Flexibility Remains The Key To Effective Estate Planning

On June 7, 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted which, through 2009, provides for reduction in maximum tax rates, increased exemptions from taxes, and repeal of the estate tax in 2010. What are the implications of this law for estate planning?

Of significant note is the new laws “sunset” provision, which causes the law to expire on Dec. 31, 2010, and effectively reinstates the wealth transfer tax system as it existed prior to its enactment. Furthermore, even if the estate tax repeal is extended, various taxes will remain payable at death.

Consider the impact of carry-over basis and capital gains tax; annuities, qualified retirement plans and other assets attracting ordinary income tax; and state death taxes. Consequently, clients will continue to seek guidance on minimizing taxation and estate erosion, and given the uncertainties of the estate planning landscape, they will seek planning solutions that foster flexibility to accommodate changes in the law and their future circumstances or objectives.

Survivorship life insurance has long been recognized as a cost-effective and tax-efficient method of funding estate liquidity, and has played a pivotal role in many popular estate planning techniques, including the Irrevocable Life Insurance Trust. However, in traditional “ILIT” planning, the policy is owned by the trust from the inception of the plan in order to exclude the insurance proceeds from the insureds estates.

The insureds are excluded as trust beneficiaries and cannot access policy cash for education funding, retirement income, or other lifetime needs. Also, the terms of an irrevocable trust cannot be modified if circumstances or objectives subsequently change.

Therefore, flexibility, access, and control are compromised.

A Survivorship Standby Trust offers a creative solution. The “SST” accommodates the dual objectives of estate liquidity and lifetime income, using a single planning concept and financial product, while minimizing income, estate, and gift taxes. In addition, the SST promotes flexibility by permitting modifications to the plan, which does not become operative and irrevocable until death.

How does an SST work? The spouse with the anticipated shorter life expectancy is the applicant and owner of a survivorship policy insuring both spouses. The SST is designated the contingent owner and beneficiary, and receives the policy upon the death of the policyowner. The policy remains personally owned until death.

Consequently, cash value can be accessed through withdrawals or loans (generally without income tax). In addition, the premium payments are not taxable gifts, so the annual exclusion and unified credit can be conserved for other planning.

If, as anticipated, the policyowners death occurs first, the policy value (reduced by the value of lifetime withdrawals or loans) is included in the policyowners estate, but estate tax can be minimized or eliminated with remaining unified credit.

Alternatively, if the non-owner spouse dies first, the policyowner can assign the policy to an ILIT or other third party. The transfer can be sheltered from gift tax with the annual exclusion or unified credit, and if the policyowner survives three years, the proceeds are excluded from his or her taxable estate.

Since the non-owner spouse has no “incidents of ownership” in the policy and is generally excluded as an SST beneficiary, neither the cash value nor death benefit is included in his or her estate, regardless of the order of deaths.

As a result, upon the survivors death, the SST receives an income tax and estate tax free benefit, which can be used to provide estate liquidity, ensure estate equalization, create a family legacy or even a “wealth replacement” bequest in coordination with a charitable bequest.

Beyond ILIT alternatives, there are numerous other “value added” planning techniques that incorporate flexibility and tax efficiency into an estate plan, and in which life insurance plays a complementary role. Under the new law, gifts beyond $1 million remain taxable. Consequently, use of tax “leverage” and “discounting” is especially significant in passing appreciating assets to family.

For example, “split interest trusts” such as a Grantor Retained Annuity Trusts accomplish a deferred gift of appreciating property to heirs, and permit the grantor to retain income from the trust for a specified term. Only the discounted present value of the remainder interest constitutes a taxable gift to the trust beneficiaries, not the full value of the asset. If the grantor survives the trust term, the property (at its appreciated value) passes to the remainder beneficiaries without additional gift tax, and is excluded from the grantors taxable estate at death.

This technique leverages the unified credit, reduces gift and estate taxes, and preserves the grantors income. A term life insurance policy is commonly recommended to provide liquidity if the grantor does not survive the trust term, and results in the inclusion of the trust property in the grantors estate.

For the charitably inclined client, Charitable Remainder and Lead Trusts enable the donor to provide for charitable as well as non-charitable beneficiaries, and receive significant tax benefits. A CRT permits the donor or someone else to receive income payments from the trust, either for a specified term or for life.

Following the income period, the trust assets pass to a charity(s) of the donors choice. The donation generates a current income tax deduction, and unlimited charitable gift and estate tax deductions based on the value of the charitys remainder interest. CRT planning is often paired with wealth replacement life insurance to ensure the inheritance of the donors heirs is not diminished by the charitable bequest.

Conversely, a Charitable Lead Trust provides the income interest to charity for the trust term, and the remainder interest to non-charitable beneficiaries of the donors choice–typically children or grandchildren. For tax purposes, the value of the remainder interest to the family is based on the discounted present value rather than the full value of the property contributed to the trust, promoting leverage of the unified credit and GST tax exemption.

Following the trust term, the appreciated value of the property passes to the donors heirs without additional gift, estate, or GST tax consequences. “CLT” planning can include a charity-owned life insurance policy on the donor to leverage the charitys income payments into a larger bequest upon the donors death.

Business, investment, and income producing assets are well suited to the advantages of estate and business succession planning with Family Limited Partnerships and Limited Liability Companies. These advantages include the availability of valuation discounts (based on minority interest and/or lack of marketability) for gift, estate and GST tax purposes, and the opportunity for the senior generation to retain income and control.

Life insurance plays a complementary role in key person or buy-sell funding, or as an estate equalization bequest for heirs who are not active in the business. Properly structured, an FLP or LLC (as the owner and beneficiary of life insurance) can also be a flexible alternative to an ILIT for a policy intended for estate liquidity or other purposes.

In conclusion, the new estate tax law does not alter the fundamental approach to estate planning. Instead, it provides opportunities to promote value-added solutions which can accomplish multiple tax and non-tax planning objectives, and provide the flexibility to accommodate changes in objectives and circumstances–including future changes to tax law.

Eva M. Victor, J.D., LL.M. is an advanced sales consultant for the Penn Mutual Life Insurance Company, Horsham, Penn. She can be reached via e-mail at victor.eva@pennmutual.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 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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