Forget Repeal–Focus On Family Wealth Transfer Challenges

Regardless of what the President and Congress decide to do with the estate, gift, and generation-skipping transfer tax system, there will always be a need for family financial planning. Even in a world completely devoid of taxes, there will always be a need for the services we render.

Many people have assumed that in an estate tax-free environment there will be no “estate-related” reasons to provide liquidity. Quite simply, this is wrong–liquidity solves problems.

It provides income, pays down debt, allows for continuing a business, pays for education, balances inheritances among various classes of heirs, provides for a second spouse and meets the expenses of estate administration. All of these problems occur with or without estate taxes.

Even if estate tax repeal is made permanent, it makes sense to keep your attention on estate liquidity planning.

Several things have happened recently that have focused attention on estate planning. First, of course, are the complicated provisions of the Economic Growth and Tax Relief and Reconciliation Act of 2001 (EGTRRA).

Second, the depressed economy and the stock market certainly have heightened peoples awareness of their wealth and the uncertainty often associated with investments. This is a motivating factor for clients to pursue aggressively estate-planning opportunities. A key component of this planning is to provide estate liquidity through the placement of insurance products.

Consider some of the details in EGTRRA. As you might imagine, the carry-over basis regime is extremely difficult to administer. Remember when we tried this 25 years ago with literally no success? The carry-over basis regime was such a disaster that it was retroactively repealed back in 1981. Even with the advent of computers, there is nothing that indicates we will be any more successful in tracking basis now than we were some 25 years ago.

Obviously, under a carry-over basis regime, record keeping will be at a premium. This is going to add cost to the administration of estates. It will also place a huge burden on you as financial advisors to your clients. And we all know that if we are unable to substantiate basis, the Internal Revenue Service presumes your basis is zero.

You can also imagine the potential conflicts over basis allocation among various beneficiaries of an estate. No beneficiary of an estate wants to take carry-over basis unless that basis is reasonably close to fair market value at the time of receipt. This is because of the locked-in capital gain associated with the lack of a full basis step-up.

In many estates, especially when the surviving spouse may not be the parent of the decedents children, there will be significant tension over the allocation of assets to the children over a spouse.

This is particularly the case in estates that contain closely held businesses that may be run by the children of the deceased. An executor might want to allocate the stock in the business to the surviving spouse just to get the spousal step-up in basis. The executors zeal to get a basis adjustment will have to be tempered by the request of the children to allocate the stock to them even though no step-up in basis will be allocated.

Obviously, this is a major problem, one that can and should be solved with life insurance.

In cases such as these, even though no estate tax may be due, the capital gains tax burden could be very substantial. Thus, instead of procuring life insurance for the purpose of paying estate taxes, we will be placing life insurance as the solution to a very complicated basis adjustment allocation in the estate.

Obviously, a new focus for all of us in an estate tax repeal/carry-over basis era will be capital gains taxes. And, whenever capital gains are an issue, we consider using a charitable remainder trust. Under carry-over basis rules, we will be using them even more.

While the charitable remainder trust is great for the donor, it is lousy for the heirs. This is because at the time of the donors death, or the expiration of the specified term of years, the remaining assets all pass to charity. Hence, the donors heirs are eliminated from receiving an inheritance from the capital asset that was sold through the CRT.

Wealth replacement life insurance should be implemented in scenarios such as this. Cash flow to meet premiums will never be a problem because the annuity amount or unitrust amount will provide the premium payments. Thus, a complete plan for multiple generations is achieved through the efficient placement of insurance.

If EGTRRA is made permanent, this would mean that for 2010 and beyond we would have a carry-over basis system. While all this is going on, the individual states are facing massive budget crunches. Just 28 days after President Bush signed EGTRRA 2001 into law, Rhode Island re-enacted a separately administered estate tax system capping its exemption at $675,000. Many other states have followed suit. I predict this trend is not going to stop.

Suddenly dual planning for state estate taxes versus federal capital gains taxes is now required. So, now, your task will be to counsel clients through this duality of planning which is time consuming and expensive.

It is hard to tell what the estate tax consequences of dying in various states will be at this early juncture. But in states like Rhode Island, which has set a very low threshold for estate tax, there will be many estates that will be subjected to substantial state estate taxes that otherwise would have escaped estate tax liability in its entirety. The disparity in the laws of the various states presents a planning opportunity for clients that have options over their state of domicile. It will be incumbent upon us as advisors to stay on top of the various state estate tax laws as they develop.

I view state estate taxes as an issue that needs to be dealt with effectively in the same manner in which we once dealt with the federal estate tax before the major reforms of 1981. Liquidity needs will occur at both the first and second deaths of a husband and wife. First death liquidity will be needed to meet capital gains taxes on assets that are not allocated to a surviving spouse.

First, death liquidity may also be necessary to meet some state estate taxes where the allocation of assets to a credit shelter trust for federal estate tax purposes causes estate tax to be paid to a state where the first death occurs before 2010.

Second, death liquidity will clearly be needed on assets that will be distributed to second generation heirs to meet state estate tax burdens regardless of whether the decedent dies in 2010 or later.

Another area of estate planning that deserves attention in a modified estate tax system is family business succession planning. Even without taxes, family-owned businesses are extremely fragile. Although the estate tax is often cited as a reason for the failure of businesses in successor generations, the reality is the estate tax is often not the cause at all. The much more prevalent cause is the lack of proper succession planning.

Business succession planning is purely about saving a business. Thus, in an estate tax-free world, businesses are still fragile and liquidity is king. Business owners need to be reminded of this fact. I am sure you have encountered business owners who told you that insurance is no longer necessary because of estate tax elimination. That is not true in the succession arena.

It is also not true in several other areas associated with business succession planning. Every businessperson will complain to you about the difficulty of attracting and retaining high-quality employees. One of the methods of accomplishing this goal is by implementing an attractive plan for employees. Ultimately, the goal is not just to reward the employee, but also to provide for a soft landing for your client, the business owner. When you assemble the right combination of key employee benefits which include life insurance, disability insurance, retirement programs and the like, you will provide the business owner with some of the tools necessary to attract and retain key employees.

Furthermore, we want to put in place the necessary life insurance products to enable key employees eventually to buy out the business owner. This way, the business owner will be secure in that a sound plan for his retirement has been secured and the employees will be attracted and retained by the prospect of business ownership. None of the foregoing discussion has anything to do with estate taxes. This level of planning is required for every business succession case regardless of whether estate taxes are eliminated.

Planning today makes the two inevitabilities of life a bit easier for those that will be left behind. The joke is that those two inevitabilities are death and taxes. And its true–it is not a joke. For many of us, death and taxes is why we are in this business. Estate planners plan for the inevitable and when someone dies, there will be a tax in one way, shape, form or another. You have the products to provide certain results in uncertain times. So, stop worrying about estate tax elimination. Taxes and other expenses at death are still prevalent–no matter what the politicians may want the public to believe.

John M. Harpootian, J.D., is principal of Paster & Harpootian Ltd., Providence, RI. He may be reached at john@ph-estplan.com. This is an abridged version of a presentation he gave at the MDRT meeting in Las Vegas.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 30, 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.