Flexible Strategies To Deploy In Uncertain Times

According to the Tax Policy Center, as a candidate for President, Barack Obama said he would make the estate tax permanent, with the $3.5 million exemption and the 45% top rate that were already scheduled to take effect on January 1, 2009, before he assumed office. Of course, that was before a financial tsunami flooded Wall Street, swamping the likes of Lehman Brothers, Merrill Lynch, and AIG.

Now, some $2.5 trillion bailout dollars later, what President Obama and 535 members of Congress will do with the estate tax–set to expire in 2010, only to be reborn in 2011–is anybody’s guess.

My guess is that after the financial flood recedes and the bailout bill comes due, we’ll still have the estate tax, possibly with a higher exemption amount.

Such guesses, even educated ones, are of little comfort to wealthy clients who are eager to preserve their estates and who want to pay estate taxes for pennies on the dollar. Traditionally, such people use life insurance, often survivorship life insurance, to pay the tax man. And more often than not, they set up an irrevocable life insurance trust or ILIT to own that insurance, thus removing death proceeds or cash values from their estate.

However, with the current uncertainty about estate tax law, they are understandably reluctant to establish a trust that is irrevocable and seemingly inflexible. Their primary concern, of course, is that once the policy is inside the ILIT, any cash values that accrue will be out of reach and useless should Congress eliminate the estate tax that prompted the insurance purchase.

Fortunately, certain strategies can provide great flexibility in an ILIT without diminishing the estate tax advantages these trusts afford. With a properly drafted ILIT, your wealthy clients can move forward with estate planning, knowing they are not locked into a plan that might otherwise become obsolete with a stroke of the president’s pen.

The 4-year rider

One of the easiest strategies to execute is the so-called 4-year rider that comes free of charge with most survivorship policies. The rider essentially doubles the policy’s death benefit for 4 years, giving the insured one year after the insurance purchase to assess what the estate tax law will be in the future. Given that Congress has about one year to decide whether to keep, modify, or eliminate the current estate tax, that should be enough time.

Assuming Congress enacts the plan Obama proposed during the campaign, the insured can then transfer the policy into the ILIT without fear of the “three-year rule”–Section 2035 of the tax code, which stipulates that assets that have been gifted through an ownership transfer, or assets for which the original owner has relinquished power, are to be included in the gross value of the original owner’s estate if the transfer took place within 3 years of his or her death–dragging the policy back into his or her estate. Even if that happens, the net, after-tax death benefit would be the same as if the policy had been purchased in the ILIT without the rider. However, if the estate tax is repealed permanently in the first year, the insurance and any cash values remain outside the trust to do with as the client sees fit.