bequests may go unfunded.
An executor for a decedent whose estate is subject to the modified carry-over basis rules will be forced to make complicated and likely contentious decisions based on complex and ambiguous tax laws. Consideration should be given to granting executors extremely broad authority and protection in such circumstances.
Clients should also consider whether a temporary change in the estate tax rules merits revising estate planning documents. The key factors are mortality risk and estate size. Clients with high mortality risk and/or large estates have the highest tax exposure although mistakes in smaller estates could devastate the standard of living of the surviving spouse or children. Like investment risk tolerance, it is a question of client temperament and ultimately, a client decision. Some clients won't be able to sleep at night until they take action while others won't give it a second thought.
Sales strategies -- term and permanent
Estate tax uncertainty creates a dilemma for wealthy clients considering life insurance. They can buy insurance today, but they might pay for more insurance than they will eventually need. Or, they can wait until the estate tax situation is more settled, but take the risk life insurance may not be affordable or even available at that time.
Many advisors are addressing this dilemma by recommending convertible term insurance. Term insurance can be an effective hedge against a liability, the size and certainty of which is unknown, because it provides immediate protection at a low, out-of-pocket cost. Married couples should consider individual term policies that can be converted into a single joint and survivor policy. Depending on the outcome of federal estate tax legislation, the term insurance can either be:
o converted to a permanent policy (at current health status regardless of any future impairments); or
o dropped with the client likely having spent less than if permanent insurance had been purchased.
While term insurance is sometimes the right solution, the estate tax risk of higher-net-worth clients can be divided into at least three distinct categories and the most appropriate type of insurance, term or permanent, will depend on the category. The case study in the sidebar on this page illustrates the concept and analysis.
Conclusion
The uncertainty regarding the federal estate tax provides an excellent opportunity to reconnect with our clients. It also provides a reminder of how much of our work with clients has nothing to do with taxes.
Despite unprecedented uncertainty, basic planning needs remain for most clients. Spouses still want to care for partners. Parents still want to provide for children. Owners still want to protect businesses. Focusing on the basics and helping clients make educated decisions provides a great planning foundation in this environment.
Case Study
Joe is a single, 65-year-old client with net worth of $10 million. Joe is convinced Congress will retain the estate tax and that the best case scenario is a $5 million exemption and a 35% rate, though he believes the most likely outcome is a $3.5 million exemption and a 45% rate. Joe also believes the worst case economic scenario over the next 20 years is 3% annual growth of his estate.
Let's look at Joe's potential estate tax liability under three different scenarios.
Scenario A
Assume death in 2030, with a $1 million exemption, a flat 55% rate and 5% annual growth.
Joe's estate of $26,532,977 would face federal estate taxes of $14,043,137.
Scenario B
Assume death in 2030, and Joe's most likely estate tax scenario ($3.5 million exemption and a flat 45% rate) and 5% annual growth.
Joe's estate of $26,532,977 would face federal estate taxes of $10,346,840.
Scenario C
Assume death in 2030, and Joe's best case estate tax scenario ($5 million exemption and a flat 35% rate) and worst case economic scenario of 3% annual growth.
Joe's estate of $18,061,112 would face federal estate taxes of $4,571,389.
Planning points
o Term insurance might be the conventional recommendation, but since Joe feels strongly that his estate tax will, at a minimum, equal the $4,571,389 projection in Scenario C, he should consider buying at least that much in permanent insurance now. Doing so will allow him to lock in the most competitive permanent coverage currently available and, for that portion of the coverage, protect against future market changes that might make permanent life insurance more expensive or otherwise less desirable.
o Joe should also consider convertible term insurance for the additional $5,775,451 of exposure in Scenario B or, depending on his viewpoint, the $9,471,748 of exposure in Scenario A.
Matt Vandenack, JD, CLU, is a National Advanced Solutions Specialist with the Principal Financial Group in Des Moines, Iowa.
While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that The Principal(R) is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. Clients should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
