If estate tax law reverts to pre-2001 provisions in January 2011, your clients may be exposed to punishing estate taxes. How can you prepare for this and protect your clients’ wealth?
In 2001, Congress passed, and President George H.W. Bush signed, The Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Exemptions for estate taxes increased annually from $675,000 in 2001 to $3.5 million in 2009. Exemptions phased in by stages over time, and the estate tax and generation-skipping tax was repealed on Jan. 1 of this year.
One of the most noteworthy distinctions of EGTRRA is that its provisions are calculated to “sunset,” or revert on Jan. 1, 2011, to the provisions that were in effect prior to its passage in 2001. Unless additional legislation is authorized, these changes will be permanent.
Sunset eludes the Byrd Rule
This sunset provision eluded the Byrd Rule, which is a Senate rule that amends “The Congressional Budget and Impoundment Control Act of 1974.” Under the Byrd Rule, Senators can obstruct a piece of legislation if it purports to appreciably swell the federal deficit beyond a 10-year term.
This allowed EGTRRA to stay within the letter of the Pay As You Go (PAYGO) law, while removing nearly $700 billion from amounts that would have triggered PAYGO sequestration.1 PAYGO mandated that all shortfalls — whether from spending or revenue decreases — must be made up for by other spending reductions and/or revenue increases. It was thought that this would restrain increases in deficit spending.
In the initial PAYGO regimen, enacted in the Omnibus Budget Reconciliation Act of 1990 (OBRA ’90), by statutory requirement, if legislation enacted during a session of Congress had the effect of increasing the projected deficit for the following year, a “sequestration” would be triggered. A sequestration is an across-the-board spending reduction of non-exempt mandatory programs to offset this increase in the deficit, as calculated by the Office of Management and Budget.
In this bill, Congress was forced to keep its books balanced as it created new tax reductions. When this bill was passed, the president and Congress hadn’t predicted the cost of two wars, the financial debacle of 2009, and the rise in unemployment. Congress had expected the economy to grow, average taxpayer incomes to increase, and for the country to save money by not being at war.
Congress is in a much different place today and is going to discover it very difficult to find permanent spending cuts to offset permanent tax revenue reductions. These are needed to offset permanent estate tax repeal. This means one of two things: (1) An increase of the estate tax exemption; or (2) spending cuts which would be required to make this possible.
While campaigning, President Obama said he favored an exemption of $3.5 million or more. No one could have predicted the financial turmoil our country has suffered during the last few years. However, in President Obama’s State of the Union address, he clearly said that the tax cuts on the wealthy instituted by President George W. Bush and Congress would be left to expire.
Many of your clients relied on advice made with the assumption that the $3.5 million exemption would survive. Obviously this advice could be devastating to a family’s financial well-being today.
What’s likely to happen next?
Since polarization in Washington is so strong, Congress may do nothing and estate tax laws will revert to the rules which applied in 2006. Your clients will then have a $1 million exclusion from estate taxes and quickly become subject to 50% estate taxation rates.
Other forces may place your clients in an even worse scenario. “Bracket creep” was a term used in the ’80s which referred to the trend for the middle class to creep into higher income tax brackets as they slowly received cost-of-living pay increases. This meant that technically your clients were worth more, but because of inflation, they could only buy the same goods as they did before. Yet, they were paying more in taxes.
The same issue is true for estate taxes. As inflation kicks in over the next few years, many families’ estates will slowly exceed the $1 million value per person, yet their wealth will still be relatively modest.
Another issue is the valuation of small businesses. Believe it or not, low long-term interest rates have an inverse effect on the valuation of many small businesses. Although using the “capitalization rate” by itself is an oversimplified method, it is certainly one factor used to value property. If the IRS can use a technique to increase the value of your estate, you can be assured they will assert this into the valuation mix to force the payment of more estate taxes. The double-edged sword of reduced estate tax exemptions and estate bracket creep makes for a very disturbing situation.
Many top estate tax attorneys and CPAs have been advising their clients that the proposed estate tax exemption of at least $3.5 million would be extended before year’s end. However, many of them agree now that too much polarization and gridlock exists in Washington today for that to happen. Because many clients didn’t purchase life insurance over the past five years to cover this contingency, a huge opportunity for additional life insurance purchases exists.
The cost of waiting is more significant with life insurance than any other financial instrument. If your client waits until next year to buy, they run three risks: (1) Losing their insurability status; (2) becoming a year older; and (3) facing significant rate increases this year from many life insurance companies. If buying life insurance was as simple as buying a stock, bond or mutual fund, it would be fine to wait until next year to buy. However, it’s much more complicated than that: Some life insurance purchases can be delayed by the clients and their advisor’s decision cycles. So if your clients want to be prepared for Jan. 1, 2011, they need to act now.
How to protect your clients
One easy and inexpensive solution could be Annual Renewable Term (ART). A few companies have recently revised and re-priced their ART products. Since 40% of all new term sales are 20-year term, and the majority of the rest are 10-year term policies, a new ART product has been developed which competes favorably with both of these plans. This new product has a premium that starts around the 10-year rate, but slowly increases up to the 20-year rate over the next 11 to 15 years. The net effect of the new ART is that the cumulative rate is less costly than the 20-year term for at least the first 15 to 17 years of the contract. Your client gets a 20-year guaranteed rate, and the product is fully convertible to age 70.
As insurance professionals, we need to make sure our clients are prepared for the rainy days. In other words, they need to be prepared for no action by Congress on estate taxes. The only way to do this is to place the insurance in force today while you client is still insurable. At the minimum, your client needs to purchase a convertible term policy to protect them from the inaction and gridlock of the politicians.
Jonathan A Shaw, CLU, ChFC, is the President and CEO of Shaw American Financial Corporation. He currently serves as President of the Louisville Chapter of the Society of Financial Professional Services, and was recipient of the 2006 Medal of Honor by the Kentucky Association of Insurance and Financial Advisor’s (KAIFA). Shaw is also past director of the Louisville Association of Life Underwriters and the past chairman of the Political Action Committee.
Footnote:
1. “The Budget and Economic Outlook: Fiscal Years 2004-2013, Appendix A, The Expiration of Budget Enforcement Procedures: Issues and Options” – Congressional Budget Office