By John S. Budihas

With the reduction of the estate tax and its one-year repeal on the horizon, many people thought they would soon be saying goodbye to liquidity planning with life insurance for preserving assets and creating legacies.

After all, the highest estate tax marginal tax will reduce to 45% in 2007 from 55% in 2001. The lifetime exclusion equivalent increases to $3.5 million in 2009 from $675,000 in 2001. The generation skipping tax exclusion will equal the exclusion equivalent in 2004 of $1.5 million and thereafter track its rise to $3.5 million in 2009. And when the federal state death tax credit expires in 2005, many states may rethink their estate and inheritance taxes.

No matter how you say it, the need for life insurance liquidity dollars seemed destined to become history.

Well, don’t write off estate liquidity planning with life insurance just yet. What type of planning is right for your clients depends upon what type of assets make-up their estates and what their objectives are with respect to asset accumulation, asset preservation and asset distribution. This is the essence of estate planning. People still feel asset and asset preservation remain primary objectives. How successful they are could depend upon the implementation of one or more life insurance planning strategies:

Liquidity need #1. If a large part of a client’s estate is composed of pension or profit sharing assets, IRAs, annuities, non-qualified deferred compensation benefits, vested stock options, unpaid installment sales payments, income taxation alone may preclude attaining estate planning objectives.

Since the Internal Revenue Service classifies these assets as income in respect of a decedent (IRD), they may be subject to estate taxation for the deceased taxpayer/owner and income taxation for the family beneficiaries.

The highest combined marginal estate and income tax bracket rates in 2009 will equal 80% (45% estate/35% income). True, if the one-year estate tax repeal of 2010 becomes permanent then the increased $3.5 million lifetime exclusion per spouse can negate estate tax consequences for most IRD assets. However, estate tax elimination would correspondingly increase the beneficiary’s federal income tax liability on these same IRD assets. Currently, any estate taxes paid on IRD assets create an itemized deduction that can be applied against the IRD income received by the beneficiary.

Liquidity need #2. Will the step-up in cost basis for inherited assets to their fair market value be repealed in 2010? That is what the new tax law states. A limited basis step-up is permitted in the new tax act for select non-IRD property ($1.3 million for property transfers and an additional $3 million for qualified spousal property to spousal beneficiaries). Those with low cost basis assets that have grown in value to $5 million, $10 million or $20 million in most cases will need tax-advantaged life insurance assets to offset any capital gains liability and thus avoid the depletion of the capital asset itself. Life insurance assets allow a taxpayer’s estate to pay capital gains taxes for “pennies on the dollar.”

Liquidity need #3. Family and non-family closely held businesses are at risk. It’s been reported that approximately two out of three family businesses will not be successfully transferred to first generation family members and less than 15% of those businesses will make it to the second generation.

Liquidity planning is essential for family owned businesses to equalize the distribution of estate assets to those family members who are not actively involved in the family business, especially when the business constitutes most of the taxpayer’s estate value. Otherwise dissension, rivalry and incompetence generally cause the liquidation of the concern and the resulting loss of up to 60% of fair market value. A life insurance plan is a cost- and tax-effective solution for successful transition of a family business.

Non-family owned businesses that have not implemented adequately funded business continuation plans are also more likely than not to incur these same liquidation losses. A viable continuation plan guarantees that a predetermined buyer will have the necessary cash to purchase the deceased owner’s business interest from his estate at its current fair market value. A life insurance funded buy-out agreement provides the liquidity at the very time that it is needed.

Note that a life insurance liquidity need exists for successful family and non-family business continuation, regardless of whether the “sunset” provisions of the existing tax law changes become effective on Dec. 31,2010. Very few businesses have been forced into liquidation due to an estate tax consequence.

Liquidity need #4. Litigation and creditor claims are major causes of asset depletion that often defeat the successful transition of assets to the heirs of an estate. One of the best ways to replace lost assets with discounted dollars may be to establish a domestic asset replacement trust, funded with life insurance. A highly flexible but irrevocable trust with proper spendthrift provisions can insulate a family’s trust assets from litigation and creditor attachment to help ensure the successful attainment of estate planning objectives. Discretionary powers can be given to the trustee to distribute trust assets in such a manner as to fulfill the planning objectives of the creator of the trust.

Regardless of the changes that occur in tax law, trust and life insurance planning is a strategy for all seasons to help ensure that the taxpayer will be in the right place at the right time. Flexibility and liquidity will be the essential ingredients for every plan over the next decade to combat the ongoing uncertainty in tax law, where the only constant continues to be change.

John S. Budihas, CLU, ChFC, CFP is a business, estate and trust planning consultant for Hartford Life, in Sarasota, Fla. He can be reached at john.budihas@hartfordlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 29, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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