The Economic Growth and Tax Relief Reconciliation Act of 2001 earmarked the federal estate tax for a one-year repeal in 2010, with full reinstatement in 2011. Ever since, the debate has raged over whether or not repeal should become permanent.
What a difference a day makes. The election of a Democratic-controlled Congress on Nov. 7, 2006 has cast new uncertainty over the possibility of repeal. Many pundits believe the Democrats will keep the tax on the books for the foreseeable future.
Suddenly, estate planners are reporting new interest in estate tax planning while life insurers are introducing new life insurance policies to take advantage of what now appears to be a growing market. Research by LIMRA International, Windsor, Conn., earlier this year found that 70% of affluent consumers feel that protecting their estate from taxes is a "very important" or "critical" financial goal. However, 68% of respondents with an estate plan did not take action to update their plan, despite uncertainty over repeal.
This means estate planners and other financial professionals need to reach out to their affluent clients and help orient them to the real possibility that their estates will be subject to the estate tax. In 2011, if the estate tax is reinstated after a one-year hiatus as currently scheduled, the highest marginal rate will be 55% and the personal exemption will be $1 million. That translates into a big bite out of your client's financial legacies.
Individuals with $1 million and couples with $2 million in net worth need to plan for this possibility. Given the relative uncertainty of America's political landscape, they also should hedge their bets against the potential repeal of the tax if the deck in Congress suddenly gets reshuffled. But where should they start?
Certainly, anyone whose estate may be subject to taxation should create as much liquidity as possible. Many people have traditionally placed life insurance policies within an irrevocable life insurance trust (ILIT) to provide a ready source of cash to cover estate taxes and other expenses without adding to the size of the taxable estate itself.
Some clients who consider themselves on the cusp for estate taxation may be reluctant to part with the dollars necessary to purchase a large life insurance policy or to fund a policy that is beyond their reach because it's placed within an irrevocable trust. Proper drafting techniques can alleviate this problem, however, ensuring that at least one member of a couple has indirect access to the assets within the ILIT.
This is accomplished using an "ascertainable standard" that obligates the trustee to make disbursements to meet requirements for a beneficiary's health, education, maintenance and support. The ascertainable standard is most effectively exercised when the trustee enjoys a close or friendly relationship with the insureds. Typically the trustee is an adult child or close family friend.
Incorporating such an "access provision" as part of an ILIT allows a married couple to maintain a life insurance policy separate from the taxable estate while permitting one of the spouses indirect access to the policy's cash value. One spouse is the grantor of the irrevocable trust and the other spouse is a beneficiary of the trust. The trustee (who is not one of the spouses) typically also has discretion to make distributions to the spousal beneficiary. Such access provisions can be used as part of an ILIT that includes either a single life or survivorship life insurance policy.
In addition, term life insurance may be needed to protect against the grantor of the trust dying before the beneficiary of the trust. The death benefit from the term life insurance policy is then used to pay the premiums on the permanent life insurance policy within the ILIT.
