The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010 or the Act) temporarily extends most of the provisions of the Bush-era tax cuts. Because it is set to expire on December 31, 2012, the Act creates a two-year window to take advantage of its provisions. Following is a discussion on the Act’s wealth transfer provisions with suggestions on how they could be used to encourage life insurance sales.
Federal Estate and Generation
Skipping Transfer (GST) Taxes
In most cases TRA 2010 was designed to extend tax provisions that were about to expire. However, in the estate, gift and GST tax arenas, the Act didn’t just extend tax benefits, it significantly expanded them.
Estates of wealthy people who die between 2011 and 2012 can take advantage of these expanded estate tax and GST tax benefits:
• Maximum rate estate and GST tax rates of 35 percent.
• Estate tax exemption of $5 million (indexed for inflation in 2012).
• GST tax exemption of $5 million.
• Estate and gift taxes are reunified at $5 million.
• Estate tax unified credits can be “portable” between spouses. This means that a surviving spouse may elect to take advantage of the unused portion of a deceased spouse’s estate tax exclusion and add it to the remainder of his own estate tax exemption; only the unused credit of the last deceased spouse can be “imported.”
Although these estate tax changes sound beneficial, their use will likely be limited because clients must die to take advantage of them. The portability provision is even less likely to be used because both spouses must die during the two-year window. Clients who don’t expect to die before 2013 should probably plan on an estate tax exemption of $1 million and a maximum tax rate of 55 percent (the exemption amount and maximum tax rate percentage set by current law after the two-year window ends).
Federal Gift Taxes on Lifetime Transfers
Favorable New Rules. The Act also significantly expands the gift tax limits. Some of the expanded gift tax provisions include:
• Maximum gift tax rate of 35 percent.
• Lifetime gift tax exemption of $5 million per person (indexed for inflation in 2012).
• Reunification of the gift tax and estate tax, which means that transfers of wealth will have essentially the same tax result regardless of whether they were made during life or at death. In 2011 and 2012 the same rate schedule which will be applied to both lifetime gifts and transfers after death.
• GST exemption of $5 million per person.
The Act’s gift tax provisions present immediate and valuable opportunities for those willing and able to make large lifetime gifts. Like the estate tax provisions, the gift tax provisions expire at the end of 2012. However, they are potentially much more valuable than the estate tax provisions because people can use them without dying (as long as they complete their gifts before the two-year window closes).
Tremendous Gifting Opportunities over the Next Two Years. Even though temporary, the expansion of the lifetime gift tax exemption to $5 million could be one of the most important changes in federal wealth transfer taxes in recent memory. This exemption had been fixed at $1 million since 2001. Increasing it to $5 million is unprecedented.
Clients who had previously used up their $1 million exemptions have now been “restocked” with an additional $4 million of tax-free gifting capacity. Married spouses who have both used their gift exemptions are now able to make additional gifts separately or in split gifts to transfer up to an additional $8 million gift tax-free. Married couples who haven’t used any of their exemptions could together give away a total of $10 million ($5 million each) gift tax-free during 2011 and 2012.
Wealthy clients have nearly two full years to design and implement their gifting plans. If they want to give away more, they can do so and pay gift taxes at the relatively low rate of 35 percent.
Life Insurance and Gifting. Many financial professionals know that life insurance is a tool with the potential to efficiently transfer wealth to younger generations. To make the sale, you will need to effectively answer at least two client questions:
Question 1: Why should I make gifts? Donors who can afford to make lifetime exemption gifts need to understand that lifetime gifts can have important advantages over transfers at death because:
• Leverage (growth in asset value) after the gift occurs is outside the taxable estate.
• If the gift is made through a trust, future control over the gifted assets can be maintained through a trustee who has a legal duty to follow the terms of the trust.
• If the gift qualifies as a generation skipping transfer, the $5 million GST exemption can be used to potentially remove the gift from the federal transfer tax system for several generations (the actual length of time depends on state law).
• Donors may be able to see the benefits the gift provides with their own eyes.
• Gifting creates more certainty because the tax consequences for 2011 and 2012 are known; unfortunately, no one can be certain what the gift/estate tax laws will be after 2012.
• Income tax savings may be generated when an income-producing asset is gifted to a donee who is in a lower income tax bracket than the donor.
Question 2: Why should I use life insurance in my gifting? A convincing answer to this question is critical to making the sale. The fact is that life insurance has the potential to offer a unique combination of several valuable advantages when it is used as part of a gifting strategy:
• Growth/Leverage. Premiums paid for life insurance death benefit protection can provide significant leverage in the early years and may provide a competitive rate of return through life expectancy.
• Income Tax-Free Payment. Policy death benefits (including the amount in excess of premiums paid) are generally income tax-free under IRC Section 101.
• Predictable Value. A policy may be structured to pay a known death benefit amount when the insured dies.
• Value Not Directly Linked to Market Performance. The policy may be structured so that the death benefit may not directly depend on financial market performance.
• Liquidity. The death benefits are paid in cash; generally no income taxes, transfer costs, commissions or management fees are subtracted from the death benefit.
• May Avoid Estate and Generation Skipping Taxes. Ownership of the policy may be structured so that the death benefits will not be subject to federal estate or GST taxes as part of the insured’s taxable estate.
Life Insurance Sales Opportunities
for Wealthy Clients
Healthy parents and grandparents who can afford to make lifetime gifts have a great opportunity in TRA 2010—perhaps a once in a lifetime opportunity. The increase in both the gift tax and GST exemptions to $5 million creates unique potential to pass on large amounts of wealth to younger generations. Some of the time-tested gifting strategies that regularly use life insurance to effectively transfer wealth include:
• Irrevocable Life Insurance Trusts (ILITs). Funding opportunities for new and existing ILITs commenced on January 1, 2011, when the gifting and GST exemption increases became effective. Clients who were happy with their current ILITs could gift more to them; those who wanted something different could create new ILITs and fund them with new gifts. For married couples, the combined lifetime transfer opportunity increased from $2 million to $10 million. Depending on the terms of the trust, using the exemption increases could potentially help clients avoid problems that may arise from funding the trust with $13,000 annual exclusion gifts (Crummey withdrawal powers).
Healthy & Wealthy Prospects Do You Know Someone Who…
• Has a net worth of more than $5 million (single) or $10 million (married)?
• Has already used his $1 million lifetime gift tax exemption or who has written a check to the IRS to pay a gift tax?
• Is well off financially and has grandchildren he cares about?
• Is uncomfortable making gifts that require sending out a temporary (Crummey) withdrawal power notice or who doesn’t want his children or grandchildren to know he is making a gift for them?
• Makes large gifts to charity?
• Is an attorney or CPA and gives tax/legal advice to wealthy clients?
• Has implemented a life insurance premium finance arrangement?
• Has established an Irrevocable Life Insurance Trust (ILIT)?
• Has created a generation skipping transfer (GST) trust for his family?
• Has created a private split dollar or private loan arrangement?
• Has one or more special needs child or grandchild?
• Generation Skipping Trusts and Dynasty Trusts. The increased gifting exemption may be combined with the increase in the GST exemption to create new funding opportunities for generation skipping and dynasty trusts. Allocating GST exemptions to lifetime gifts funding these trusts could possibly insulate large amounts of wealth from the transfer tax system for many generations (depending on state law). Lifetime exemption gifts (especially gifts to GST/dynasty trusts) may also be attractive because they don’t require a present interest on the part of trust beneficiaries.
As a result, the use of temporary withdrawal powers (also known as Crummey powers) and the need to give notice of them to beneficiaries could possibly be avoided. Present interest gifts (also called annual exclusion gifts) currently have a ceiling of $13,000 per donee; these gifts could be used on other transfers.
• Charitable Gifts Replaced with Life Insurance Death Benefits. Clients who are charitably inclined could decide to make lifetime or testamentary gifts to their favorite charities or charitable foundations and use life insurance to replace some or all of the assets given away. A potential application for this strategy is a charitable remainder trust (CRT).
The client establishes a CRT and funds it with a gift of securities or real estate. The CRT trustee sells the donated asset and uses the sale proceeds to make annual payments back to the client. The client uses the after-tax value of these payments and the value of the income tax deduction generated by funding the trust to make gifts to an ILIT or dynasty trust which purchases life insurance on the client’s life to replace the assets given to the CRT. At the client’s death the remaining CRT assets are distributed to charities named as CRT beneficiaries. The life insurance death benefits are paid to the ILIT/dynasty trust trustee who manages and distributes them under the trust’s terms.
• Premium Financed Life Insurance. Clients who have existing premium financed life insurance arrangements may decide to use part of the increase in the gifting exemption to transfer assets to the ILIT so it can fully or partially repay the funds it borrowed from commercial lenders. They could also make gifts to the ILIT to provide the trustee with the cash needed to make interest payments on the outstanding loan.
Clients considering new premium finance arrangements have the potential to contribute more funds to the ILIT gift tax-free and thus could potentially reduce or eliminate the need for the ILIT trustee to borrow funds from outside lenders to pay policy premiums.
• Existing Private Split Dollar and Private Loan Arrangements. Clients who have advanced funds for the benefit of their families in private split dollar or private loan arrangements may have an opportunity to reduce the amount to be paid back to them or to “roll out” of these arrangements completely. The two year increase in the gift exemption to $5 million in 2011 and 2012 may allow them to forgive some or all of the repayment they are entitled to receive under the arrangement.
Forgiving the repayment of a private loan or a private split dollar advance could be attractive because it does not require the transfer of any additional cash or property. It also has the advantage of reducing or eliminating the economic benefit reporting (private split dollar) and interest reporting (private loans).
Questions That May Come Up
During the Sales Process
• Assuming the client is insurable, how much life insurance should he purchase? Many clients have no idea how life insurance companies view their potential for life insurance coverage. In many cases it can be helpful to know how much new life insurance coverage they could potentially purchase under an insurer’s underwriting guidelines (their insurability reserve). Knowing this number can be an important factor in deciding how much life insurance to buy. Knowledge of their available insurability reserve can help clients make informed decisions about how much life insurance to purchase.
• What Non-Life Insurance Gifting Alternatives May Be Considered? Life insurance isn’t the only financial tool that could deliver positive wealth transfer results for high-net-worth clients. A disadvantage for life insurance is that the gifts generally must be made in cash. Other gifting strategies may not require cash to make gifts. Instead the client may be able to make gifts by transferring title to property. Some of these strategies include: qualified personal residence trusts (QPRTs); grantor retained annuity trusts (GRATs), and family limited partnerships (FLPs).
• Does life insurance make financial sense for me? How financially efficient will a life insurance policy on my life actually be? For life insurance to be useful in gifting scenarios, it must deliver an internal rate of return (IRR) that is competitive with those generated by other financial vehicles and strategies. If the life insurance proposal for a particular client doesn’t show a competitive after-tax IRR at the client’s life expectancy, it may be wise to consider other gifting strategies.
• Where will the premium dollars come from? Premium dollars can come from a variety of places. Cash and short term, liquid savings vehicles are best, but many clients may not have millions of dollars in savings accounts or certificates of deposit, etc. readily available.
IRAs and tax-qualified retirement accounts could potentially be used. Tax-qualified retirement accounts can potentially be attractive as premium sources for wealthy clients who are over age 591/2 and who do not expect to need the account balance for retirement income. Any distributions will be subject to income taxes, so it is wise to consider only the after-tax distribution as a potential source of premiums.
Another alternative is for clients to look through their asset portfolios and decide to sell one or two of them. The after-tax proceeds from the sale could provide some of the cash needed to fund the gift. Because TRA 2010 retains the 15 percent rate on capital gains, 2011 and 2012 may be good years to sell capital gain assets.
• What Timing Options Are Available? There are at least three options for implementing a life insurance-based wealth transfer strategy under TRA 2010:
1. The Do It All Now Strategy. Some clients will be in a position to make their gifts and purchase the life insurance immediately. They may have both tax and legal advisors who recommend acting quickly and enough liquid assets.
2. The Wait Till the Last Minute Strategy. Other clients will decide to wait until just before midnight on December 31, 2012, to establish their trusts and gift away the funds to pay the premiums. Of course, by waiting, they assume a variety of risks, including that they will become uninsurable or die unexpectedly and that the assets/funds they expect to use to make their gifts may dry up or disappear.
3. The Secure the Insurance Now, Make the Big Gifts Later Strategy. Still other clients will want a low risk strategy that keeps them in control and their options open for as long as possible. They may decide to make their life insurance decisions early and put the coverage in force and use convertible term coverage to keep their initial outlay low. In 2012 they could convert the term coverage to cash value life insurance. They will make gifts needed to pay the premiums, but they may wish to postpone making the biggest gifts to the fourth quarter of 2012, at the end of the two-year window.
Conclusion. TRA 2010 continues the uncertainty that surrounds wealth transfer planning. Its provisions are temporary and expire at the end of 2012. The temporarily expanded lifetime gifting limits seem to create valuable life insurance sales opportunities for wealthy clients. TRA 2010 gives them a two-year window in which to transfer large sums of wealth to children and grandchildren or to trusts for their benefit. Life insurance is a tool with a unique combination of potential advantages which may help increase the value that is passed on to clients’ families.
Now is a great time to set up meetings with clients and their tax and legal advisors to discuss the planning options TRA 2010 makes available over the next two years.
These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone.
