Possible answers to tricky questions from clients.
Imagine that an estate planner gives a presentation to clients on the estate and gift tax provisions of the Tax Cuts and Jobs Act (the Act). The clients hear that, as of January 2018 and running through 2025, the estate, gift and generation-skipping transfer (GST) tax exemptions are doubled to $11.18 million in 2018 and indexed thereafter, the estate, gift and GST tax rates remain at 40 percent and step-up in basis for inherited assets (other than income in respect of a decedent (IRD)) is preserved. They hear something favorable about how basis is determined when a policy is sold in a life settlement. And, as a postscript to the discussion of the Act, they hear that the current design flexibility of grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs) is preserved and that the proposed regulations to Internal Revenue Code Section 2704 were “unproposed.”
After the presentation, several of the clients approach the planner and ask these questions:
“While they fiddle around with that sunset business, how do I figure out how much life insurance I need for liquidity and for how long I need it?”
“They’ve just effectively repealed the estate tax as far as I’m concerned. Why should I keep paying the premiums on that policy?”
“Those big premiums are using up a lot of gift tax exemption that you tell me that I could use (or preserve) for other things. Got a Plan B?”
“The agent says that life insurance is a great vehicle for ‘capital transfer.’ Huh?”
“I’m about to buy a pretty large policy. With the increased exemptions, do I need an irrevocable life insurance trust (ILIT)?”
“That ILIT was the dumbest thing I ever did! Maybe I don’t need it now. What can ‘we’ do about it?”
“Should I use life insurance as an investment in my ILIT?”
“Can’t I just sell the policy? I’d really like to have the cash.”
“I have that old split-dollar policy in my ILIT. I’m told that, unlike me of course, the plan won’t get better with age. Is it really a problem? If so, what should I do about it?”
“They didn’t repeal the estate tax, so I’m going to move ahead with purchasing that policy in my ILIT. Have been there and done that with split dollar and don’t want to go there again. Is there a simpler way to get premium money into the ILIT?”
However easy these questions are to ask, they aren’t particularly easy to answer in a full and fair fashion. Virtually every one of these questions calls for the planner to have a broad set of technical, consultative and collaborative skills. We won’t address each and every question in the order we posed them. Rather, we’ll address the questions in a more aggregate, contextual fashion, but we’ll defer the split-dollar discussion to a later article, in which we can address treatment of old, pre-regulation plans as well as use of new arrangements after the Act in a more comprehensive fashion.
Estate Liquidity
Like so many other areas of tax planning, it can be somewhat challenging to discuss a topic like life insurance for estate liquidity after the Act in a way that meets the clients’ needs for a clear explanation that actually answers their questions before it exceeds their attention span. The more intuitive the explanation and the more it creates a kind of a heuristic thought process that leads the client to an informed decision, the better.
While certainly not the only way to approach that discussion, one way to think about it is to group clients into one of two categories. The first category includes clients who own a so-called “illiquid and estate tax-sensitive” asset. A good example of such an asset is a family business, which, absent a source of liquidity, could be difficult for the family to maintain for reasons that could involve more than estate taxes. The second category is pretty much everyone else. You might further categorize these clients as either having no taxable estate now but maybe having one after sunset (if that happens) or having an estate that’s taxable now and always will be, assuming no complete repeal.
A natural point of departure for the first type of client is whether the client will keep the business (or other asset) in the family or sell it to a third party or a management team. These are two very distinctive discussion tracks, each calling for its own set of planning applications and opportunities.
Keeping the business. Let’s start on the keep side and assume that this is de novo planning, meaning that it involves a potential new purchase of life insurance. The planner, the agent and the client’s other advisors should take off the filters and identify all of the needs for liquidity, not just estate tax. Those needs can include capital for the surviving spouse, equalization among business and non-business children and so forth. The team should also look down the field, as it were, to structure the insurance so that each premium dollar can help meet more than one need. For example, the same policy that would provide capital for the surviving spouse can also provide capital for equalization among business and non-business children or estate liquidity at the death of the spouse.
Putting the spotlight on the impact of the Act on this type of situation, we may actually find that it doesn’t have much impact. Why? Because a careful study of the situation will likely uncover a constellation of needs, both tax and non-tax, which will pretty much exhaust the budget anyway. Of course, how the prescription is ultimately filled will depend on the size and composition of the estate, the extent of the transfer planning the client is willing to do, how quickly he’ll get it done and a host of other factors. In some circumstances, typically when the transfer planning will be robust enough and timely enough to reduce the liquidity need to a manageable level, the insurance prescription can end up being an artful combination or bifurcation of term and permanent insurance. In other circumstances, the need is so great and of such duration, that planning can only mitigate the liquidity need, not eliminate it. In those situations, term insurance won’t cut it. Regardless, the big mistake is to fail to coordinate the way the insurance is selected, designed, funded and paid for with the estate and business succession planning. But, that’s for another day and another article.
Now let’s change the facts and assume that we’re keeping the business. Let’s further assume that there’s a lot of insurance in force. But, the client believes that the combination of the increased and indexed exemptions and his ability to do (more) GRATs and sales to IDGTs will take care of the liquidity problem nicely or at least make it manageable.
The client is likely to ask why he shouldn’t be able to cut back on the insurance, maybe even substantially. The planner should be careful to avoid what appears to be a politically based and largely self-serving response, such as, “Well, you realize that these beneficial changes are only temporary and even before then, a new administration could…” A better response might be to take the client back to basics, much like we did with the new purchaser, not only sifting through the needs for capital and liquidity at his death (and the later death of his spouse), but also taking him through what the life insurance can do for him as a pure capital transfer vehicle and, maybe even as what we might call a “default estate plan,” in which the insurance does for him what he’s not willing to do for himself.
The main point is to underscore the value of having the coverage in force, identifying the real risks of cutting the coverage back (or worse) and then trying to replicate it at a time when the underwriters are no longer favorably impressed by the client’s medical reports. The point is that it’s not just about liquidity for estate taxes; it’s about the policy’s value as a potentially irreplaceable financial tool for him and his family. Now, in fairness, the client could rightfully say, “OK, I get it. But, let’s assume that on Monday morning, I start all that planning that you and others have been talking to me about. Isn’t there some way that I can at least reduce my outlay for the coverage? Something has to give here!” Well, now, we could have some room to maneuver and maybe, if the policy itself has a flexible premium structure, the client could choose to reduce the premiums to the minimum required to support the death benefit until there’s more visibility about his needs, the tax law and the other factors that influence his decisions.
Selling the business. The sell the business side of the discussion was interesting before the Act and continues to be with the Act. But, the paradigm is different, and the discussion track is different. Here, we need to know enough about the facts and circumstances to know when a sale transaction would take place and to have a reasonable idea for just how liquid the client will be after the sale. Of course, there are those who’ll say, “What difference does it make, he still has a big estate and a big tax?” That’s true, but he no longer has an estate tax-sensitive asset, and maybe he doesn’t care how much of that large but liquid estate the children have to pay in taxes, and maybe he’s just done with the expense and complexity of all that planning and insurance.
A line of inquiry that clients might find helpful is basically to ask them if there’s some critical mass of capital/estate that they think is enough, that is, needs to be protected from estate tax, whether through planning or insurance. After that, the children are on their own. In most cases, the clients are ready to give the answer to that question. It’s $X, and then enough is enough. In those cases, we’ll revisit the existing insurance portfolio or construct a new one that fits the bill.
It will be interesting to see how many of these clients who become liquid will be interested in dealing with the complexity and cost of “second act” estate tax planning and providing for/maintaining the associated liquidity. It may be a bridge too far because it just won’t offer the value proposition that it used to, all things and families considered.
Planning for everyone else. By definition, they don’t have an illiquid estate tax-sensitive asset. Run the same analyses and ask the same questions as with the other clients. Determine the optimum timing for the liquidity, that is, how much liquidity at the client’s death versus at the death of the second of the client and surviving spouse to die. If the liquidity cost curve will eventually fade away, the client can layer the coverage with different products so the client won’t pay for liquidity he won’t need.
Capital Transfer
This topic can come into play when clients are considering new purchases (in their ILITs) as long-term investments. It can also come into play when clients wonder what to do with policies in their ILITs that are no longer needed for estate liquidity.
Many wealthy clients are shown life insurance as a trust investment for pure wealth transfer. The primary advantage of this use of life insurance is that the internal rate of return (IRR) on the death benefit may be as good or better on a risk and attitude-adjusted basis as anything else the trust would invest in. This application of life insurance could be a worthy use of some (or all) of the increased exemption. Even if the concept of life insurance as an investment for the trust makes sense for a given client, there’s still an important role for policy selection and design. Often, the default tends to be a guaranteed universal life product because it locks in the IRR on the death benefit. But, depending on the performance specs of the particular product, the guaranteed nature of the locked-in IRR may not be as attractive to the client if it trades off other characteristics such as the potential for (more) robust accumulation of cash value that can be accessed on a tax-free basis by the trust for distributions to the beneficiaries (not the insured).
The main point from a planning perspective is that the Act didn’t alter the fundamental tax advantages of cash value life insurance as either an accumulation vehicle or a wealth transfer vehicle. Therefore, clients might well find that it makes sense to use their expanded exemption to fund an ILIT for this purpose. Similarly, clients who aren’t sure what to do with policies no longer needed for liquidity might find that this strategic redeployment of their policies is something to consider.
Problematic ILITs
Advisors had better be ready to handle a lot of questions about ILITs in the coming months. Consider, for example, the client who created an ILIT 15 years ago. The ILIT bought a large policy to be used for estate tax liquidity, among other things. Think about all of the personal, financial and tax changes that could have occurred in that client’s life twixt the time the ILIT was created and today. It’s entirely reasonable (likely?) that for one or more of the following reasons, the client is now unhappy with the ILIT:
• The client says, “I just don’t care anymore! Get me out of here!”—admittedly, we don’t know if we need an estate planner or a psychologist to get to the bottom of this one, but it may just be that the client is fed up with the year-to-year hassle and expense involved in the care and feeding of the ILIT.
• The ILIT no longer fits the client’s needs or family situation—we’ve all seen this, many times over.
• The client is no longer on speaking terms or has no business relationship with the trustee or an affiliate of the trustee.
• The ILIT’s design/structure is causing gift/GST tax issues with the premiums.
• The ILIT isn’t quite income tax defective enough, thereby precluding use of advantageous strategies to leverage gift (and GST) tax exemptions or perhaps solutions to problems with a split-dollar arrangement. Grantor trust status could be a critical part of fixing the problem, for example, maybe the next premium transfer is better lent to the ILIT than given.
If the planner doesn’t already have it, he’ll need a copy of the ILIT. He’ll also need any gift tax returns reflecting how the premium gifts have been treated and how much gift tax/GST tax exemption the client/grantor (and his spouse) have left as of 2018. A critical inquiry will be whether (and how assuredly) the ILIT is a grantor trust and, if so, how and as to whom.
If the ILIT is to be undone in one fashion or another, what are the options for the undoing? This sub-topic easily merits an article (or treatise) unto itself. As a practical matter, there’s nothing new here to report purely as a result of the Act. What’s also not new or different is that if the client wants to migrate the policy from an ILIT he dislikes to another ILIT or even to some other form of ownership, he’s probably going to have to settle for the least bad choice. There’s no perfect wave here.
Options from one side of the fix-it spectrum to the other can include:
• Court reformation/non-judicial modification (if permitted under local law).
• Decanting (if permitted under local law).
• Distribute the policy to adult beneficiaries (if possible under the trust).
• Distribute the policy to a new ILIT created by the grantor for the same beneficiaries. However, state law must allow this policy distribution, and there could be fiduciary issues.
• Sell the policy to a new ILIT. The grantor could create and fund a new ILIT, which could purchase the policy from the old ILIT. The sale would be a transfer for value, but the new ILIT would be a grantor trust or a partner of the insured grantor, thereby alleviating the issue. Still, there are valuation and fiduciary issues to deal with.
• Sell the policy to the grantor. The grantor says, “OK, I understand that I can’t just get it back. I have to buy it. For how much?” The trustee says, “I’ll have to talk to my manager.” The transaction wouldn’t be a transfer for value because the sale is to the insured, but again, there are valuation and fiduciary issues to deal with. But, what’s the game plan after he owns it? Does he start all over again?
• Have the grantor acquire the policy by way of a swap power in the ILIT. Yes, there are valuation issues to deal with, but not the same fiduciary issues.
Remember, the ILIT itself may be just fine. The problem may be with the policy.
Need for ILIT
Clients may ask you why they need an ILIT with the increased exemptions. There’s no right answer to this question, but planners should have a template for a response. Before you suggest to someone that he lay out $2,500, $5,000, $10,000 or more and go through all the initial and ongoing hassle of an ILIT, ask some probing questions:
• First, let’s put the numbers second. Is the client (really) sure that he won’t want or need access to the policy? Clients will be well served by staying away from ILITs unless there’s a clear, convincing case that they’ll never need or want that policy back.
• Is the family situation functional enough to use anything irrevocable? Well, that depends on what the meaning of “functional” is. We’re not sure we can describe it, but we know it when we see it.
• Is an ILIT worth the cost, hassle and risk that you could actually have to buy your own life insurance policy back? How much of a premium, forgive the phrase, is that ILIT really worth?
• The Act aside, is the ILIT really needed for estate liquidity? In all likelihood, the surviving spouse (who receives the proceeds tax-free anyway) will spend down so much of the proceeds over the rest of his life that the estate tax issue will take care of itself. In a lot of cases, that’s just what will happen! On the flip side, there are clearly cases when the ILIT makes all the sense in the world, in that it just doesn’t make sense to expose big bucks to the transfer tax system. But, you’ll need to have some rules of thumb to guide clients through this when it might be a closer call.
The Act has renewed interest in spousal lifetime access trusts (SLATs) as a way to use the increased exemption without, shall we say, excessive decrease in control over a transferred asset. In this context, a husband can create a SLAT for his wife’s benefit and fund it with part of his $11.18 million gift tax exemption. During the wife’s lifetime, the trustee (who may be the wife) can distribute income and principal as needed to her for her health, education, maintenance and support. She can also have a “5x5” power and a testamentary limited power of appointment. Thus, the husband has “indirect” access to the trust’s income and principal. Well, maybe. When the wife passes away, the unappointed trust property passes estate tax free to the children.
The SLAT could function as (and instead of) an ILIT. Here, the SLAT would be the applicant, owner and beneficiary of a policy on the husband. The trust uses the funding to pay the premiums. Once cash value develops, the trustee can access the policy by way of withdrawals and loans. But, the trust shouldn’t give the husband incidents of ownership in the policy!
Beyond the IRC Section 2042 concern, SLATs present some issues. What happens if the wife dies or the parties get divorced? Does the husband lose his indirect access to the trust’s income and principal? Apparently so.
Financing Premiums
Now we’ll offer some observations about how you can help clients fashion sensible approaches to financing premiums on ILIT-owned policies, the term “sensible” meaning an approach that: (1) doesn’t snatch complexity from the jaws of simplicity, (2) looks for real economic (out-of-pocket) savings and not just tax savings,
(3) minimizes use of gift tax exemption, and (4) can have an exit strategy other than death.
The stair-step approach. A client establishes the ILIT as an income tax defective trust and makes outright gifts of the premium to the ILIT, using annual exclusions and/or exemptions, depending on the situation, as well as on how counsel designed the trust.
As a general rule, the ILIT should be a grantor trust. Grantor trust status helps to avoid transfer-for-value issues if the grantor/insured sells a policy to the ILIT to avoid the 3-year rule. Revenue Ruling 2007-13 holds that a transfer to a grantor trust is a transfer to the insured.
If income-producing assets are gifted to the ILIT to provide cash flow to pay premiums, the grantor’s payment of the ILIT’s income taxes will be the equivalent of a tax-free gift to the beneficiaries of the ILIT. He defunds the estate without gift tax. Grantor trust status can facilitate transfers from one ILIT to another, that is, if both ILITs are grantor trusts, transfers between the two are disregarded for income tax purposes. Grantor trust status will eliminate income tax implications of a private premium split-dollar or premium financing arrangement. We’ll get back to this point, but it doesn’t hurt to mention it now because the more important it is to save exemption for step-up, the more valuable the ability to lend those premiums to the ILIT without income or gift tax consequences will be.
While a discussion of how to make the ILIT income tax defective is beyond the scope of this article, planners will have to determine which grantor trust powers would give the client/grantor: (1) the most assurance that the trust is income tax defective, and (2) the most flexibility to do mid-course corrections without having to get a law degree or without his having to give everyone else the third degree.
Once the ILIT is up and running and primed with the initial gifts, the grantor can use the increased exemption to make one or more substantial tax-free gifts of income-producing property to the ILIT, property that would be discountable if possible. Then, the client establishes a GRAT, which he funds with income-producing property. Taking GST tax into consideration, the GRAT names the ILIT as remainderman, so that at the end of the term, the property is distributed to the ILIT, which isn’t subject to the GST tax.
The objective of these large transfers is to fund the ILIT with income-producing property on a gift tax-efficient basis, thereby enabling the ILIT to pay an increasing share of the premium with its own cash (the income tax on which is paid by the client). Every dollar of premium the ILIT can pay with its own cash is a dollar of taxable gift that the client won’t have to make.
This approach tends to make a lot of sense to our clients who have a lot of cash-flowing investment property, especially if it can be put into discountable form. We can really save them a lot of gift taxes over the years by transferring that property, which many of the clients are otherwise prepared to give to the children anyway, into the ILIT.
Selecting the policy for the stair-step approach. Let’s consider the characteristics of a policy that are likely to appeal to a client using this strategy. For starters, a 15- or 20-year term policy will keep the early year premiums and taxable gifts low while the client funds the trust. Depending on how the future and the need for liquidity unfold, the trust can convert the term policy to a cash value policy. But, the trust might not need to convert if the dominoes fall in a certain order.
If, as is likely, a cash value policy is or becomes appropriate, the planning team will have to work with the client to determine the characteristics of a policy that would align well with the way the client is implementing the stair-step strategy and the trend of the client’s liquidity need. The determination of those characteristics might include such considerations as the need for flexibility to change the premium as the ILIT is funded, the need for an increasing rather than a level death benefit and so forth.
Selling the policy in a life settlement. The life settlement market has improved, the process is better understood and more transparent than ever before and the market has two tailwinds at its back: (1) the high and rising estate tax exemptions that render more and more policies expendable (at least for that particular reason), and (2) low crediting rates that are increasing the carrying costs of policies. An agent who’s well-versed in this market can help your client assess the marketability of a given policy and can explain the administrative regimen, both pre and post-sale, that’s involved.
Some Inside Baseball
Here are some generalities (meaning there will be exceptions) used to determine marketability of a policy for a life settlement transaction:
• Can sell term, universal, variable, single life or second-to-die.
• Life insurance company is sound.
• Policy has been in force for at least two years.
• Face amount of $250,000+.
• Premium shouldn’t be more than 5 percent of the death benefit and cash value not more than 15 percent to 20 percent of the death benefit. The less cash value vis-a-vis the death benefit, the better.
• Insured should be at least age 65 to 70, life expectancy of up to 12 to 14 years, smoker is better than non-smoker.
• Policy issued on a more favorable underwriting basis than warranted, and insured’s health has since turned for the worse.
The bottom line is that the life settlement buyer is looking to buy a sound policy issued by a sound insurer that’s now underpriced because it was issued at a better rate class than the insured would get today and insures someone who will, unfortunately, accelerate the IRR.
The operative guidance on the taxation of life settlements, which is Rev. Rul. 2009-13, essentially says that gain above basis is ordinary to the extent of the amount of inside build-up that would have been ordinary income on surrender and capital gains thereafter. The ruling held that the policyholder must reduce basis by the cost of insurance charges, but that was revoked retroactively by the Act. A point that should be made clear to the client/insured is that if the policy is owned by an ILIT and the ILIT is a grantor trust, the ILIT will keep the cash but send the tax bill to the grantor/insured.
Does the life settlement make sense? It depends. Does the client plan to spend the after-tax proceeds? If so, that might be the end of the discussion. But, if the client would invest the proceeds, run some scenarios to determine if the sale and reinvestment of the after-tax proceeds would leave a larger amount of money to the survivors than if the client kept (and kept paying premiums on) the policy. Ask the agent to show the lowest premium projected to support the death benefit to just beyond life expectancy. Compare the premium cost-adjusted death benefit from the policy to the after-tax result of investing the after-tax proceeds of the life settlement. When will crossover occur, that is, when will selling the policy yield a better net result than keeping it in force? Then recheck the numbers and ask, “What if…?”
—Portions of this article were presented at a workshop given by the authors and Mary Ann Mancini, partner at Loeb & Loeb LLP in Washington, D.C., at the 52nd Heckerling Institute on Estate Planning in Orlando, Fla.