How can tax planners and their clients meaningfully plan for a tax that may or may not be in place, in presently definable form, in the year that an individual eventually dies? Planners are faced with a quandary of multiple potential tax scenarios. Now that the estate tax has become a political football, with diminished concern for sound policy and stable rules of the game, estate planning will be more challenging than ever. Periodic politically-motivated changes in the law may require ever-changing estate planning. How are families to approach this reality? It seems apparent that attention must be directed to planning techniques that build into an estate plan maximum flexibility to cope with changes in the law as they occur.
Increased Importance of Irrevocable Life Insurance Trusts
The use of irrevocable trusts, always a major estate planning tool for affluent families, now becomes even more important. This author believes that the ultimate fate of the federal estate tax is unclear. As the debate unfolds into future years it will likely amount to a proposed trade of the estate tax for either a carry-over basis regime or a capital gains due at death tax approach. In this state of uncertainty, attention must be directed to techniques that ensure successful estate planning whether the estate tax is ultimately repealed or not.
Irrevocable Life Insurance Trusts: A Win-Win Strategy
How can families develop an estate plan when there is no reliable basis for predicting whether the law will be changed, and if so what the new law will be? A logical way to proceed is to adopt strategies to hedge against these uncertainties. And the unique characteristics of life insurance make an irrevocable life insurance trust a unique hedge against both the uncertainty of the law and the contingency of mortality, ensuring predictable results whether the estate tax is repealed or not, whether transferred assets are treated as having a stepped-up or carryover basis, and whether the transferor lives for one year or twenty.
The insurance-funded irrevocable trust is a uniquely flexible hedge against planning uncertainties because it can:
Serve as a vehicle for the passage of wealth, free of the burden of a possible future carryover basis regime or a capital gains at death tax;
Serve as a funding vehicle for an irrevocable trust in the event the estate tax and generation skipping transfer tax exist as today (or reappear after a period of repeal) sheltering those funds from estate tax and generation skipping transfer taxation; and
Serve as a device for elevating the plan above the political vagaries of an ever shifting set of tax rules.
POINT 1: Life Insurance Effectively Transmits Wealth Irrespective of Basis Regime
The most likely estate tax repeal model affects the basis of assets transferred at death. Instead of stepping the basis up to fair market value at the date of death, it carries over the acquirer’s basis. (A similar carryover basis provision was enacted as part of the Tax Reform Act of 1976. Due to its inordinate complexity and administrative difficulty (arguments that would not likely succeed today due to advancements in technology), it was repealed four years later, before ever taking effect.) The capital gains consequences could be substantial, eroding wealth even in the absence of estate tax.
Life insurance avoids this problem altogether: since death benefits are exempt from income tax, there is no question of the recipient’s basis, whether we have an estate tax/stepped-up basis regime or a no estate tax/carryover basis regime or a no estate tax/capital gains due at death regime.
POINT 2: Irrevocable Life Insurance Trusts Retain Their Planning Advantages under an Estate Tax Regime
If the estate tax and the GST tax are ultimately not repealed, Irrevocable Life Insurance Trusts will remain attractive vehicles for wealth transfer they have always been. The life insurance proceeds that fund the trust will still be exempt from estate tax, and the trust can be structured so as to exempt them from the GST tax as well.
POINT 3: Insulation against Political Winds
The third major benefit of life insurance as a planning tool is that it elevates the plan above the political vagaries of an ever-shifting set of tax rules.
The recent history of estate tax legislation demonstrates that the issue has become captive to political interests. There is no reason to expect an end to this situation.
The insurance-funded irrevocable trust has always offered protection against these contingencies. If the estate tax is not repealed, it retains the traditional benefits of life insurance in estate planning. If the tax is repealed, it affords unique protection against the carryover basis regime (or the capital gains at death tax regime) that will likely then be in effect. The client wins either way.