In 2001, the U.S. Congress passed the Economic Growth Tax Reconciliation and Recovery Act, which contained provisions to eliminate the federal estate tax code and replace it with a modified capital gains tax system. With the passage of this act, many people in our industry said that estate tax planning was dead.
How things change!
Recent circumstances have changed the outlook, not only with federal estate taxes but federal taxation in general.
The rosy economic situation of the decade preceding the passage of EGTRRA 2001 changed noticeably in 2001 and 2002, when the stock market plunged. A large and growing national debt replaced the projected 2001 government surpluses. Indeed, the national debt is approaching $9 trillion and the U.S. Congress has had to increase the debt ceiling for 4 of the last 6 years to accommodate the growing burden.
Add to this the baby boomers who are now between the ages of 43 and 62. This group, which comprises nearly 30% of the U.S. population and which supplies the U.S. government with significant income tax and Social Security tax revenue, is now entering into retirement in growing numbers. They are going from earned income that supplies the federal government with Social Security and income taxes to retirement income (some tax-free or tax preferred) and drawing on the federal government’s Social Security fund. Add, too, the war on terror that–by some estimates–cost the U.S. government $12 billion per month, and we have a future situation that strongly suggests Congress will need to boost tax revenues through increased tax rates.
If so, where might the taxes rise? We know the trifecta tax terrors of income tax, capital gains tax and transfer taxes (gift and estate taxation), but which one will likely increase? Could 2 or all 3 areas increase in the future?
Current taxes are lower than in times past. The highest current income tax rate is 35%, the capital gains tax rate is 15% and the current gift and federal estate tax rate at the highest marginal rate is 45%. The federal income tax rate in the past was as high as 70%, capital gains tax was as high as 20%, and the federal estate tax rate was at 55%.
In polling advisors around the country, nearly all of them agree that the current circumstances suggest tax rates will rise in 1, 2 or all 3 ‘tax terror’ areas in the future.
Is there a strategy that can eliminate all 3 tax terror areas today? The answer is yes! Lawyers call it the irrevocable life insurance trust, but considering all of the ILIT’s tax benefits, the vehicle should be renamed the multiple tax advantaged trust.
The MTAT is so often viewed as merely a means to have life insurance escape federal estate taxation that the true–and rather incredible–tax advantage power of this tool is frequently overlooked. This article will examine the multiple tax-avoidance power of this estate-planning tool.
Federal estate taxes
The general rule involving personal life insurance owned by an individual is that the proceeds of the life insurance policy are fully included in their estate for estate tax purposes. For some, this can mean that their personally owned life insurance portfolio may shrink by as much as 45% due to federal estate taxation.
One way to avoid estate taxation on life insurance is for a MTAT to be the owner and beneficiary of the life insurance policy on Grantor from the policy’s inception. By never having any “incidents of ownership” in the policy by the insured, the entire proceeds of the policy will escape federal estate taxation on the insured’s death. This represents potential savings of as much as 45% of the face amount of the policy.
In addition to the federal estate taxation savings, the life policy provides cash that can be used by an estate. Frequently, the MTAT is structured to permit loans to the estate or the MTAT purchases illiquid asset from the estate in an amount that will allow the estate to pay the estate clearance costs. By using the MTAT, the estate clearance costs are offset by the face amount to preserve an estate and pass it intact, and the cash from the life policy assists in preventing fire sales of illiquid assets. All of this can be accomplished without the life insurance being a part of the estate tax problem.
This part of the MTAT strategy is well known and accepted. But how this strategy impacts other taxes is also important.
Federal gift taxes
The payment of the premiums on the life insurance policy in the MTAT represents a gift of the premiums to the ultimate beneficiaries of the trust. The Internal Revenue Service attacked these premium gifts as gifts of future interest, arguing that the trust was irrevocable and would not distribute the proceeds until the death of the grantor or grantor and grantor’s spouse. By claiming that the premium gift was a gift of a future interest, the IRS attempted to prevent these gifts from being considered part of the grantor’s annual gift tax exclusions, subjecting the premium transfer to gift taxation in the year of the gift.
In the now famous case of Crummey v. Commissioner, a strategy was devised, which is now accepted, to allow the annual gift tax exclusions to be applied against the premium dollars to escape federal gift taxation on the amounts covered by this gift exclusion. Under the Cristofani case, this gift tax-avoidance strategy was expanded to include gifts to bona fide contingent beneficiaries of the MTAT. By including grantor’s children, the children’s spouses and the grandchildren in this gifting technique, in many cases, the entire premium amount is able to avoid gift taxation. Thus, the MTAT frequently avoids gift taxation on the premium.
Since the MTAT owns the life policy on the insured from the policy’s inception, upon death, the beneficiaries of the trust receive the proceeds free of gift taxes as well. So, in addition to gift tax protected premiums, the beneficiaries are also protected from gift tax on the proceeds. When the premium amount transferred to the MTAT to fund the policy can be covered by the collective annual gift tax exclusions of the beneficiaries, then the transfer is free of federal gift taxation.
A further tax relief positive of this strategy is that the annual gifting of the premiums that are protected by the above annual gift tax exclusion techniques are out of the grantor’s estate for estate tax purposes. Thus the premium gifts are free of federal estate tax.
Federal income taxes
Another tax advantaged element of the MTAT strategy is the absence of federal income tax liabilities. The gifting of the premiums by the grantor of the trust does not constitute taxable income to either the trust or the beneficiaries. Gifts of cash are not subject to the federal income statutes, as they do not constitute active or passive earnings. Gifts are not income taxable, but do have a carry-over basis. Thus the premiums paid to the trust do not result in income taxation to the trust or the beneficiaries.
But that’s not the complete story
By making a permanent life insurance policy the depository of the contributions to the MTAT, a special tax-favored (and effectively government-supported) benefit is given to the wealthy. Under IRS Code Section 7702, life insurance policies receive tax deferral on the internal build up of the cash values in a permanent policy.
With flexible premium variable universal life polices (FPVUL) this equity build up of cash value has frequently been considerable over time. All of this cash value build up is tax deferred. If death occurs to the insureds while the policy is in force, the entire build up becomes an income-tax-free distribution to the MTAT.
The result is to the degree that these earnings would otherwise had been income taxable; the federal government has become a joint financial partner in avoiding the federal estate tax and in paying for the life policy. In essence, the federal government is subsidizing the wealthy. This tax-advantaged power of the MTAT is frequently under emphasized and largely overlooked.
By virtue of the life insurance policy’s tax-favored nature, any earnings inside the policy can grow free of federal income taxation. Further, upon death the death benefit also is free of federal income taxation.
The third terror of taxation is capital gains tax. Under the MTAT arrangements, even this tax is lessened.
Some life insurance policies permit the insured to invest in the equity marketplace within the policy through equity sub-accounts that have some similarities to mutual funds. Thus, there may be capital growth in equities inside the policy that, in other situations involving personal ownership of the equity, would have created long- or short-term capital gains subject to capital gains taxation.
In the MTAT, the capital gains tax is avoided as long as the policy remains in force until death of the insureds. The life insurance tax-favored structure permits capital gains to add to the policy, but free of the capital gains tax.
As the accompanying table shows, the MTAT affords insureds a vehicle with which to pass on assets free of gift, estate and income taxes. The table assumes that the trust was created to cover the premium transfer within the annual gift tax exclusion amounts permitted by law; and that the policy is in force until death of the insureds.
It is important to note the MTAT will require the engagement of a well qualified estate planning attorney. The trust documents can be complex and cost several thousand dollars to draft. Additionally, the grantor will need to be insurable. If the grantor is in poor health or has a chronic illness, the premium outlay could be substantial; or the grantor may be uninsurable.
If the MTAT is tax aggressively created, it is sometimes used as a supplemental retirement income source, which creates income to the grantors free of 6 layers of tax attrition! But that is another article and another time.
As we look to the future, we can probably expect tax rates to rise. The trifecta tax terror of federal income taxation, capital gains taxation and transfer taxation are all candidates to increase. Financial professionals now have a strategy to assist to insulate clients’ wealth from current taxation on all three tax terror areas.
Now is the time to rethink the traditional view of ILITs as only an estate tax savings vehicle. It’s time to see it for what it is: A multiple tax advantaged trust.
Donald G. Schreiber, JD, CLU, is a senior advanced sales consultant for Nationwide Financial Services, Inc, Columbus, Ohio. He can be reached at .