A young attorney recently voiced a complaint to me: “I don’t understand how people can expect me to come up with a plan when there is no plan.” He was frustrated that we don’t know where the federal estate tax is going to land, and his point is well taken. We have a federal estate tax that may or may not apply to a particular estate, depending on what date the taxpayer dies. And the government has failed to indicate whether they intend to cure, modify, or ignore this sad state of affairs. So, what can we tell advisors and clients? How can we plan for our wealthy clients when the government won’t give us an accurate idea as to what will happen with transfer taxes?
When the details of a picture are unclear, the best approach is to recall what the overall image of the picture represents. Staying focused on objectives and general principles will serve us well as the details fill themselves in. In the case of estate planning, there are several principles we should keep in mind while the estate tax drama plays itself out. With these principles as our focus, it becomes all the more clear that the client’s better option is to act now rather than delay.
The Objective is Estate Planning, Not Estate Tax Planning: As advisors, we are often aware of tax consequences that can befall the unwary client. The federal estate tax, which currently can rob the estate of as much as 45% of principal, is one of the most insidious taxes. Still, when helping the client create an estate plan, we must remember that the clients’ goals are typically to:
• transfer their hard-earned wealth,
• to the objects of their affection,
• in the way they want it distributed,
• without having to share it with 300 million other people in the form of taxes.
Although the last goal is currently hard to deal with because of uncertainty around estate taxes, planning for completion of the first three goals should not stop. If we can work with our clients to accomplish these planning goals, it is easier to create temporary, stop-gap measures to deal with estate taxes. Further, by focusing on these other planning goals, it makes it easier to demonstrate that life insurance is needed to keep estate taxes from wrecking the objectives of the estate plan.
No Decision Is a Decision: The primary complaint advisors have about the federal estate tax system is that the amount of tax owed is dependent on the year in which the client dies. It is difficult to decide how to create and fund a plan when the plan’s results are date-sensitive. Since the client cannot decide date-of-death, a plan must be decided upon, even if it is subject to future review and revision. Otherwise, no decision means abdicating the outcome of the estate plan to the vagaries of mortality and Congress. Especially in the area of life insurance funding, a “no decision” decision can be irrevocable. Uninsurability cannot be reversed.
Short-term Solutions For Long-Term Needs: An estate plan should never be cast in stone: times change, families change, taxes change. Especially in an era where estate taxes are the political hot potato in Washington, it may be appropriate to create short-term solutions around long-term estate plan objectives.
An example commonly employed by estate planning attorneys is the use of disclaimer trusts. These flexible instruments can help a surviving spouse decide exactly how much property, if any, should go into a bypass trust — a useful tool in times where the estate exemption level keeps changing. Another example is life insurance. Even though life insurance is a long-term solution, techniques can be employed that allow short-term flexibility in the insurance plan design and funding. Consider these two techniques:
Private Split Dollar: Funding life insurance through a private split dollar (PSD) agreement is primarily a highly efficient way for grantors to get premiums into an irrevocable life insurance trust (ILIT) without incurring gift tax. But it also offers flexibility for dealing with the uncertainty of estate taxes. A typical PSD agreement involves the grantors having a collateral assignment in a survivorship life insurance policy held in an ILIT. If it makes sense for the grantors to now own the policy because of changed estate tax laws, the policy can revert to them in satisfaction of the assignment. If it makes sense to get rid of their interest in the policy instead, the assignment can be released as a gift. The life insurance is permanent; the way it is financed remains flexible.
Converting Two Term Policies to a Survivorship Life Policy: Some wealthy couples are simply not willing to commit to a large life insurance premium until they have a better idea as to what will happen with federal estate taxes. A short-term solution that doesn’t jeopardize insurability is to have them purchase two term policies from a company that will allow the policies to be converted into a single survivorship policy at a later date.
Address the Business of Business: Many of the wealthy estates subject to estate tax are primarily comprised of equity in privately held businesses. Advisors need to work with business owners well in advance of death in order to mitigate the sting of transfer taxes. Wherever estate taxes ultimately end up, the business owner should start now to lower the respective taxes to his or her estate.
The sooner a business owner obtains an accurate appraisal of the business, the sooner a plan can be designed to create an estate freeze at that value. Designing and funding an exit plan now will help avoid estate liquidity challenges in the future. Creating and incentivizing a management team while the owner is still in charge assures a smooth transfer of the business at death. Funding these plans with life insurance both locks in insurability and lowers premiums.
Timing — Lose a Battle to Win the War: In the current tax environment, it often makes sense to pay taxes now to avoid paying larger taxes in the future. Advisors have been recommending all kinds of seemingly strange strategies to minimize future taxes. For example, with smaller estates, planners sometimes seek to get a higher valuation on business and real estate assets. Why? If a deathbed client is expected to have an estate under the estate tax exemption ($3.5 million in 2009), a high valuation will result in a higher step up in the property’s income tax basis.
With larger estates, so-called grantor trusts have become popular even though they result in the grantor paying income tax on trust income. The strategy is to shrink the future estate’s size through payments of income taxes currently. The income generated on assets in a grantor trust (for example, a funded ILIT) are attributed to the grantor instead of the trust, leaving more net dollars to the trust for obligations such as life insurance premiums. The end result is that the trust assets, including the life insurance, are out of the estate, but the income taxes stay with the grantor and help further reduce the estate size.
Currently in estate planning, timing is everything. As long as the estate tax law remains so time-sensitive, it’s advisable to have a good tax planner, and an even better physician.
In the End, It’s All About the Funding: Advisors can sometimes become so enamored with their elegant estate plans, they forget that the plan is worthless unless it is adequately funded. Whether the estate tax is at a $1 million exemption with a 55% rate, or a $3.5 million exemption with a 45% rate, a large estate is likely in need of estate liquidity. Waiting for a possible repeal of the estate tax, and then being wrong, results in a huge, possibly unrecoverable mistake.
Buying life insurance in anticipation of a $1 million exemption only to find the exemption moved up to $3.5 million, at worst only results in a small mistake. Life insurance funding can be thought of as a financial hedge. It is a levelized pre-payment of a call on principal, the call being exercisable at death, whether that occurs in 20 years or 20 weeks. Add in the fact that this financial hedge can be held outside of the taxable estate and still be available to fund the estate tax, and life insurance emerges as one of the best estate planning tools available. Since availability of this financial hedge is dependent on the client’s health status, the time to act is now. Congress may take its time determining estate taxes; your client cannot afford the same luxury.
Steve Parrish, JD, CLU, ChFC, RHU, is national advanced solutions consultant for The Principal Financial Group. He began his career as an attorney and advanced marketer in Minneapolis, then became a financial planner and a co-owner of Walker Parrish Financial Group. After serving 12 years as vice president of marketing services for AmerUs Life, Mr. Parrish started with The Principal in 1997 as head of business markets (including sales support and advanced markets). He currently provides advanced support on a national basis, traveling extensively to help train, promote, and consult for The Principal.