The 2010 Tax Act is a game changer (for two years anyway). While everyone seems focused on the new $5 million exemption and portability, take a look in your rearview mirror and reevaluate your clients' existing insurance plans.
While it is certainly important to reassess the formula clauses in a client's will (which direct how some estate assets will be distributed) and consider new gift planning, that is not sufficient. Every prior plan, trust and insurance policy should be thoroughly reviewed.
In particular, irrevocable life insurance trusts (ILITs) are the foundation of many estate plans. Changes in the 2010 Tax Act raise a host of issues and opportunities for existing ILITs that planners should address.
Clients who previously purchased significant life insurance, and in particular survivorship policies, might be unhappy paying premiums on policies intended to fund an estate tax they now believe is unlikely to affect them. While advisors know that the law is uncertain after 2012, and in fact might revert to a $1 million exemption and a 55% estate-tax rate, few clients believe that scenario is likely enough to outweigh what they might view as the discomfort of a large survivorship insurance premium.
To refocus their clients, advisors should review the broader planning perspective that served as the backdrop for their old insurance trusts and dissuade clients from taking irrevocable actions. Ask the following questions:
* What benefits does the existing plan have other than potential estate-tax savings?
* Is the liquidity needed to address business succession or cash flow needs?
* Is the coverage required under a contractual arrangement (business buy/ sell, matrimonial agreement, etc.)?
* Is there an investment benefit? Perhaps the client's overall investment plan is rather risky, and a conservative permanent life insurance policy can provide some ballast for the portfolio. If a family business comprises a substantial component of the client's estate, perhaps the insurance remains an important component of diversification.
* Does the client have significant asset protection concerns that the insurance trust was intended in part to address? These have likely not been affected at all by the dramatic changes in the estate tax.
Once you have identified the continuing benefits from the insurance and the trust, you can modify coverage, and the trust, even if irrevocable, might afford some surprisingly flexible options (see below). Thus, the old document and plan can, in some cases, conform to the revised objectives. For example, the insurance policy might be reduced to a paid-up policy at a lower rate.
But aren't insurance trusts usually created as irrevocable trusts so they cannot be modified to address changes in the tax landscape? While most trusts are irrevocable, irrevocability doesn't preclude considerable flexibility.
As part of the review of the client's overall insurance plan, a consultation with the client's estate planner to identify options that the trust might take is vital to evaluating planning options properly. Consider these outcomes:
* An irrevocable trust might give a trust protector the authority to add or remove beneficiaries and shift the trust to a state where the laws are more conducive to the recommended changes.
* The trust agreement itself might permit distributions of the entire trust principal to current beneficiaries, thus providing an economical means to terminate the trust, distribute a much reduced paid-up policy to heirs and simplify the overall plan.
* It may be feasible to transfer (decant) the existing trust into a new trust that better reflects the new planning landscape. This can provide tremendous flexibility. If the governing instrument permits a transfer of trust assets to a new trust, decanting might be accomplished under the terms of the trust. A growing number of states permit decanting under state statute. Some states that have not enacted statutes allowing decanting may permit a shift to a new trust under court cases (state common law) in that state.
GIFTING BIG POLICIES
Planners know that the default decision on a significant life insurance plan is to have the policy held by a trust. Often, clients whose circumstances were different when they purchased an earlier policy own those policies with high cash values outside of trusts. That exposes the cash value to claims and lawsuits, and the death benefits to estate taxes.
Even if a planner identified this issue, the high-value insurance policy may have remained outside of a trust because of the difficulty under prior law of transferring the policy into the trust without triggering a gift-tax consequence. After the 2010 Tax Act, it may be simple to shift such a policy into a trust.
For example, if the policy has a cash value of $500,000, under prior law the client may have been reluctant to utilize half of his or her lifetime gift exemption to transfer the policy into a trust. A large value policy would have also been impractical to transfer using the relatively modest $13,000 annual gift exclusion amounts. Loans, split-dollar arrangements and other techniques may have been more complicated than the client was comfortable with. Under the post-2010 rules, the client might simply transfer the policy to a trust and use up a portion of the now much larger $5 million gift exclusion.
While the 2010 Tax Act has opened up a big planning opportunity to clean up old non-trust life insurance policies, not every policy will warrant transfer. As the differential between the value for gift-tax purposes and the death benefit narrows, the benefit of transferring the policy for tax purposes dissipates. However, the asset protection benefits might still support such a transfer.
The 2010 Tax Act changes split-dollar life insurance planning so dramatically that every split-dollar plan should be reviewed. For many, the high $5 million gift exemption amount will afford an opportunity to unwind the existing arrangement and simplify the client's existing plan without dismantling the essence of what the original insurance plan was designed to accomplish.
By way of background, split dollar is a way of funding and owning a life insurance policy. For example, in a typical family split-dollar arrangement, the insured may advance funds to an insurance trust, and the insurance trust purchases and owns insurance. The advances by the insured will be repaid from policy proceeds and are secured by an interest in the policy.
Over the years, the amount due from the trust to the insured grows and erodes the benefits of the arrangement. At some point it becomes worthwhile to unwind the split-dollar arrangement.
Estate planning lawyers use lots of approaches to create an exit strategy to unwind these split-dollar plans, including creating grantor-retained annuity trusts (GRATs) that flow into the insurance trust. The tremendous increase in the gift exemption to $5 million gives many clients a rather simple resolution. The client can simply gift to the insurance trust the amount necessary for it to unwind the arrangement.
Life insurance is a key part of many client estate plans. In most well-crafted plans, the insurance is owned by an ILIT. Once planners have identified new planning goals for clients in light of the changes made by the 2010 Tax Act, all existing policies and trust documents should be reviewed. Insurance trusts are one of the most important. With creative planning, it is often feasible to tailor existing policies and even irrevocable trusts to serve the client's needs better.
Martin M. Shenkman, CPA, MBA, PFS, JD, is an estate planner in Paramus, N.J. He is co-author of Estate Planning after the Tax Relief and Job Creation Act of 2010: Tools, Tips and Tactics, available at www.cpa2biz.com.