For many wealthy clients, the fear of the federal estate tax is a thing of the past, following the fiscal cliff tax deal that permanently raised the exemption for a couple to $10.5 million and made the exemption portable between spouses.
Understandably, they will now expect their planners to offer less complexity and lower costs than they had to endure in the past.
So what do you offer a client no longer threatened by the federal estate tax in this new normal of estate planning? Consider the new Swiss Army knife of planning: the multipurpose irrevocable life insurance trust, or MILIT.
Many wealthy clients already have irrevocable life insurance trusts, or ILITs, to hold life insurance. An ILIT protects life insurance proceeds for a surviving spouse and minor children, prevents creditors from reaching proceeds and has other benefits. Regardless of the estate-tax machinations in Washington, ILITs will remain a common estate planning tool.
But this old stalwart needs a makeover to become the keystone of planning in the new era. The bottom line will be to offer clients a single multipurpose trust to handle many planning goals.
STATE ESTATE TAXES
If your clients live in a state that has a tax exemption that is lower than the federal amount, they may face a significant state estate tax. Nevertheless, the potential savings in state estate tax and possibly an inheritance tax pale in comparison with what clients might have faced if the federal estate-tax threshold had been lowered, and clients may have very little appetite for a highly complex plan of action.
The combination of a 20% capital gains rate, the 3.8% Medicare tax on passive income, the phaseout of exemptions and itemized deductions for high-income taxpayers and possibly a state capital gains tax could push the marginal capital gains rate to 28%. That can be greater than the state estate tax rate.
So if you take the traditional approach and fund a bypass trust on the death of the first spouse, rather than relying on portability (using a simple outright bequest and having the surviving spouse use the first-to-die spouse's unused exemption), you may save state estate taxes on the second death.
But the assets in the bypass trust won't get a step-up in basis - an increase in the amount on which the gain is calculated for income tax purposes - to the fair value of the property at the time of the death. That could cost the heirs more.
Connecticut is the only state that has a gift tax. So for residents of the other 49 states, giving away assets while you are alive can minimize or even avoid the state estate tax.
Here's one example of some of the factors that come into play: Consider clients who live in a state that has an estate-tax exemption of only $1 million. They have a family net worth of $6 million as well as a $2 million term life insurance policy. With the new exemption and portability, there is no worry about federal estate tax. But the life insurance should probably go into an ILIT just to protect such a large sum.
Upon death, the traditional plan would be to finance a bypass trust on the first death with $1 million, so no state estate tax would be incurred. The balance of the estate passes to the surviving spouse directly or in a trust qualifying for the marital deduction. On the second death, there is a second $1 million state exemption. But that leaves $4 million (assuming the insurance is in the trust or lapsed) subject to state estate tax. That hurts, but not as badly as the combined federal and state estate tax used to hurt.
For most wealthy taxpayers under the federal exemption, the new higher income tax rates are actually more of a worry than estate taxes, given the large permanent, inflation-adjusted exemption. Seeking income tax shelter inside a permanent insurance policy is nothing new, but the numbers should look better for those clients in the highest income tax bracket.
So perhaps the standard term insurance plan and ILIT of old might give way to an ILIT holding a permanent life insurance policy, the cash value of which the client might access during retirement.
Spousal lifetime access trusts, or SLATs, have been a preferred approach, and grew especially popular in 2012, when many wealthy clients stormed their planners' offices late in the year seeking estate planning solace. That is because a SLAT provides a mechanism for a client to grow assets outside their estate, but in a manner that the family can access. A common SLAT might designate the spouse and all descendants as beneficiaries so expenses and needs of the spouse and heirs could all be paid out of the trust.
But there is more:
- A SLAT can be set up as a grantor trust. That means the earnings that accrue inside the trust remain taxable. This is a great estate reduction tool. (The client pays the tax, and the trust grows assets faster outside the client's estate.) It also means that before the client's death, highly appreciated assets inside the trust can be swapped for cash so that the appreciated assets are pulled back into the client's estate and get a step-up in basis.
- Once the client dies and grantor trust status ends, the SLAT will become a complex trust that can distribute income to the spouse and all heirs. With the higher graduated tax rates, distributions can be made to lower-bracket heirs who are under the threshold for the maximum tax bracket and the 3.8% Medicare tax. So after death, a SLAT can be a great income-shifting tool.
- The SLAT can provide protection for assets inside the trust. This is a big advantage over a bypass trust. The bypass trust is funded on the first death, which may not occur until the surviving spouse is in his or her 80s. How much asset protection do they need then? A SLAT, in contrast, can be set up now - when the asset protection makes more sense.
ORDERING A COMBO
What happens if you combine an ILIT, a bypass trust and a SLAT? You get a MILIT: a single trust that can serve the purpose of the traditional insurance trust and a well-crafted SLAT. The MILIT is not limited to the state estate-tax exemption amount, so the clients can put in as much value as they feel comfortable removing from the reach of their state estate tax - making it far more advantageous than a bypass trust limited to the state exemption.
How does this fit clients' growing desire for cost efficiency and simplicity? They may rely on a single trust instead of three (and perhaps even replace the commonly used revocable living trust, as well).
That is a cost savings in both legal fees and annual administrative fees. It's also easier for a client to get his or her head around one trust, the common ILIT, instead of several. Further, the client gets to test-drive the plan right away, rather than burdening a spouse with the task of dealing with the complexity after his or her death.
Finally, the client can ease into the swimming pool rather than making a cliff dive into what may be frigid waters. The client can put in as little as he or she wants into a MILIT, and, if comfortable, add more in future years.
One other advantage of the new ILIT approach is that, in your client's insurance trust, you don't need to have Crummey power - a mechanism that transmutes a gift to a trust into a gift that will qualify for the gift-tax annual exclusion (in 2013, that's $14,000 per year per donee). But that transmutation requires a formal written notice and other bothersome formalities.
If your client funds a MILIT with real assets to gain the asset protection and state estate-tax savings, those real dollars can fund life insurance premiums without the annual hassle of Crummey power.
BEAUTY OF MILITS
What can you offer clients who no longer see the value in estate planning and are cost-conscious and simplicity conscious? A MILIT is a great solution. Here are some of its benefits:
* Protection for up to $5.25 million in assets contributed to the MILIT (and on up to a second $5.25Ã¢â‚¬â°million if the spouse sets up a similar but different MILIT) from lawsuits and claims.
* Far more state estate tax savings than the old bypass trust approach could afford.
* A step-up in basis on assets before the first death, by swapping assets.
* The income tax shelter of a permanent life insurance policy during the client's lifetime and, after the client's death, the ability to sprinkle income to the lowest-bracket family members.
* The simplicity of one multipurpose trust that is pretty much as familiar as the good old ILIT.
Planning for the new set of rules requires some advisors to make big changes. Revising techniques to fill the new circumstances will be the key to helping clients meet their new needs.
Martin M. Shenkman, CPA, PFS, J.D., is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.