By: Martin M. Shenkman, CPA, MBA, JD
Life insurance has always been, and will always remain, one of the foundation stones of many, perhaps even most, estate plans. In the simplest terms, lower earning or wealthy taxpayers need life insurance for the pure death benefit. If a breadwinner dies, that income source has to be replaced for the family. From an estate tax perspective, insurance has frequently been used as a tool to pay estate tax in an efficient manner, by having the life insurance policy owned by a trust, so the value is removed from the taxpayer/insured’s estate while control over its value and use is maintained. One of the most common applications of life insurance had become the use of "second-to-die" or "survivorship" insurance. This insurance pays off when the last of a husband and wife die. This was, and remains, under the TRA, when the estate tax is due. Tax is generally avoided on the first death because of the unlimited marital deduction. But, upon the second death, any assets above the estate tax exclusion would be subjected to tax.
However, with the dramatic increase in the estate tax exclusion, and the portability of the exclusion, many millions of taxpayers that may have faced an estate tax in the past, won’t in the future. So shouldn’t they cancel their life insurance? Probably not, and certainly not so fast without some serious consideration given to the entire planning picture.
What will happen with the estate tax in 2013? If a policy is cancelled now the insured may not be able to replace it in case life insurance may be needed in the future. Perhaps, if a taxpayer is really doubtful about the estate tax becoming onerous again they should maintain their policies for the next two years and then decide. Depending on the nature of the policies it may be feasible to reduce or even eliminate, premium payments in the interim.
Insurance is often bought for multiple reasons. Policies should not be discarded merely because of a change in the estate tax law. Even a policy that is considered a source to pay estate tax, can also be viewed as providing a guaranteed inheritance, if the parents or other benefactors decide to spend down their estate. Insurance is now spoken of as an asset class to provide ballast to a portfolio. Before cancelling a policy, consideration should be given to any benefits that will be sacrificed from this perspective. A permanent life insurance policy, held in an irrevocable insurance trust, can have important asset protection benefits. No tax change, not even one as generous as the TRA, reduces liability exposure.
And remember, state estate taxes may not be disappearing.
In short, insurance should be evaluated in light of the TRA estate tax changes. If neither reduction or elimination of a policy is appropriate, after consideration of all relevant facts, a decision should be made in consultation with an insurance adviser as to which of the many options is preferable. A policy may be allowed to lapse, surrendered for its cash surrender value, reduced to a paid up policy, exchanged for a policy that meets current needs, or sold.
Split-dollar is a technique used to pay for insurance premiums. In an estate-planning context, this can best be explained with a simple illustration.
A husband and wife with a large taxable estate established an irrevocable life insurance trust to purchase and own a policy on their joint lives (a survivorship policy). Because of the limitations on annual gifts to the trust, they loan the trust money to pay the annual premiums. The loan is characterized as a split-dollar loan for income tax purposes, which helps assure that the loan will be treated as a loan. Upon the death of the last spouse, the insurance trust collects the insurance policy proceeds and repays the loan it owes the insured’s estates.
Several considerations arise with respect to split-dollar transactions in light of the TRA. First, many split-dollar transactions need an exit strategy. At some point, the split-dollar arrangement may need to be unwound (see the comments in Chapter 6 about using GRATs to fund insurance trusts for this purpose). A major incentive for split-dollar insurance arrangements was to avoid current gift tax costs on funding large insurance purchases by trusts. In 2011, the $5 million exclusion will permit taxpayers/insureds to make substantial gifts to their insurance trusts without any current gift tax cost. These gifts can be used to unwind split-dollar arrangements and simplify the insurance funding mechanism. Further, if this is combined with a lesser need for life insurance, in light of the TRA increased $5 million estate tax exclusion, then the reduction in insurance, combined with the payoff of a prior split-dollar arrangement, might make future insurance premiums low enough that they can be met with simple annual gifts of $13,000 per beneficiary of the trust.
Gifts are typically made to life insurance trusts (often known by the acronym “ILIT” for Irrevocable Life Insurance Trust). These gifts fund the payment of life insurance premiums. If a life insurance trust is established to benefit grandchildren (“skip persons” in GST parlance), then the GST exemption (explained in Chapter 3) had to be allocated to gifts made to the insurance trust. Until the enactment of the TRA in mid-December 2010, it was not certain that there would be any 2010 GST exemption to allocate to the trust or that a gift could be made in trust for a grandchild to take advantage of the zero GST rate in 2010. Therefore, for those endeavoring to address transfers made to irrevocable life insurance trusts to which it was initially assumed, no GST exemption could be allocated, loans instead of gifts may have been made. The 2010 TRA may obviate the need for worry. For those that made loans to insurance trusts to avoid the consequences of transfers that could not be protected by the allocation of GST exemption, those loans can be repaid and GST exemption can be allocated.
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