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Financial Planning > Tax Planning

3 Big Hot-Buttons for Advanced Sales

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How will the approaching expiration of estate and gift tax provisions of the 2010 Tax Relief Act impact your clients? Can one structure an irrevocable life insurance trust as a non-grantor trust? What role can side funds play in fixing life insurance-funded split-dollar or private premium financing arrangements that were established without an exit strategy?

Lawrence Brody, a partner at the St. Louis, Mo.-based law firm Bryan Cave LLP, provided answers to these questions, among many others focused on wealth transfer planning, during the opening general session, “What’s Hot, What’s Not—2012 Edition,” of LIMRA’s Advanced Sales Forum, held in Chicago August 6-7.

Following the 2010 Law to 2013

Much of the talk by Brody—who co-presented the session with Thomas Commito, a vice president of Sales Concepts at Lincoln Financial Distributors, Radnor, Pa.—dealt with wealth transfer planning considerations in 2012 of the 2010 Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010; and of the Obama’s Administration’s 2013 budget proposal.

A top concern of advisors is the effect of the 2013 proposal on irrevocable life insurance trusts (ILIT), a standard tool of financial planners for shielding policy proceeds from estate tax and for paying the estate taxes assessed on other assets. The budget proposal would, if adopted, change the estate tax treatment of grantor trusts by coordinating income and transfer tax rules applicable to these trusts.

The lack of coordination under the current tax regime, said Brody, lets individuals transfer “significant wealth” without transfer tax consequences.

Brody highlighted tax implications of cases where income tax rules treat a trust creator (“grantor” or “settlor”) as the trust’s owner for income tax purposes. Trust assets would, for example, be includable in the gross estate of the settlor for estate tax purposes. And a gift tax would be imposed on trust distributions to a beneficiary during the settlor’s life. Brody noted that nearly every life insurance trust is a grantor trust under the Internal Revenue Code, which directs ILIT trustees to use the trust’s income to pay premiums.

“If the 2013 proposal were adopted, we’d have to change the way we create irrevocable life insurance trusts, many of which are intentionally created as grantor trusts,” said Brody. “Clients who establish ILITs would have a tough time keeping the trust out of their taxable estate.”

“There’s only one way to do it: You have to stipulate that trust income to pay premiums is discretionary—not required,” he added. “And payments could only be done by the trustee with the consent of the beneficiary. That’s the only way I can think of to make an ILIT not a grantor trust.”

One bit of good news, Brody continued, is that the proposal would be prospective, affecting only trusts created after the proposal’s enactment. One exception to the prospective rule: pre-existing trusts that are later integrated with a new ILIT.

Turning to charitable gifting, Brody noted that clients who haven’t used their lifetime gift tax exemptions can make gifts up to $5,120,000 through the end of 2012 without incurring gift tax; the federal estate, gift and generation-skipping transfer (GST) tax exemption thereafter returns to $1 million, as per the pre-2001 tax regime.

Clients who have previously used their full $1 million gift tax exemption, or have exceeded their gift exemption and paid a gift tax, can therefore make an additional $4,120,000 gift in 2012. (In 2011, the gift tax exemption was $4 million.)


Claw-back: Your Worst Nightmare?

Brody noted, however, that gifts in 2011 and 2012 exceeding the reinstated $1 million exemption could potentially be “clawed back” into a client’s estate in 2013, making the excess gifts subject to the estate tax.

But he also pointed out that Congress may not have intended to impose such a claw-back; and that a claw-back likely would “sunset” (expire) in 2013. The reason: The 2010 Tax Relief Act providing for the increased gift tax exemption treats the earlier 2001 tax act (EGTRRA), upon expiration, as if it never were enacted.

The sunset provision aside, Brody noted that, with a few exceptions, only the difference between available exemptions would be clawed back. Any appreciation on, and income derived from, a gift would not be subject gift tax. Additionally, a claw-back doesn’t apply to a client’s lifetime use of the GST tax exemption—hence the value of allocating the increased gift tax exemption to an inter-generational or dynasty trust.

“I don’t think you can get hurt very badly even if the claw-back stays in force,” said Brody. “In most cases, all that happens is there is a recalculation at death as to how much of your money you gave away.”

The one exception, said Brody, involves married couples who qualify for an excess $4,120,000 gift as a marital deduction. If the claw-back stays in force, adding back the $4,120,000 next year would generate an estate tax for the couple.

Given the tax-favorable treatment of appreciating property, clients now should consider gifting assets that will grow in value and have the assets appraised—assuming they can still secure the services of a good quality appraiser before the increased gift tax exemption expires in 2013.

“Appraisers all over the country are telling us, ‘We’re done taking on new appraisals for 2012—we’re booked.’ If you haven’t already scheduled an appraisal, it’s probably too late to get a good appraiser to do the work this year.”

Brody said that using the increased gift tax exemption of a wealthy spouse to create a lifetime non-marital trust for a less wealthy spouse could move the exemption (plus appreciation and undistributed income) out of both spouses’ estates. The non-marital trust would give the less wealthy spouse/trust beneficiary access to the trust assets.

But Brody cautioned that such non-marital trusts may run afoul of the “reciprocal trust doctrine,” which prohibits gift and estate tax abuses that may arise when two spouses create trusts for each other. A wiser course, he noted, is for the wealthier spouse to create a non-marital trust for the less wealthy spouse, and for the latter to create a trust for children, perhaps by using funds gifted from the wealthier spouse and both spouses’ increased gift exemptions.

If, alternatively, a client were to use the increased gift and GST exemptions to make a gift to an inter-generational dynasty trust (which is exempt from a claw-back), the gift would, as per the Administration’s budget proposal, be exempt from the GST tax for 90 years. Gifts to a dynasty trust would also enjoy creditor and spousal claim protection.

Brody warned, however, that gifting a $5,120,000 generation-skipping transfer tax exemption to grandchildren and the balance of a client’s estate to children could invite a lawsuit from children who believe they have been unjustly disinherited from their fair share of the estate.

“In such cases, the advisor will have a new nickname: defendant in a malpractice lawsuit,” said Brody. “The use of the dynasty trust made perfect when the GST exemption was $1 million. It may not make sense when the exemption is $5,120,000.”

Brody added that, because the increase in the estate and GST exemptions are only effective for 2011 and 2012, not all client estate plans will need to be reviewed and amended to reflect the higher exemptions.

Those that will likely need to be amended include formula-driven plans, such as those involving a second marriage and a credit shelter (non-marital) trust established for children by a prior marriage. Also to be reviewed are wills and trusts that leave all assets to a surviving spouse or that use “disclaimer plans:” arrangements wherein all assets are left to a surviving spouse, but that permit the spouse to disclaim a credit shelter trust for his or her benefit.

“With these disclaimer plans, you don’t have to worry as much about what the exemption amount is because it will automatically self-correct,” said Brody. “This assumes, of course, the spouse has decent counsel and is willing to disclaim. Many of our high net worth clients are actively looking into these plans.”

Should a plan, however, call for transferring an unused $5,120,000 million estate and gift tax exclusion from a decedent client to a surviving spouse under the 2010 Tax Act’s “portability” provision then, said Brody, advisors need to bear in mind some caveats. Among them: the portability exemption isn’t indexed for inflation; doesn’t exempt from the estate tax appreciated property received by the surviving spouse; expires in 2013 (though the President’s budget proposal calls for making it permanent); and only applies to the last deceased spouse.

This last provision may preclude portability in cases where a surviving spouse remarries. Conversely, said Brody, a widow or widower whose previous spouse used all of a portable exemption can gain a tax advantage by marrying a second spouse who has not used his or her portable exemption, provided the new spouse dies first.

“[When drafting the 2010 law] Congress was worried that people would, after their spouse died, look for an older, unhealthy, poor person to marry to be able to get their exemption,” said Brody. “I can see the ad in Craigslist now: ‘I’m older. I’m unhealthy. I have no assets. And I haven’t used my exemption. Call me!’”

Side Funds to the Rescue 

Still another use of increased lifetime exemption entails “fixing” existing insurance or estate planning transactions. Examples: life insurance-funded split-dollar or private premium financing arrangements that were established without an “exit strategy” to allow repayment of advances or loans during the insured’s lifetime. The increased gift and GST exemptions could, said Brody, provide such an exit strategy by creating “side funds”—assets inside the trust apart from the life insurance policy.

“We’re now seeing clients incorporating side funds into under-water insurance trusts in order to use the increased exemptions,” said Brody. “We’re also seeing clients use the exemptions to protect against transfer taxes when terminating an above-water split-dollar or premium financing arrangement that has lots of policy equity.”


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