On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (The 2010 Tax Relief Act). This legislation extended several income tax provisions and made significant changes to gift, estate and generation skipping transfer taxes.
While many of the income tax provisions will impact financial service professionals, perhaps the biggest impact will be felt in the area of estate planning.
The legislation made several significant changes for 2011 and 2012, including the following:
–Replaced one year modified basis regime with a 35% maximum estate and gift tax rate.
–Reunified the gift and estate taxes, with an applicable exclusion of $5 million in 2011. This is indexed for inflation in 2012.
–Restored generation skipping transfer (GST) taxes at 35%, with a $5 million exemption.
–Provided portability of estate tax exemptions between spouses.
These changes have created an opportunity for financial professionals to provide counsel to clients based on their specific situations. There are a variety of reasons to review an estate plan. But tax law changes provide a prime opportunity to make sure your client’s basic life insurance affairs are in order by ensuring he/she has enough insurance to replace a lost income stream, for example.
Because The 2010 Tax Relief Act changes are only certain for 2011 and 2012, the planning techniques must include flexibility. A plan that does not consider potential changes for 2013 and beyond could expose the client to unexpected negative consequences.
Let’s look at an example: Jim and Betty Smith have an estate worth $20 million. They own a business which is rapidly growing in value, and would like to utilize their applicable gift tax exclusions to transfer some of the growth to their children, and grandchildren. If they each make a maximum gift (excluding any annual gift exclusion amounts), they can transfer $10 million dollars worth of stock in 2011 or 2012. Any appreciation in value of the transferred stock will be for the benefit of the children and grandchildren.
Assuming the government passes legislation to make the changes permanent, this technique accomplishes what they intend, and the client would plan for estate taxes of 35% on the projected estate. Frequently the liquidity for the estate tax is funded using life insurance, meaning the purchase of a life insurance policy with a face amount of at least $3.5 million.
In addition to the estate tax, look to make sure your client’s other objectives can be met. For example, if Jim and Betty have three children and only one works in the business, determine what distribution would be considered equitable for each child. Life insurance is frequently used to provide this liquidity to equalize the amounts paid to each beneficiary.
Unfortunately, there are no guarantees this will happen.
Because Congress is split by party lines on the estate tax, budget restraints and the House’s “Pay-Go” requirement, the legislation may not be made permanent. If nothing is done, this legislation will sunset in 2013, meaning the individual applicable exclusion may revert back to the 2001 rate of $1 million*, and the maximum estate tax rate may go back to 55%.
Using our case study above, the estate could owe taxes on an $18 million estate (plus any growth on the retained assets) meaning there could be taxes due of approximately $10 million.
This example illustrates what is sometimes referred to as the ‘clawback” provision, which is one interpretation of the potential results of the sunset provisions. Without the purchase of life insurance to provide the liquidity to pay the potential estate tax bill an unintended result could potentially leave the estate with a tax bill equal to, or greater than, the remaining assets.
The example illustrates the importance of understanding the potential consequences of any recommendations, and supports the continued use of life insurance as a funding vehicle to provide needed liquidity. A key element to completing a plan over the next two years will be maintaining flexibility in the techniques offered.
This creates opportunities for financial professionals who specialize in estate planning and the techniques used to minimize the impact of estate, gift and GST taxes.
Uncertainty in the markets remains so there are many techniques that should be carried forward from the past several years. They include, but are not limited to: establishment of “B Trusts with lifetime access provisions and Standby Trusts. In addition, Grantor Retained Annuity Trusts (GRATs), private financing arrangements, split dollar, sales to intentionally defective grantor trusts, Family Limited Partnerships (FLPs) and Family Limited Liability Companies (FLLCs) utilizing discounts allow clients to leverage their gifts.
Although these leveraging techniques may not always be in favor, currently they seem to be useful for larger estates. The increased gifting amounts provide a tremendous amount of leverage for techniques which incorporate a life insurance component.
To provide flexibility inside of products, life insurance carriers are also offering new riders, or utilizing conversion privileges that offer clients choices. For example, a rider that offers a cash value guaranteed to be equal to 100% of premiums paid after a certain number of years, if the estate tax is repealed can be of value.
Provisions that allow two term policies to be converted to one survivorship policy allows the client to plan today without committing a great deal of money, just in case things change. The goal is to minimize the risk for consumers, so they will take action in a time of uncertainty.
In summary, no-one is certain what the future of estate, gift and GST taxes will be beyond 2012. Accordingly, it’s important to be well versed on planning techniques and product offerings that offer as much flexibility as possible.
Dennis Stessman is a director of advanced marketing with Prudential Financial, Newark, N.J.