5 New Opportunities For Life Insurance Planning Strategies

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James Madison, our fourth president and a leading political theorist, postulated in the Federalist Papers that if tax law is too verbose it will not be read and it if is too long it will not be understood.

Too bad no one took his advice. The U.S. Tax Code has since grown to 25 volumes with more than 45,000 pages. The documents required to explain the Code are four times as long as the Code itself. Congress further padded those volumes in 2001 when it passed the Economic Growth Tax Reform & Reconciliation Act (EGTRRA) with more than 300 changes in gift, estate and income tax laws.

As the industry has seen over the past year, these changes created a good deal of uncertainty and instability for those trying to create long-term financial plans. But these changes also opened the door to four new life insurance-oriented strategies to address liquidity needs, plus a new estate-planning strategy.

Life Insurance Need #1. Although EGTRRA repealed the federal estate tax in 2010, sunset provisions reinstate the tax as well as the top marginal rate of 55% on Jan. 1, 2011. Only the estates of those who die in 2010 will avoid the federal estate tax. Whatever future changes may occur in estate tax law, a properly designed life insurance plan can promote wealth preservation. The death benefits from a life insurance policy can be used to pay the estate tax for “pennies on the dollar.”

Life Insurance Need #2. EGTRRA capped lifetime gifts at $1 million. If a taxpayer decides to fund a lifetime credit shelter trust in 2004, with $1.5 million–the amount equal to the then available death-time exclusion–he or she would trigger a $210,000 federal gift tax.

This is a dilemma for planners and taxpayers because it is generally more efficient to transfer property during life than at death. After all, lifetime gifts allow the donor to remove all future asset growth from estate taxation.

The following strategies can be used to neutralize and counter the $1 million EGTRRA gift tax exclusion on lifetime transfers:

(1) Multiply the tax-free annual exclusion gifts of a present interest to a trust by the number of potential beneficiaries named and give each beneficiary a limited amount of time to withdraw the donors gift to the trust.

(2) Spousal gift splitting allows a spouse to apply his or her exclusion/exemption to property owned and gifted by the other spouse.

(3) Gift valuation discounting techniques such as Grantor Retained Annuity Trusts (GRATS), Charitable Lead Trusts (CLTs), Qualified Personal Residence Trusts (QPRTs), and Family Limited Partnership (FLP) interests. All of these strategies potentially can leverage existing exclusions and exemption amounts, and allow greater tax-free property transfers. GRATS and CLTS, if properly structured, may discount an assets value for gift tax purposes by 50% to nearly 100% and thus avoid or greatly minimize any gift tax consequences.

Life Insurance Need #3. EGTRRA repealed the federal credit for state death taxes paid in 2005. In fact, half of the credit already is being phased out. This means that incurred federal estate taxes will no longer be offset and that very likely the combined federal and state death taxes due will be much greater. Under the pre-EGTRRA subsidy rules, an estate that owed the federal government $50,000 and the state $20,000 would typically pay no more than $50,000. A credit for state death taxes was applied against the federal tax bill.

Thirty-seven states plus the District of Columbia made their state death tax equal to the credit allowed. They were called “sponge” tax states. What will the sponges do when there is no credit? Approximately half of the states today are in their worst fiscal crises of the last half-century. It has even been reported recently that states will lose approximately $25 billion in revenue over five years during the credit phase out.

Already 11 of the 37 original sponge tax states have “de-coupled” themselves from the repeal provisions of EGTRRA and have indicated that their state death taxes will continue to equal what the pre-EGTRRA federal credit was. Plan to pay any potential increased federal and state death taxes with leveraged life insurance dollars.

Life Insurance Need #4. Some states have frozen their exemption for life and death gifts at the pre-EGTRRA level of $675,000. If one were to fund a credit shelter trust this year in New Jersey, for example, with the allowable $1 million federal exemption, it would trigger a $33,000 gift tax. Massachusetts and Minnesota have frozen their exemption at $700,000. Now, states are also “de-coupling” from the federal exemption to grow revenue. Planners and taxpayers must not overlook that an increasing share of their ultimate tax bill is likely to go to the state where they live.

Life Insurance Need #5. The federal estate tax is scheduled to be repealed for one year in 2010. Those who inherit property that year would avoid estate taxes but potentially could incur a large capital gains tax liability. Thats because a new “stepped-up” basis that currently applies to inherited assets will be replaced by a modified carry-over basis rule.

The basis of assets received from a decedent in 2010 will be carried over to the inheritor rather than being stepped up at the fair market value at death. The basis of the estate assets transferring to nonspouse beneficiaries may be increased by up to $1.3 million. Asset transfers to spouses will be eligible for an additional $3 million increase.

Should the EGTRRA carry-over cost basis regime endure, it will create a great burden on those millions of closely held family corporations should the heirs desire to sell the business after the owner dies. Thus another potential liquidity need.

Constant changes in tax laws can and do create planning opportunities for taxpayers who want to accumulate wealth and transfer a financial legacy. Countermeasures need to be taken to neutralize the increasing demand for revenues by both the federal and state governments. Life insurance can provide an anchor in the sea of instability and uncertainty caused by continuous and expected tax law changes.

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


Reproduced from National Underwriter Edition, June 23, 2003. Copyright 2003 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.