The Tax Relief Act of 2010 made significant changes to the federal transfer tax system, including a $5 million federal estate and gift tax exemption. As a result, there will be fewer clients affected by federal estate taxes and they will have more opportunities to use life insurance to accumulate wealth without worrying about the inclusion of death benefit proceeds in their estates. But the Act only applies for the next two years and the exemption could revert to lower levels after 2012. Therefore, clients will need to be prepared to do additional estate planning.

Two new approaches to estate tax planning

There are two approaches to federal estate tax planning under the new law: the “get it out of the estate” approach or the “keep it in the estate” approach. The “get it out of the estate” approach involves using the now-higher gift tax exemption to transfer assets out of the client’s estate. This approach may be appropriate for older clients because who no longer need some of their assets. Younger clients, however, may be hesitant to move large amounts of assets out of their estate. They may choose the “keep it in the estate” approach and use the higher federal estate tax exemptions and the ability to transfer unused estate tax exemptions to the surviving spouse.

Wait-and-See estate plan

One “keep it in the estate” approach is called the Wait-and-See estate plan. This approach uses a combination of life insurance and trusts in a way that offers clients flexibility to support changing circumstances throughout their lives. It is a strategy for married couples who want to maintain control of – and access to – life insurance policies that eventually will be used to fund their legacy, estate taxes, or both. This approach uses a credit shelter trust established at the death of the first spouse. A credit shelter trust typically is funded with assets up to the federal estate tax exclusion. The value used in funding the trusts is the fair market value of the asset at the time of the death of the owner. Traditionally, this trust is funded with assets that may appreciate in value because they will not be included in the estate of the other spouse. There are two techniques for the Wait-and-See estate planning: the one policy approach and the two policy approach.

One-policy approach

The one policy strategy typically is used in common law states and instances where there is a clearly mortality inferior spouse. It includes a second-to-die life insurance policy owned by the spouse who is mortality inferior (typically the husband). Because the life insurance policy is in the married couple’s estate, they can use it to accumulate wealth and supplement retirement income. When the husband dies, the second-to-die policy will fund the credit shelter trust during the administration of his estate. The value of the policy for estate tax purposes will not be the death benefit but its fair market value, which should be close to the cash value. When the mortality superior spouse (typically the wife) dies, the death benefit will be outside of her estate and paid to beneficiaries of the estate plan.

However, if the wife dies first, the husband may wish to transfer the policy to an Irrevocable Life Insurance Trust (ILIT), bringing into play the three year estate inclusion rule. There are three ways to deal with the three year rule. One way is to sell the policy to the ILIT instead of giving it. A bona fide sale of a life insurance policy avoids the three-year rule. A second way is to purchase a short term policy to cover the extra estate tax liability for keeping the death benefit in the estate. The final way is to use a rider on the policy where the life insurance company allows the surviving spouse to buy an additional four-year term death benefit. An additional cost and restriction may apply to the use of such a rider.

Two-policy approach

The two policy approach involves cross-ownership of single life insurance policies by the spouses. The husband will own a life insurance policy on the wife and vice versa. When the first spouse dies, the policy on the survivor is placed in a credit shelter trust in the first spouse’s estate. Again, the value of the policy for estate tax purposes will be its fair market value. The two policy approach is used in community property states and with younger clients who want income replacement after the first death.

In conclusion, the Wait-and-See approach provides: 1) an opportunity for clients who want to own life insurance policies during their lifetimes, and 2) estate planning flexibility to adapt to the ever-changing federal estate tax laws.

Tax considerations

This information is a general discussion of the relevant federal tax laws. It is not intended – nor can it be used by any taxpayer – for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.