Wealthy families are presented with an unprecedented opportunity to transfer wealth to subsequent generations for the remainder of 2012.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 20101 reunified the estate, gift, and generation-skipping transfer (GST) taxes into a cohesive transfer tax system. It also raised the exemption amount to $5 million.2 The act replaced the system that had existed for the past 10 years, where the gift tax exemption remained at $1 million3 while the estate tax exemption gradually increased until the tax was eliminated in 2010. Now that the estate and gift tax exemption has been linked at $5 million, the potential for large generational transfers has never been greater and may not exist again at this level. However, the future of U.S. transfer taxes is unclear.
Under current law, the estate and gift tax exemption are scheduled to drop to $1 million with a 55% tax rate.4 The Obama administration’s budget proposals for 2012 and 2013 call for individuals to have a gift tax exemption of $1 million and an estate tax exemption of $3.5 million with a maximum rate of 45%. On the other hand, Republican presidential candidate Mitt Romney is an advocate for “eliminating the death tax.”5 Not to be forgotten, there is also the specter of “claw back”6 and the fact that 21 states and the District of Columbia tax transfers at death.
Why clients can’t afford to wait
Given all of the uncertainty facing clients, how can we motivate them to act before the end of 2012?
First, it should be explained that given the government’s expenditures and national debt, the need for revenue is paramount. It should also be noted that the federal government has imposed transfer taxes on and off since 17977and consistently since 1916.8 Given the government’s bills and our national history, betting on full repeal is a risky proposition. Moreover, lifetime gifts are superior to testamentary transfers because the future appreciation will not be subject to estate taxes at the donor’s passing. If the same asset were held in the estate until death, all of the growth would be captured by the estate tax.
Second, it helps to provide context for how and when the estate tax must be paid. The estate tax is due nine months after the decedent’s passing.9 If the deceased’s family lacks the liquidity to pay the estate taxes, the executor is required to (i) convert the estate assets into cash (perhaps selling at less than fair market value, since the estate tax liability deadline may force a fire sale), or (ii) finance the debt.10
Permanent life insurance represents the ideal asset for dealing with an estate tax liability. Life insurance provides immediate cash for payments of taxes and other debts. Moreover, rates of return on life insurance death benefits may significantly exceed potential returns on other asset classes. In more than 200 years of American history, no death benefit has ever been denied due to a carrier’s insolvency.11 The certainty of life insurance proceeds can offset the market volatility and instability often associated with other asset classes. With properly structured ownership, life insurance proceeds may be received free of income and estate taxes.
Third, even after a wealthy client understands the rest of this year may represent a closing window for multi-generational planning, he or she may still experience uneasiness in making the irrevocable commitment a gift requires.12 Most clients are apprehensive about making a gift to an irrevocable trust because they cannot change or designate new beneficiaries or reacquire transferred assets in the case of emergency. However, there are many ways to build flexible estate plans.
• Using a spousal lifetime access trust may allow individuals to make large gifts with a higher degree of confidence.13 A spousal lifetime access trust is an irrevocable trust established by one spouse that permits a beneficiary spouse access to the trust assets during the life of the settlor without exposing the trust assets to the federal estate or GST taxes. Obviously, for this strategy to be suitable, your client must be married with a solid relationship and the couple must share wealth transfer goals.
• Appointing a trust protector14 can provide the grantor assurance that someone is charged with certain powers to address circumstances the settlor could not foresee, such as changes in either the tax law or state law. Trust protectors may be vested with the power to amend or terminate an irrevocable trust or even add or delete beneficiaries.
• Clients may also want to consider the strategy of making intra-family loans, i.e., engaging in a private financing transaction, with the trust. Interest rates are at historic lows, therefore private financing is extremely attractive. Each month, the Internal Revenue Service (IRS) provides various prescribed rates for federal tax purposes that must be charged for most loans and installment agreements to avoid imputation of income or gifts under the Internal Revenue Code. These rates, known as Applicable Federal Rates (AFRs), are regularly published as revenue rulings.
Using a combination of a gift and loans is a suitable approach for those clients who have an appetite for wealth transfer but favor flexibility above all else, because the lender can get his or her money back. However, private financing to achieve wealth transfer is not without drawbacks: outstanding loans can be included in the decedent’s taxable estate and require ongoing administration.15
The strategy is simple. The settlor/lender makes a loan to an intentionally defective grantor trust16 at AFR in exchange for a promissory note. The trust pays the lender interest annually or accrues it to be paid back at the end of the term. If the loaned assets outperform the AFR, the excess is transferred to the trust, gift tax free. Because the trust is a grantor trust as to the settlor, this transaction does not create any income tax consequences. The excess growth (the amount not paid back to the grantor as interest) is invested by the trustee. The flexibility of this arrangement lies in the fact that the loan will be repaid at some point in the future, thereby giving the settlor a mode of reclamation.
How to spell out the benefits
Estate planning advisors understand the opportunity the current estate tax act affords. However, clients will not implement a wealth transfer plan if they do not understand exactly how it quantifiably improves their family’s long-term financial condition and what cost they must bear to execute the plan. This thought brings us to our fourth, and final, practice pointer regarding how to motivate clients: clearly demonstrate how their economic condition and that of their entire family can be improved and at what cost.
It is impossible to precisely predict an asset’s income and capital appreciation performance. However, unless alternatives are laid out before a client, they will not act. Therefore, certain reasonable assumptions must be made.
It is simpler to compare alternatives if one assumes a constant rate of return. Ask your client to make his own income and growth assumptions based on his past investment experience and future projections. Be prepared to display the alternatives both graphically and mathematically, year-by-year. Since you are engaged as an estate planning advisor, you should be equipped to show the “net assets to heirs” of each alternative. The overall results can be displayed as a dollar amount, while the economic effectiveness of each alternative can be measured by its internal rate of return. As long as the client and his advisors are comfortable with the underlying assumptions, the resulting calculations should produce consistent results that allow the client to make a decision with confidence.
However, in order for an estate planning analytical tool to accurately measure a family’s options, it must:
• Distinguish between the tax-exclusive nature of the gift tax versus the tax-inclusive nature of the estate tax.
• Accommodate the uncertain estate tax future by being able to display results with various estate tax assumptions, such as the current exemptions and rates being made permanent; reversion to prior law; or the administration’s proposal of a $1 million gift and a $3.5 million estate exemption at a 45% maximum rate.
Bearing in mind the forgoing, it is helpful to illustrate the following:
1. Not making a lifetime transfer, retaining the assets in the taxable estate and continuing whatever income and growth assumptions your client instructs you to make past your client’s (or joint) life expectancy.
2. Transferring the client’s full lifetime exemption amount as a gift, continuing whatever income and growth assumptions your client instructs you to make in trust.
3. Transferring the client’s full lifetime exemption amount as a gift and using only the income it generates for life insurance premiums.
4. Transferring the client’s full lifetime exemption amount as a gift and using the entire amount for life insurance.
Clients have considerable plan design flexibility regarding the type of policy, the amount of insurance, and the size and frequency of the premiums. Depending on product pricing, it may be advantageous to fund a life insurance policy on a level-premium basis, even though the trust has received funds in a large lump sum. Client priorities, such as the need for flexibility, may dictate that the trust should maintain a sizeable asset balance, so trust assets are not eroded by payment of premiums.
These are not one-size-fits-all approaches, and any assumptions about the future performance of investments and future federal and state tax laws cannot be made with certainty. However, modeling out these approaches provides an undeniable quantitative analysis of each option: the potential benefits to the client’s family and the potential costs.
For clients who can afford it, making a lifetime gift before the end of 2012 is clearly superior to waiting until death when future appreciation will be subject to estate taxes. The obstacles to making lifetime gifts are centered on anxiety about making irrevocable gifts and advisors’ failures to sufficiently communicate the magnitude of the opportunity. These obstacles, though very real, can be surmounted. If clients understand estate plans need not be inflexible and the wealth transfer opportunity is clearly delineated by comparing the alternatives, they are more likely to act.
The way to motivate clients is to provide a simple comparison that clearly demonstrates the costs of refusing to act versus the benefits of making a lifetime gift this year.
The authors would like to thank Meredith Garcia-Tunon, CLU, FLMI, ACS, for her comments on and invaluable contributions to this article.