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Portfolio > Alternative Investments > Real Estate

Protecting the family interests

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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.

“Casual” clients

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 Others may think that estate taxes have already been repealed, or that their estate won’t be large enough to be taxed.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 Our country’s earliest estate taxes were each repealed within a few years, after the military efforts they were intended to support had ceased.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 EGTRRA “repealed” the estate tax only for 2010.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.

They’re rich

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.”

“Careful” clients

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.

Protecting the kids’ money

A client may be particularly susceptible to creditors and frivolous lawsuits because of his occupation or wealth. Whatever the reason, the purpose of a life insurance policy can be thwarted by an adverse judgment. While some states protect a beneficiary’s interest in the proceeds, others protect only a negligible amount, or an amount necessary for supporting a spouse or child, if anything at all. If the state affords limited or no protection, personally owned life insurance policy values may be subject to claims of the insured’s creditors. If an ILIT owns the policy and the client has no incidents of ownership, the client’s creditors generally cannot reach policy values intended for trust beneficiaries.

When an ILIT may not be needed

Some good reasons for life insurance in an irrevocable trust may be obscured by estate tax reform. Without estate taxes, a revocable trust – or simply a properly structured beneficiary designation – may accomplish the same objectives.

Transfer taxes, old and new

Annuities, IRAs and qualified retirement plans produce income in respect of a decedent (IRD). IRD is income a decedent was entitled to at death, and had not taken but would have received had they lived. A beneficiary must pay income tax on IRD when distributed, but gets an income tax deduction for the estate tax paid on IRD. However, if the estate is not subject to estate taxes, there will be no offsetting deduction – necessitating more life insurance. If the estate value plus the death benefit are under the exclusion equivalent amount, the policy doesn’t have to be owned outside the estate.

Also, in 2010 when the estate tax “disappears,” so does the step-up in cost basis at death for capital assets. There will be a $1.3 million “capital gains tax exemption” ($4.3 million for a surviving spouse). The beneficiary decides which assets get the benefit of the exemption. The other assets use the deceased owner’s basis, thereby potentially triggering capital gains tax when the beneficiary sells. A life insurance policy can help provide funds to cover the taxes with no estate tax drain on the death benefit proceeds.

Spendthrift protection

While an ILIT may help protect policy values from an insured’s creditors, it may be necessary to consider other creditors – the beneficiary’s. Revocable trusts can contain spendthrift provisions preventing the beneficiary’s creditors from attaching an interest in trust assets. A spendthrift provision limits the beneficiary’s right to assign their interest. Instead, the trustee distributes income and principal according to the trust’s terms. As an added benefit, a spendthrift clause protects assets against the beneficiary’s unwise money management. Since life insurance need not be in an ILIT to protect death benefit proceeds from current and future creditors of the beneficiary, the grantor can maintain control of the policy.

Buy-sell alternative

Often, a business owner’s family is not involved in the business but the owner wants to leave them the business. The owner may not want the family to have to sell when the price or time may not be right. A trust can help.

The mechanics may vary, but the strategy typically works like this. A trust buys life insurance equivalent to the value of the owner’s interest. With no estate tax, the trust can be revocable. (At the owner’s death, it becomes irrevocable). When the owner dies, the trust receives the death benefit proceeds and buys the business interest from the family.

Surviving owners serve as special trustees with power to vote the stock, thereby retaining control of the business without interference from inactive or inexperienced family members. As trustees, they must act in the best interest of the trust beneficiaries. This may result in a conflict of interest, as they must balance business growth and income to the family. The family need not depend on business income, however, because they have life insurance money.

Special needs

Special needs children may qualify for government assistance to meet their minimum living requirements. Parents often supplement that assistance to help make their children’s lives more comfortable. If the parents die and simply leave money to the child, that gift could disentitle the child to any more government benefits. A special needs trust can help keep assets out of the child’s name for purposes of qualifying for certain government programs, perhaps by limiting trust distributions to only supplemental needs. Parents often fund such trusts at death from the proceeds of a life insurance policy they own.

The bottom line: be flexible

Ultimately, we still don’t know what the estate tax environment will look like. Prudent planning incorporates what we know yet remains flexible to adjust to what we don’t. The ILIT is an inherently inflexible device. But there are steps your clients and their attorneys can take to help an ILIT respond to estate tax changes.

  • The grantor can give someone (other than his spouse) a limited power of appointment. If estate tax exposure goes away, that person can exercise the power in his discretion – but absolutely not at the grantor’s request – and assign property to anyone (even the grantor) other than himself, his estate or his creditors.
  • If the ILIT owns a survivorship life insurance policy, one spouse can be the sole grantor. The trust may allow the trustee to use income and principal for the non-grantor spouse’s maintenance and support. The non-grantor spouse should not be the trustee or have a power of appointment. Nor should he or she make gifts to the ILIT (although both spouses may split gifts).
  • The grantor can name a trust protector, an unrelated party who can amend or terminate the trust under certain conditions, such as estate tax changes.

These and other considerations require an attorney’s services. Meanwhile, you should understand your clients’ estate tax exposure and how it may change. More importantly, you should understand your clients’ objectives to determine whether an ILIT is right for them.


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