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Financial Planning > Trusts and Estates > Trust Planning

Flexible Strategies To Deploy In Uncertain Times

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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.

Surprisingly, there’s a lot your wealthy clients can do to build flexibility into an ILIT as well, a good thing since whatever happens in the next few years is bound to change a few years later. Consequently, flexible estate planning should be at the top of their agenda in any case.

But before we go further, understand that trust grantors already have more power over the trust–flexibility, if you will–than you may realize. For example, the grantor can also borrow from the trust so long as the loan meets commercially reasonable standards. However, no matter what Congress does to the tax law, the grantor can’t change the trust’s beneficiaries or other terms of an irrevocable trust–but a trust protector can.

A trust protector is a third party, preferably independent of the grantor, who has the power to tell the trustee what to do, depending on the powers the grantor gives the trust protector at the outset. For instance, the trust protector can have the power to amend the trust, change the date that beneficiaries qualify for distributions, change the situs of the trust, and even remove the trustee.

Because of the current uncertainty, the grantor probably would want to give the trust protector power to amend the trust in the event of changes in the tax laws that would affect the trust. Such powers vested in a trusted third party turn an inflexible trust into one flexible enough to relieve most, if not all, of your clients’ concerns. Of course, there are caveats. The most obvious is that in naming a trust protector, the grantor is giving a lot of power to another person.

Couples can create additional flexibility in their ILIT by naming the non-grantor spouse as a trust beneficiary, turning the trust into what is variously called a spousal access or spousal lifetime access trust. These arrangements allow the non-grantor spouse to receive distributions from the trust, governed by an ascertainable standard.

Spousal access trusts are technically tricky, but they work. Typically, the grantor names both his spouse and children as trust beneficiaries and says the trustee can make distributions to them, generally for their health, education, maintenance, and support. In short, a spousal access trust allows the non-grantor spouse beneficiary to have access to the insurance policy’s cash values if estate taxes are eliminated or drastically reduced in the future.

Avoiding missteps

As you can see, there are ways to address your wealthy clients’ concerns about purchasing life insurance in an irrevocable trust in these uncertain tax times. Of course, anyone thinking about using these strategies should consult a good estate planning attorney to avoid any missteps that could result in the life insurance being pulled back into the grantor’s estate. What they should not do is sit on the sidelines waiting for Congress to act. That wait could be costly if your client dies before President Obama finally sets pen to paper and signs a new estate tax law.

Brian K. Titus, JD, LLM, CLU, ChFC, is second vice president of the Advance Planning Group
at The Phoenix Companies, Inc. You can e-mail him at
[email protected]


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