By: Martin M. Shenkman, CPA/PFS, MBA, J.D.
Insurance has, and will always remain, an integral part of many estate plans, regardless of the status of the estate tax. Life insurance can be used, as it has for many decades, to build an estate (e.g., for a young client with a modest estate and a family to support in the event of premature death), provide liquidity to an estate (e.g., a client the whose estate is primarily comprised of real estate or business interests), for funding buyout agreements, and more. The American Taxpayer Relief Act of 2012 (“ATRA”) has changed the use of life insurance in profound ways. What are some of the new factors practitioners should consider?
√ Don’t Cancel Existing Life Insurance Without Reviewing All Options: Insurance was frequently purchased as a means of paying estate tax. A classic tax plan for many clients was to purchase survivorship life insurance payable on the death of the second spouse to die and held in an insurance trust to cover the estate tax. For many clients the primary purpose for these policies is not irrelevant. Unless the client’s estate will exceed the $5.25 million exemption, or $10.5 million for a couple, no federal estate tax will be due. What should be done with the policy? Consider the options:
• Cancel the policy for the cash value. If the policy is held by a trust, the cash value should be paid to the trustee and distributed pursuant to the terms of the trust. While this is the simplest and obvious step, it is often not the best for the client.
• Consummate a tax-free exchange for another policy that will provide advantageous income tax planning benefits or better serve the clients new post-ATRA objectives.
• Use the existing policy, a paid up policy, or a scaled back death benefit to cover estate liquidity needs (perhaps reduced to reflect the reduction or elimination of federal estate taxes as a liquidity need).
• Exchange the policy for an annuity that meets cash flow needs and is consistent with the client's current financial and retirement plans.
• Sell the policy into the secondary market, which might net the client more than the cash surrender value.
√ Review Adequacy of Existing Coverage: If insurance is held for personal wealth creation or income replacement (e.g., a young person seeking to provide for his or her family in the event of premature death), be certain that the assumptions underlying the policy are reviewed. Too often clients assumed much higher investment returns on insurance proceeds than may be realistic now. If the client’s net worth was adversely affected by the recession, is the coverage still adequate? While tax and asset protection are important issues, assuring adequate and appropriate coverage is essential. Remember that in many situations life insurance is purchased online, sold to a client by an insurance consultant, or purchased on the recommendation of an estate-planning attorney, and no projection of what the client’s real needs are, may have ever been done. Even when projections are done, if they are not revisited periodically they may be useless. Even a rudimentary budget and projection will often demonstrate that clients are dangerously underinsured, or over insured with costly policies that don’t serve their needs.
√ Be Sure Any Changes to Trust Owned Insurance Comply with the Trust Requirements: If the life insurance is held by a trust, be certain that the client has his or her estate planning attorney review the trust to assure that the desired transaction is permissible. Practitioners, post-ATRA, have frequently been asked to help with transactions to terminate policies or change policies. Caution: Be careful not to help facilitate a transaction that violates the terms of the trust unless there is guidance from an attorney supporting what is being done. If a beneficiary later sues the trustee for violating the terms of the trust you don’t want the figures pointing at you. The mere fact that the client that established the trust wants to do something does not mean it is permissible. The trustee, not the client who formed the trust, is the decision maker.
√ Gifting Assets to Avoid State Estate Tax May be a Costly Strategy: Insurance may be better than gift strategies many are considering. Many clients might benefit from gifting away assets before death to avoid tax in a decoupled state. However, this is not always the optimal strategy. Assume for example, that your client owns a business structured as an S corporation that she started with a negligible investment decades ago. The business is presently worth approximately $4 million. Her investment assets are worth about $1 million, so that her estate has a total value of $5 million. She is domiciled in a decoupled state with a $1 million exemption. One planning option would be for her to gift her S corporation stock to an irrevocable self-settled domestic asset protection ("DAPT") trust. That would permit her to receive trust distributions in future years if she needed, but nevertheless have the assets and any growth in them removed from her estate. Most important, if she lives in any decoupled state (other than Connecticut which has a gift tax) there will be no gift tax consequences to her gift. This can be a simple and effective way to avoid state estate tax. That could provide a state estate tax savings of approximately $400,000. That tax savings could be especially important to realize if your client wished to bequeath the business intact to her son and her remaining assets to her daughter. Under this dispositive scheme the state estate tax, if paid from the residuary bequeathed to her daughter would eliminate almost half of the daughter's inheritance thereby benefiting the son in an even more lopsided manner. If instead the state estate tax were made the burden of the son, it could prove a difficult cash flow drain on the business the taxpayer wishes to retain intact. But a very different approach may be preferable. Leave the business interests in the estate so that the tax basis is stepped up on death and use life insurance to cover the state estate tax.
√ Consider Life Insurance to pay State Estate Tax: Life insurance can be used to address state estate tax in a decoupled state. 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. The practical issue is to what degree clients who believe that their wealth levels will never subject them 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 "assured" savings will be a reduction in state estate tax. But even that might not be assured if a surviving spouse moves to a new state: the state changes its laws, etc. Client hesitancy to undertake more comprehensive planning may 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. Many clients may opt to avoid the decision of whether to undertake more involved planning, or the complexity of whether and how to use portability and/or a bypass trust and the myriad of ancillary decisions, by looking to life insurance to address the state estate tax costs, or alternatively the capital gains cost heirs may face.
√ Does Your Client Really Have to Keep Doing Annual Crummey Notices: Crummey powers have been used in almost every life insurance trust. But as common as they are, they are a constant source of confusion and frustration for clients. While insurance trusts should continue to be used regardless of whether the client is subject to an estate tax (to protect and control the insurance proceeds), are Crummey powers really necessary? Historically a key step in every life insurance trust plan was to assure that gifts to the life insurance trust qualified for the gift tax annual exclusion ($10,000 inflation adjusted, $14,000 in 2013). But if the client will never be subject to an estate tax why bother? The exclusion is $14,000/donee in 2013. These are the annual notice provisions whereby the trustee notifies every beneficiary that a gift was made to the trust and that the beneficiary has a time period during which he or she may withdraw it. The beneficiaries would typically be notified in writing. In many cases the beneficiaries would be requested to sign a counterpart to the written notification confirming their receipt of the notice. Might it now become practical to actually draft Irrevocable Life Insurance Trusts (ILITs) without Crummey powers? For clients with moderate wealth estates, if they are really certain that they will never be subject to a federal estate tax, why burden them with annual homework they don't want to do and too often don't handle properly if at all? Note that if a trust doesn’t include annual demand powers, a gift tax return will be required each year gifts are made to allocate gift tax exemption since gifts to the trust will not qualify for the annual gift exclusion. Perhaps there is another alternative that no practitioners would have recommended prior to ATRA. Consider having beneficiaries sign a one-time statement waiving the right to future written Crummey notices and acknowledging that they will be made orally and the trustee signing agreeing to give verbal notice. While the common advice in the past was to use written notices so that there would be proof to show the IRS that notice was given on an audit, the only 709 or 706 most clients will ever file will be one to secure portability on the death of a first spouse. There seems to be no reason why a verbal notification should not suffice to meet the requirements of a present interest gift. Caution: Be certain that the trust document does not require an annual written notice be given if the intent is for the trustee to merely give an oral notice.
√ Consider Income Tax Advantages of Life Insurance: Because of the post-ATRA environment of higher income taxes and the 3.8% Medicare tax on passive investment income, 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 estate tax benefits that had previously proven the draw. The higher income tax rates ATRA imposed 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. While many may believe that the cost structure of life insurance is such that the use of life insurance as part of an investment plan is inadvisable, look again at the actual returns the particular client has realized from his or her investment portfolio over time. Many clients have so lacked the discipline necessary for investment success that a quality like insurance policy will have actually outperformed what the client has realized. Life insurance companies, by law, are required to keep substantial reserves. The reserves are low risk. The fear created by the recent recession has made many clients worried over their investment portfolio. Adding a reasonable component of permanent life insurance as ballast to the client's investment portfolio may be appealing to some clients. The post-ATRA income tax benefits may enhance that.
√ Clients can Access Insurance Cash Value (even in trust) Tax Free: A valuable benefit of permanent life insurance is the tax-free build up of value inside of the policy. Clients can, with a modicum of monitoring and planning, access this cash value in the future if desired. Even if the policy is held in trust this may be feasible. For example, wife establishes an insurance trust to own permanent insurance on her life and names her husband and children as beneficiaries. An independent trustee may be able to borrow money out of the policy in future years and distribute those funds to the husband, all income tax free. Unless the policy is characterized as a modified endowment contract ("MEC"), and if the policy isn't surrendered and withdrawals don't exceed the client's tax basis in the policy, the excess of the policy cash value above the income tax basis in the policy is not subject to income tax. The client can avoid income tax when withdrawing money from the policy if the withdrawals are limited to the income tax basis, and then thereafter cash is withdrawn in the form of loans taken out for the excess above basis. If the insured dies with a policy in force, any cash value above the income tax basis not previously withdrawn is also not subject to income tax, even if the policy is a characterized as a MEC.
√ Watch the Transfer for Value Rules Trap When Moving Policies: Post-ATRA many clients may seek to move life insurance policies around to meet the new planning realities. For example, a client may have a life insurance policy held in a corporation that was to be used for a redemption buy out. Now, they may wish to simply transfer a policy that may no longer be needed for that purpose into an insurance trust to protect it, and retain the policy for its income tax advantages. Be careful not to inadvertently trigger the transfer for value rules in this type of transaction as that could make all the death proceeds taxable. Unless improperly transferred, the death benefit paid under a life insurance policy is not generally subject to income tax.
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