It is said that paying estate taxes is voluntary. That is, a client can plan to minimize his estate tax exposure.
One of the most common estate tax planning tools is an irrevocable life insurance trust (ILIT). The income tax-free death benefit of an ILIT-owned policy has even greater potential leverage because the proceeds may be excluded from a client’s taxable estate. Given what has and may happen with estate tax reform, however, are ILITs still necessary? The answer depends on the type of client.
Clients uncertain about estate taxes fit into one of two categories. “Casual” clients need estate tax planning, but don’t realize it. “Careful” clients may not face estate taxes, but do understand the importance of planning.
A casual client wants to minimize taxes, but has not done any substantive estate tax planning. Some have postponed planning. Others may think that estate taxes have already been repealed, or that their estate won’t be large enough to be taxed. For these clients, an ILIT may be useful in estate tax planning.
There will be an estate tax
Casual clients must understand that “nothing lasts forever,” particularly in Washington. Our country’s earliest estate taxes were each repealed within a few years, after the military efforts they were intended to support had ceased.
Since 1916, however, estate taxes have been more permanent. The marital deduction – 50 percent in 1948, increased to 100 percent in 1981 – reduces the estate tax’s impact for decedents leaving wealth to their spouses. The exclusion equivalent amount – increased to $225,000 in 1981, $600,000 in 1986 and by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) – allows decedents an estate tax credit against the value of assets passed on. Nevertheless, these devices can merely offset estate taxes. EGTRRA “repealed” the estate tax only for 2010. It is scheduled to return in 2011.
Reform will not be sufficient
In every Congress since EGTRRA became law, the House – but not the Senate – has voted to repeal the estate tax. In 2006, one proposal would have exempted estates up to $5 million, applying capital gains tax rates to estates between $5 million and $25 million, and twice that rate to estates above $25 million. The measure failed, however, as opponents argued that revenues would “cost” 75 percent of what repeal would cost. Meanwhile, we wait as 2011 fast approaches.
Even if a client rightly believes that his estate is too small to be taxed, unforeseen events could change that. Some clients’ estates may quickly grow to levels that subject them to estate tax – from positive investment performance, a sale of a business or an inheritance. If any of these events are within a client’s realm of possibility, his estate plan should accommodate the “risk.”
Estates of “careful” clients may have to pay federal estate taxes, not because of the assets the client owns, but because of how the client owns life insurance. Careful clients buy life insurance to help meet financial objectives like income replacement or estate equalization, or simply to leave a legacy to children and grandchildren. If the client personally owns such policies, the death benefit will be included in their estate, and could push the estate value to levels high enough to trigger tax liability. Protecting the estate from unforeseen taxes may be reason enough to consider an ILIT. But ILITs may offer additional benefits for “careful” clients.
Shifting estate tax burdens
Before 2005, most states imposed a death tax in the amount of the federal estate tax credit allowed. EGTRRA began gradually phasing out the credit in 2002. By Jan. 1, 2005, the credit was gone altogether. Many states replaced the lost revenue by “decoupling” their tax system from the federal estate tax system, and imposing a tax based on pre-EGTRRA law.
While the federal estate tax exclusion equivalent amount has increased to $2 million (and is scheduled to increase to $3.5 million by 2009), some states recognize only a $1 million exclusion equivalent amount or less. Furthermore, since these states no longer tie their estate tax to the federal credit, they set their own marginal tax rates, effectively eliminating federal limits on state revenues. For instance, a $2 million estate in 2007 may have no federal estate tax liability but may still have to pay state estate taxes in excess of $100,000.