Since 2013, when Congress raised the bar to almost $11,000,000 for married couples to pay Federal estate tax, the estate planning space has been bifurcated into two segments: The mass affluent families that will not be subject to Federal estate tax, and the wealthy who will have an estate tax liability even after the almost $11 million unified gift and estate tax exemption.
The mass affluent segment unfortunately has been largely ignored, even though they have very real needs. With likely asset depletion using popular income distribution strategies during retirement, there has never been a greater necessity for legacy creation. Most affluent families expect to leave something to their loved ones or a charity. Unfortunately, even families with $2 million to $3 million in reserves may face complete spend down by the time the second spouse dies. About 21 states remain that transfer taxes on death and the exemptions are usually one to two million dollars, or less, with rates as high as 16 percent. For clients living in these states a proactive approach may be required. Credit shelter trusts or liquidity provided by life insurance come to mind. Another case for concern involves couples where one member is a non-resident alien. These couples can owe federal estate tax on U.S. property and the exemption is only $60,000. With the prevalence of foreign investors and immigrants, this represents a growing need for liquidity and planning. Lastly, it is always important to consider whether the client owns illiquid assets that might need to be liquidated in a down market or assets that involve substantial carry costs. Strategies to meet these needs can range from credit shelter trusts in transfer tax states to substantial life insurance coverage for legacy creation and value replacement.
For wealthy families there is a fog of uncertainty concerning whether to plan and, more important, how to plan. This has translated into planning apathy in some cases. Clients are asking “why plan?” when the Federal estate tax may be repealed. There are many valid responses to this comment. One of the most appropriate is that a repealed transfer tax would most likely have a sunset provision of no more than ten years and due to budget deficits could be repealed earlier by an administration with a different agenda. If planning is the objective, how should we do it? Remove as much value as possible from the estate to minimize transfer tax, or keep as much as possible in the estate to maximize the step up in basis under Section 1014 of the Code? Ron Aucutt, an expert in this area, opines that whether the tax on transfer is “estate” or “capital gain” the result is the same. If the step up in basis is lost, we have a realization of gain at death which is the way Canadians are taxed. This method can be just as costly as an estate tax. The current proposals from both branches of the Federal government seem to leave the gift tax intact. In other words delinking the gift tax from the death time transfer tax or Federal estate tax. If this direction prevails traditional planning techniques will still be prevalent for wealth transfers prior to death. All of the above should be strong motivation to plan and provide the liquidity to protect.1
This past year has not been without clarification in key areas. Executive Order 13789, issued in April, directed Treasury to review regulations that were issued in 2016 and 2017 to determine if the regulations cost too much, are too complex, or exceed the IRS’s authority. REG-163113-02 relating to Sec. 2704, which deals with restrictions on the liquidation of interests for example in family limited partnerships, was considered burdensome. The proposed regulation would have significantly reduced the use of valuation discounts important to the viability of many family businesses. This is great news for families using an FLP strategy. In the agribusiness community FLPs are often used to protect the land legacy for future generations. The land interest is separated from the actual farming operation where succession would be covered by a traditional buy-sell agreement. Good news indeed for this strategy.2
In a period of uncertainty, flexibility will be a key to appropriate planning. Techniques like Spousal Limited Access Trusts (SLAT) which provide options prior to death will be favored, as will Qualified Terminable Interest Property Trusts (QTIP) which also provide options.
As financial professionals it is critical to have the death time conversation, both with mass affluent and high net worth clients. In the mass affluent space it is common for families that have accumulated $2 million to $3 million during their working years to feel confident about leaving a financial legacy. Using a 2.8 percent systematic withdrawal strategy, which is Morningstar’s recommendation in the current interest environment, the likelihood of complete spend down is high. Legacy creation using life insurance is a potential strategy. There are many options including: Single premium guaranteed universal life, indexed universal life, and whole life. Fortunately, because of the cost efficiency of life insurance, these strategies can be implemented without a dramatic reduction in lifestyle.
In working with high net worth clients flexible planning is the key. Large gifts resulting in immediate gift tax payments should be avoided. Just as it is important to accurately quantify risk in an investment portfolio, it is vitally important to look at the legal risk in an estate planning strategy. For example, some financial professionals are still using Gaussian models to quantify risk. This can result in an underestimation of risk compared to a more modern Mandelbrotian or fat tailed approach. Likewise, caution should be used when considering a complex, less flexible, expensive, or administratively complex estate planning strategy. An example of this might be a Beneficiary Defective Inheritance Trust. This strategy can be effective in avoiding transfer taxes under current statutes, regulations, and case law, but might be less effective if statutes and regulations change.
Whether individually owned or placed in a simple Irrevocable Life Insurance Trust, life insurance remains one of the most flexible alternatives. Rather than being a planning technique, life insurance is an asset that provides financial liquidity from day one. It offers a range of income tax benefits including tax deferred growth of cash value, tax free access to cash value, and a tax free death benefit. It provides liquidity regardless of the transfer tax environment in place at the time of death. This can help families avoid costly liquidation of assets at death due to market conditions or carry costs. All around, life insurance is a versatile piece in the estate planning puzzle. Whether you are just entering the estate planning space or have participated in many implemented plans, it is critical from both current planning and a persistency standpoint to revisit the value of both estate planning and the life insurance policies that provide the financial wherewithal to complete them.
Parthemer, Esq., Mark R. “The Experience to Meet Your Family’s Complex Needs.” Bessemer Public New > Home, July 2010, www.bessemertrust.com. September 23, 2017
Nevius, Alistair M. “Treasury Identifies 8 Regulations as Burdensome.” www.thetaxadviser.com, 7 July 2017. September 23, 2017
This material is intended for educational purposes only. For financial professional use only. Not to be used for consumer solicitation purposes.
Income tax free distributions are achieved by withdrawing to the cost basis (premiums paid), then using policy loans. Loans and withdrawals may generate an income tax liability, reduce available cash value, reduce death benefit, or cause the policy to lapse. This assumes the policy qualifies as life insurance and is not a modified endowment contract.
Both loans and withdrawals from a permanent life insurance policy may be subject to penalties and fees and, along with any accrued loan interest, will reduce the policy’s account value and death benefit. Assuming a policy is not a modified endowment contract (MEC), withdrawals are taxed only to the extent that they exceed the policy owner’s cost basis in the policy and usually loans are free from current federal taxation. A policy loan could result in tax consequences if the policy lapses or is surrendered while a loan is outstanding. Distributions from MECs are subject to federal income tax to the extent of the gain in the policy and taxable distributions are subject to a 10 percent additional tax prior to age 59½, with certain exceptions.
The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Partners Advantage does not provide legal or tax advice. Partners Advantage cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Partners Advantage does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Partners Advantage makes no warranties with regard to such information or results obtained by its use. Partners Advantage disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
William H. Jackson
JD, CLU is the senior advanced markets consultant at Partners Advantage, working with all divisions of the company to assist financial professionals and agencies in growing their businesses. He provides his valuable strategies on a number of areas, including tax, financial, philanthropic, retirement, business and estate issues. He is part of an in-house team of highly experienced professionals at Partners Advantage which provides insights on complex cases and products. These services also include an in-house underwriting team and compliance and suitability team. Prior to joining Partners Advantage, Jackson served in a number of sales and product marketing roles at Sun Life and AIG Sun America. Jackson also has extensive experience managing pension, business and estate planning, and deferred compensation divisions. Jackson may be reached via email at: firstname.lastname@example.org.