Wealth Planning Strategies That Address Estate Tax "Repeal"

Case Study #1

The first Case Study involves Wade and Rebecca Thompson, ages 65 and 60 respectively. They have a current estate of $3.8 million including $250,000 of life insurance on Wade inside the estate. Based on an InsGift analysis, after their retirement income cash flow needs have been met, their estate is expected to grow to $5.9 million in 10 years, $9.4 million in 20 years, and $14.4 million in 30 years.

Figure 1 (an InsGift area graph) compares the effect of the old estate tax rules ("Old Rules") with the new estate tax rules ("New Rules") on wealth transferred to their heirs. After a gradual year-by-year reduction in estate tax rates through 2009 followed by one year of repeal in 2010, the New Rules disappear in 2011, and the Old Rules return. The bulge in Wealth to Heirs during the first 10 years of Analysis 1b shows the effect of the New Rules.

Figure 1

Analysis 1a: Old Rules; Analysis 1b: New Rules

Figure 2 (an InsGift Bar Graph) takes a snapshot of 2010. If both Wade and Rebecca were to die that year, the New Rules reduce death taxes by a little over $1.6 million, and Wealth to Heirs is increased by a similar amount. (After 2010, the difference goes away.)

Figure 2 (Year 2010)

What if estate taxes are continued on a modified basis and the 2009 rules are extended into 2010 and beyond? Figure 3 compares this alternative:

Figure 3

Analysis 1a: Old Rules; Analysis 1c: 2009 Rules Extended

This alternative, if enacted, could produce a dramatic effect for Wade and Rebecca's heirs. Will our politicians do it -- or something like it? In our opinion, it is not too likely -- but, nonetheless, Figure 3 illustrates a possible compromise to the charade of the sunset provision of the new law. For illustration purposes, this alternative has been coded into Version 6.0 of InsGift.

Our lawmakers could vote to continue repeal past 2010. This seems to be the least likely of the possibilities since the cost of repeal is projected at $4.3 trillion over the subsequent 10 years (as estimated by the Center on Budget and Policy Priorities). Nonetheless, some clients will want to consider the possibility of this occurring, and Figure 4 shows its effect.

Figure 4

Analysis 1a: Old Rules; Analysis 1d: Repeal Made Permanent

This alternative is also coded into Version 6.0 of InsGift.

Now that we've reviewed some of the alternatives for Wade and Rebecca, how do we integrate their possible effect into meaningful wealth preservation planning?

There are at least two highly effective ways to deal with unknown future death tax legislation, and each must have the ability to adapt to a change in the rules. For example, if the New Rules are not expected to change, wealth preservation strategies must be continued as they have in the past since one year of repeal (2010) cannot be used as the benchmark that dictates overall planning. On the other hand, our lawmakers could enact permanent repeal (unlikely as that appears to be in view of the revenue loss).

Planning Technique #1 (the "Amendable" Irrevocable Trust):

Typically, life insurance used for wealth planning is owned by an irrevocable trust. What happens for, example, if a substantial policy is placed in an irrevocable trust and death taxes are permanently repealed? Assuming there is no further need for the life insurance, can we revoke the trust? Such trusts are irrevocable, right? Not always!

Access to funds in trust could be accomplished if the trust has a provision naming a Limited Power Holder who has the right to move trust assets to a successor trust (the old trust would remain an empty shell), and the successor trust could be a revocable life insurance trust drawn in favor of, in our example, Wade and Rebecca. This procedure would give them control of the life insurance policy, and they could surrender it for its cash value or keep it in force as a valuable personal asset. Assuming permanent repeal would also involve the continuance of the new capital gains tax rules that take effect in 2010, if the policy were kept in force, its stepped-up death benefit would be the only capital asset passing to heirs not subject to ultimate capital gains tax.

For many clients, this strategy will be a good "proceed now, reverse later" planning technique.

Due to potential coercion issues, a Limited Power Holder should not be an employee of the grantor of the trust or an employee of any entity controlled by the grantor. Brothers and sisters (or, perhaps, very close friends) are likely candidates. Due to fiduciary responsibilities to trust beneficiaries, the trustee of the trust should not be named a Limited Power Holder nor, in our opinion, should a beneficiary of the trust.

A client's counsel may wish to add successor Limited Power Holders in the event a single Limited Power Holder is deceased or otherwise unable to act. Counsel may also wish to provide for multiple Limited Power Holders in which two (or more) must concur in the transaction. Alternatively, counsel may wish to include multiple Limited Power Holders where any one may exercise the limited power granted. (Limited Power Holders need not be advised of their appointment as such when the trust is drawn.)

Specimen wording for Limited Power Holders is included in Version 10.0 (or higher) of InsMark's Documents On A DiskÒ System ("DOD") or InsMark's Documents On The NetÔ System ("DON") under the Irrevocable Trust and Incentive Irrevocable Trust categories in a series of specimen trusts called Ultimate Irrevocable Life Insurance Trusts.

Below is specimen wording from one of the several examples of Limited Power Holder appointments in DOD or DON:

Note: The suitability of this strategy for a particular client must be determined by legal and tax advisers on a case-by-case basis; however, even very conservative clients may wish to include the language in their trusts in case the feature becomes desirable at a later date.

This Limited Power Holder strategy can be illustrated in InsGift.

Figure 5 shows the effect of this technique. In it, we are comparing Strategy 1: No Successor Trust (reflecting the New Rules with repeal taking place only for 2010) with Strategy 2: Successor Trust in 2010 (reflecting Repeal Made Permanent in 2010 and thereafter). Both strategies assume that Wade and Rebecca are insured under a new $2.2 million participating survivor whole life policy owned by an irrevocable trust. Premiums are illustrated to be level at $100,000 in all years which, with eight annual exclusions and a little of their unified credit, allows them to gift funds to the trust without incurring gift tax. In Strategy 2, the policy is assumed to revert to Wade and Rebecca's control in year 2010 and kept in force by them thereafter as a personal asset.

Figure 5

Strategy 1: New Rules ($2.2 Million Policy in Irrevocable Trust; No Successor Trust)
Strategy 2: Repeal Made Permanent in 2010 ($2.2 Million Policy in Irrevocable Trust transferred to Successor Trust in 2010)

The power of life insurance plus the elimination of estate taxes makes Strategy 2 in Figure 5 perform superbly.

Next, note the impact of Strategy 2 on Wade and Rebecca's living Net Worth shown in Figure 6.

Figure 6

Strategy 1: New Rules ($2.2 Million Policy in Irrevocable Trust; No Successor Trust)
Strategy 2: Repeal Made Permanent in 2010 ($2.2 Million Policy in Irrevocable Trust transferred to Successor Trust in 2010)

The recovery of the life insurance cash values in Strategy 2 in Figure 6 accounts for the increase in Wade and Rebecca's living Net Worth (after accounting for paying the policy's continuing premiums).

Let's add Scenario 3 which assumes permanent estate tax repeal after 2010 without the purchase of the insurance.

Figure 7

Strategy 1: New Rules ($2.2 Million Policy in Irrevocable Trust; No Successor Trust)
Strategy 2: Repeal Made Permanent in 2010 ($2.2 Million Policy in Irrevocable Trust transferred to Successor Trust in 2010)
Strategy 3: Repeal Made Permanent in 2010 (No Trust and No Insurance)

Strategy 3 in Figure 7 (no insurance) is clearly not the best option, but what about the effect on living Net Worth as no life insurance means no gifts or premiums are required? Examine Figure 8 below.

Figure 8

Strategy 1: New Rules ($2.2 Million Policy in Irrevocable Trust; No Successor Trust)
Strategy 2: Repeal Made Permanent in 2010 ($2.2 Million Policy in Irrevocable Trust transferred to Successor Trust in 2010)
Strategy 3: Repeal Made Permanent in 2010 (No Trust and No Insurance)

Ignoring life insurance is not reasonable from any perspective -- whether estate taxes are repealed for one-year or fully (or anywhere in between) because the gain in Wealth to Heirs via Strategy 2 shown in Figure 7 at the top of this page is accomplished with a negligible effect on living Net Worth as shown in Figure 8.

You must look carefully at Figure 8 not to miss the jump in living Net Worth in year 10 of Strategy 2 that is hidden by the Strategy 2 flag. Both short- and long-range, Strategy 2 stays ahead of Strategy 3 (no insurance).

Case Study #2

This Case Study involves a wealthier couple, Nathan and Greta Baier, also ages 65 and 60. Based on an InsGift analysis, after their retirement income needs have been met, below is a snapshot of their projected estate values along with the expected transfer taxes using the New Rules -- including repeal for one year in 2010.

*Full repeal for one year

**Amount of transfer taxes shown in Year 10 is heirs' income tax on pension values.

Other than year 10, this couple has a significant estate tax problem. Until IRS Notice 2002-8 was issued, we might have recommended a Private Equity Split Dollar Plan (collateral assignment or split owner) as a funding solution involving an irrevocable trust as the Plan Recipient; however, the Notice tells us that yet-to-be specified additional gift tax consequences will result from using this split dollar concept.

Is Private Endorsement Split Dollar a better choice? It solves the gift tax issue presented in IRS Notice 2002-8 since the cash values are owned by the Plan Sponsor, but it will not avoid including the trust's share of the death benefit in the insured's estate. No one, at least to our satisfaction, has yet devised a way to accomplish this with Endorsement Split Dollar for the simple reason that the endorsement method casts the Plan Sponsor (Nathan and/or Greta in this case) as policy owner who merely endorses a portion of the death benefit to the trust.

Planning Technique #2 (Flexible Split Dollar):

[Note: The following strategy will be useful at least until publication of the final regulations promised by IRS Notice 2002-8. There is some doubt whether the technique can be used for new plans entered into after final regulations are published. This is because Notice 2002-8 appears to limit split dollar economic benefit treatment to plans in which the Sponsor is the owner of the policy; if the Recipient owns the policy, the later Notice appears to dictate Section 7872-based loan treatment. Final regulations may clarify this issue.]

Formally known as Limited Collateral Assignment Split Dollar, Flexible Split Dollar should surge into prominence due to the flexibility required by the new estate tax law. With this variation, an irrevocable trust owns the policy and assigns the cash value to the Plan Sponsor; consequently, this strategy eliminates any gift-tax problems associated with IRS Notice 2002-8 since no cash values are transferred to the trust as a result of the Plan Sponsor's premiums. In addition, because plan documentation prohibits the Plan Sponsor from canceling the policy and/or borrowing or withdrawing funds from it during the term of the split dollar arrangement, the estate tax free nature of the trust's death benefit share should be accomplished.

As the name implies, the power of this form of split dollar is its flexibility. Since the future of death tax repeal is now highly uncertain (Congress has surely found a new political football), any wealth planning device must include very high levels of flexibility. An effective plan must not only address the New Rules (one year of full repeal in 2010), it must also be responsive to full repeal should it occur -- and anywhere in between.

Assume that our politicians vote to extend repeal permanently in 2010. This means the Flexible Split Dollar plan will no longer be needed -- nor will ownership of the policy by the trust be required since the trust itself will no longer be needed -- at least as a strategy to reduce estate taxes. If the Plan Sponsor would like to reclaim the policy as a personal asset, Flexible Split Dollar offers this versatility. Consider the following language in the Agreement between the parties contained in the Private Limited Collateral Assignment Split Dollar (the formal name for the private version of Flexible Split Dollar) set of specimen documents in Version 11.0 (or higher) of InsMark's Documents On A Disk System or InsMark's Documents On The Net System. (The term "Owner" refers to the trust.)

The language in 10.A allows the Plan Sponsor to request termination -- not of the policy -- but of the Flexible Split Dollar plan.

Even if 10.A is not included, the language in 10.B effectively does the same thing since the Plan Sponsor could withhold gifts to the trust thus "starving" the trust of funds it needs to pay its premium share. Since the trust presumably has no other funding source, either 10.A or 10.B triggers the option contained in the first sentence of the last paragraph of Article 10:

"Upon such termination, the Owner shall have a 90-day option to receive from Sponsor a release of assignment of the Policy in consideration of a payment to the Sponsor of an amount equal to the Sponsor's Policy Interests as herein defined."

Since all policy cash values are assigned to the Sponsor, the trust would typically have no other funds with which to exercise this option thereby triggering the results dictated in the second sentence of the last paragraph:

"In the event the Owner elects not to exercise said option, the Owner shall transfer the entire policy to the Sponsor in satisfaction of the Owner's obligations to the Sponsor."

Overall result? The policy reverts to the Plan Sponsor.

Note: One of the exceptions to the Transfer for Value rules of IRC Sec 101 (income taxation of death benefits in excess of the new policy owner's cost basis) allows a transfer to the insured. Therefore, if the unwinding of the Flexible Split Dollar arrangement involves transferring the policy to the Plan Sponsor, and he/she intends to keep the policy in force, be sure such transfer occurs only when the Plan Sponsor and the insured are the same party. (In the rare case where the Plan Sponsor is not the insured, if policy ownership is subsequently re-transferred to the insured by the Plan Sponsor, problems associated with Transfer for Value rules should also be avoided on any subsequent death benefits.

Note: Watch out for gift tax issues associated with a re-transfer.

Let's examine the results of the versatility provided by Flexible Split Dollar in the context of Nathan and Greta's estate.

Below is an illustration for the private version of Flexible Split Dollar. The underlying policy is $10 million of survivor variable life (increasing death benefit) insuring Nathan and Greta. Premiums are $100,000 a year. (The Plan Sponsor's assigned share is the greater of its accumulated premiums or the cash surrender value.)

Private Flexible Split Dollar

Illustrated values in the Table are hypothetical. In an actual presentation, an insurance company's basic illustration must be present along with a prospectus. Gifts to the Plan Recipient in Col. (1) are determined using U.S. 38 rate calculations (Table 2001 based).

If New Rules Prevail: Assume the New Rules hold (repeal lasts for one year in 2010, and estate tax rules revert to those in effect in 2001). Figure 9 below compares Wealth to Heirs using Scenario 1 (Flexible Split Dollar plan not included) and Scenario 2 (Flexible Split Dollar plan included for all years).

Figure 9

Scenario 1: Repeal Ends After 2010 (No Policy Purchased)
Scenario 2: Repeal Ends After 2010 ($10 Million Policy Funded via Flexible Split Dollar).

The presence of the Flexible Split Dollar plan in Scenario 2 has immense wealth transfer significance. The spike in values reflects the one year of full repeal under the New Rules. (The InsGift calculations include deducting the Flexible Split Dollar plan's imputed gift valuation in later years -- Col. 7 in the illustration -- from the Baiers' unified credit.)

The living Net Worth analysis for this approach is shown below in Figure 10. Scenario 2 is ahead of Scenario 1 until well past life expectancy due to the addition of the policy's cash value to Nathan and Greta's asset base.

Figure 10

Scenario 1: Repeal Ends After 2010 (No Policy Purchased)

Scenario 2: Repeal Ends After 2010 ($10 Million Policy Funded via Flexible Split Dollar).

Repeal Made Permanent: Next is some stunning adaptability if permanent repeal occurs in 2010 and thereafter.

Scenario 3: Nathan and Greta trigger recovery of the policy from the Flexible Split Dollar arrangement with the trust and surrender the policy for its cash value. They invest the proceeds in their equity account.

Scenario 4: Same as Scenario 3 but, instead of surrendering the policy, they keep it in force as a personal asset.

Figure 11 compares the resulting Wealth to Heirs.

Figure 11

Scenario 3: Repeal Made Permanent in 2010 ($10 million Flexible Split Dollar through 2009; surrendered in 2010).
Scenario 4: Repeal Made Permanent in 2010 ($10 million Flexible Split Dollar through 2009; carried personally thereafter).

The power of the life insurance is extraordinary. With permanent repeal of estate taxes assumed, the death benefit of the retained policy reflected in Scenario 4 will pass untaxed to the heirs. Those who say that life insurance is not useful in an estate tax free environment are wrong. It is vitally valuable.

Figure 12 shows the impact on Nathan and Greta's living Net Worth of surrendering vs. continuing the policy after it is reclaimed from the Flexible Split Dollar arrangement. Scenario 3 includes investing the cash surrender of the policy in Nathan and Greta's equity account, and Scenario 4 takes into account the ongoing policy premiums of $100,000 a year required after the policy is recovered from the Flexible Split Dollar plan.

Figure 12

Scenario 3: Repeal Made Permanent in 2010 ($10 million Flexible Split Dollar through 2009; surrendered in 2010).
Scenario 4: Repeal Made Permanent in 2010 ($10 million Flexible Split Dollar through 2009; carried personally thereafter).

Note: Consider including language authorizing Limited Power Holders (discussed in Case Study #1) in the trust that participates in a Flexible Split Dollar plan. It may be a case of "belt and suspenders" flexibility, but why not include all possible options in an uncertain tax world?

One issue that may surface with survivor life policies funded via Flexible Split Dollar is the increase in economic benefit that occurs after the death of the first-to-die requiring either an increase in gifts to the trust or use of the Plan Sponsor's unified credit. There are several ways to deal with this:

1. Rollout the Flexible Split Dollar plan by gifting the Plan Sponsor's policy interests to the trust. This may use up part of the available unified credit, but it may be a better choice than continuing years of accelerated gifts in order to maintain the split dollar arrangement in force.
2. Rollout the Flexible Split Dollar plan by having the Plan Sponsor provide an IRC Sec. 7872 term loan to the trust to provide it with the funds to acquire the Plan Sponsor's policy interests, i.e., the policy cash value. Establish the loan with loan interest set to the IRC Sec. 7872 rate in effect at that time. The Plan Sponsor then gifts an amount equal to the loan interest due by the trust, a sum that should be significantly less than the gifts required to continue a single-life Flexible Split Dollar arrangement.

Note: If the trust is a grantor trust (which it will likely be), the trust's loan interest payments to the Plan Sponsor do not constitute taxable income to the grantor (assuming the Plan Sponsor is the grantor) as a grantor trust and its grantor are assumed to be a single entity for income tax purposes (IRC Sections 671 and 675, IRS Reg. 1.671-2(c), and Rev. Rul. 85-13).

3. Cast the arrangement as an IRC Section 7872 plan from inception. InsMark's Section 7872 Illustration System uses this approach, and InsGift can import plan data from the system. (InsMark's Section 7872 Illustration System complies with IRS Notice 2002-8.)

Conclusion

The use of Limited Power Holders, Flexible Split Dollar, and Sec. 7872 planning techniques provides you, your clients, and their advisers with the versatility needed to deal with fluctuating future circumstances that affect wealth transfer taxes -- and fluctuate they will. Now that they are in play, we can no longer count on any continuing consistency of federal estate tax law.

Many of your clients will try to convince you (and themselves) that wealth transfer planning is no longer needed. This is not unlike 1982 when the unlimited marital deduction was introduced and doom and gloom was prevalent among producers because many clients felt they no longer needed to plan. Producers who accepted this objection found themselves out of the estate planning business. Those who worked through the objection with their clients found the need still existed, but it had changed to second-death planning.

It is no different now. The New Rules merely present new challenges, and your clients now need planning techniques that recognize death taxes may or may not be with us in some form after 2010. This article provides you with those techniques.

Notes on Software for the Four Systems Discussed in this Article

1. Version 11.0 of Documents On A Disk System or Documents On The Net System containing specimen documentation for 1) "Ultimate" irrevocable life insurance trusts with authorization for Limited Power Holders and 2) Specimen documents for Flexible Split Dollar under the following document categories: Employer-Sponsored Limited Collateral Assignment Split Dollar and Private Limited Collateral Assignment Split Dollar.
2. Version 6.0 of InsGift -- the Wealthy and Wise System containing capacity to 1) Illustrate the effect of a Limited Power Holder returning control of trust assets to the grantors of the trust and 2) Import data from the Limited Collateral Assignment Split Dollar modules in Version 9.0 of the InsMark Illustration System.

Note: See Sample Client Workbook M in version 6.0 of InsGift for details of how the Limited Power Holder strategy discussed in Case Study #1 is illustrated. Sample Client Workbook N shows you the Flexible Split Dollar technique discussed in Case Study #2. (Sample Client Workbooks are available under Help on the Main Toolbar.)

3. Version 9.0 of the InsMark Illustration System containing both Employer-Sponsored and Private Flexible Split Dollar illustration capacity. (Look for them under the name Limited Collateral Assignment Split Dollar.)
4. Version 1.0 of InsMark's Section 7872 Illustration System.

Illustration Comments -- InsGift: The graphics in this issue are from InsGiftÒ -- the Wealthy and WiseÔ System ("InsGift") version 6.0, and you can review all reports and related menu inputs for the plans presented in this article by downloading the InsGift Workbooks named "EstTax1.!IG" and "EstTax2.!IG" from this website. Click on Producer's Center; then on Workbook Download. The Workbook can then be imported into InsGift by selecting Client Workbook/Import Workbook. If you are not licensed for InsGift, please contact InsMark at 1-888-InsMark (467-6275) for licensing information. To download the Workbooks now, click here.

Important Notice

The material in this issue is not intended as a substitute for advice from a client's own legal and tax advisers. In all cases, the approval of a client's legal and tax advisers must be secured regarding the implementation and/or use of Limited Power Holders in any form of irrevocable trust, any form of Flexible Split Dollar and the terms of its related documentation, and any form of the Private Leveraged Benefit Plan and its related documentation. The applicability and consequences of new cases, rulings, and legislation must also be considered.

Revised: [5/17/02]

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