In the wake of U.S. House’s failure to pass the American Health Care Act (AHCA) on March 24, President Trump and his Republican allies in Congress are expected to turn their sights to legislation that, though potentially as complicated, may stand a greater chance of success: enacting tax reform.
A perennial industry concern given the potentially negative impact on the tax-favored treatment of insurance and retirement saving products, a reform bill could have repercussions for agents and advisors engaged in wealth transfer planning for the affluent. That’s because life insurance is also a frequently used vehicle for paying estate tax, a much-reviled levy among GOP lawmakers keen to gut it as part of tax reform legislation.
Insurance and estate planners are taking notice.
“The estate tax is front-and-center for many of our high net worth clients,” says Sontag Advisory CEO and Managing Director Michael Delgass (pictured below). “Life insurance is important where you have a lot of illiquid assets and not enough cash to pay the tax.”
Delgass should know. An attorney and advisor, he has specialized for nearly two decades in estate, tax, succession, asset protection and business planning at prominent New York- and New England-area law firms. At Sontag Advisory, Delgass oversees a staff of 20 advisors, associates and managers at the New York City-based company. Specializing in wealth management and investment advice, the practice serves clients in more than 30 states.
Delgass says repeal of the estate tax as part of tax reform bill would be “relatively easy” to do. Key reason: The comparatively limited revenue the federal government derives from estate taxes annually.
Delgass notes that only about 5,000 estate tax returns are submitted to the IRS each year — a tiny fraction of the 152.5 million income tax returns Americans filed in 2016. Those 5,000 returns generate about $20 billion in tax receipts, a pittance compared to the $1.85 trillion in revenue from income tax returns and the $3.27 trillion in total direct revenue generated in 2016.
“The estate tax is not a big revenue-raiser, providing only about 0.5 percent of overall tax revenue,” Delgass says. “So repeal of the tax won’t cost the federal government much.”
“Yes, the estate tax can free up capital that otherwise might be inefficiently allocated,” he adds. “But from a revenue perspective, it has essentially no economic effect.”
A tax reform blueprint unveiled by House Republicans in June 2016 envisions eliminating the estate and generation-skipping transfer (GST) taxes, but other options are possible. (Photo: Thinkstock)
Estate tax revamp
Why does the estate tax figure so low in the revenue scheme of things? In a word: exemptions.
As part the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the unified gift and estate tax credit (or exemption equivalent) was set at $5 million per person ($10 million per couple) with a top tax rate of 40 percent. That varies significantly from $675,000 per person exemption and top estate rate of 55% that existed in 2000-2001, at the end the Clinton Administration.
The latter amounts were due to be reinstituted at the close of 2010, when the estate tax fell to zero following a gradual phase-out of the levy under the Economic Growth Tax Relief Reconciliation Act of 2001 (EGTRRA). New exemption levels under current law — rising with inflation, estate and gift tax exclusions are set at $5.49 million per individual and $10.98 million couple in 2017 — mean the tax is a non-issue for all but the top 0.5 percent of estates. For agents and advisors, the pool of clients needing life insurance or other planning for estate tax avoidance or payment purposes is thus also small.
That number could drop further if the estate tax is part and parcel of a tax reform package this year. The starting point for such legislation was a blueprint for tax reform (“A Better Way Forward”). Unveiled in June 2016 by Republicans on the House Ways and Means Committee, the document envisions eliminating the estate tax and the generation-skipping transfer (GST) tax, steps that then candidate Trump also called for during the presidential campaign.
A first stab at realizing the blueprint took concrete form at the start of the 115th Congress in January, when Rep. Bob Latta (R-Ohio) introduced H.R. 451, the “Permanently Repeal the Estate Tax Act of 2017.” Backed by 8 cosponsors, the legislation is similar to H.R. 725, which Latta unveiled in the 114th Congress.
A longer bill, H.R. 25, would replace the federal income tax, estate tax, gift tax and federal payroll taxes with a national sales tax. That bill has 35 cosponsors.
In lieu of the estate tax, Congress might also impose a tax on capital gains topping $10 million at death (which Trump favors). Other possible outcomes, according to a February 2017 KPMG report, include:
No repeal of the estate tax;
A phased-in repeal, followed by its reinstatement (as under EGTRRA);
Replacement of the estate tax with a carryover basis regime at death (a method for determining the tax basis of an asset that transfers from one individual to another); and
Repeal of the estate tax and continuation of a step-up basis regime (i.e., readjustment of the value of an appreciated asset for tax purposes upon inheritance).
The lack of clarity about the estate tax regime in 2017 makes for an uncertain planning environment, says Sontag Advisory CEO and Managing Director Michael Delgass (Photo: Thinkstock)
Deciding what to do
Still unclear the report adds, is the outlook for the gift tax, which neither Trump nor the GOP blueprint address. This lack of clarity, combined with the aforementioned options, makes for an uncertain planning environment.
“Advisors are really stuck,” says Delgass. “Most of the more sophisticated kinds of transactions you would do for estate planning clients require some use of the estate tax exemption.
“If you wait a year, you may be able to do a huge amount of planning all at once without using the exemption,” he adds. “But because you don’t know whether you’ll get that window or not, you may be reluctant to use the exemption — or to spend dollars on life insurance premiums you can’t get back.”
Nonetheless, Delgass continues, high net worth clients should do wealth transfer planning that costs little or that’s needed for non-tax purposes (e.g., drafting wills or trust documents needed to establish the disposition of assets at death). Once there’s greater certainty about the estate tax, clients might then safely pursue tax-avoidance transactions that can preserve more of an estate for future generations.
Among them: establishing an irrevocable life insurance trust (ILIT). As the owner of one or more life insurance policies, the vehicle’s trustee invests the insurance proceeds income and estate tax-free and administers trust assets for one or more beneficiaries. If the policies are second-to-die contracts, only children would inherit the proceeds.
“Life insurance is very good at providing liquidity when there’s a liquidity mismatch, such as when estate tax needs to be paid on a $20 million estate tied up in an illiquid business,” says Delgass. “If you don’t want to be forced to sell the business when the tax comes due, life insurance could be an excellent solution.”
(Ditto in respect to complementary solutions that can minimize the value of the estate for tax purposes. Example: Establishing the business as a limited liability company (LLC), which lets an owner/parent transfer LLC-held assets to a child without giving up control. These assets are also protected from creditors; and appreciation in the value of an LLC’s assets are excluded from the parent/owner’s taxable estate.)
If a liquidity mismatch is temporary, then a term life insurance policy may be appropriate for covering estate tax. (Photo: Thinkstock)
App developers with a tax problem
Often, says Delgass, a permanent life insurance policy, such as whole or universal life, is used to cover an estate tax. But where the liquidity mismatch is temporary, then a term life policy may be appropriate.
To illustrate, Delgass cites a technology start-up whose owner desires only to hold onto the business until it can be sold at a profit for cash or readied for an initial public offering — transactions that can provide the liquidity needed to cover a future estate tax. If, say, the business is worth $1 billion before the sale or IPO, then the owner has a temporary estate tax problem. Hence, the need for term insurance.
“I have a client now who just finished a financing round that values his tech company at more than $500 million,” says Delgass. “He says the company will either be worth nothing in 10 years or take off and, at the time of anIPO, be worth north of $500 million. To solve his temporary estate tax problem, we’ve sold him large term policies, instead of one, enormous permanent life policy.”
Should the estate tax be repealed in 2017, such large life insurance sales may no longer be necessary. But agents and advisors may need to shift their focus to another concern of the high net worth: the gift tax. If phased out or eliminated as part of a tax reform bill then, Delgass says, affluent clients will gain access to a favored technique: using gifting to lower their taxable income.
“The gift tax is really a big deal because it’s one of the ways the IRS prevents income tax arbitrage,” says Delgass. “So while it doesn’t raise much money, it does have significant income tax income implications.
“If it’s repealed, there will be a lot of income tax planning opportunities for agents and advisors,” he adds.