Journal of Financial Planning: January 2013
David M. Cordell, Ph.D., CFP®, CFA, CLU, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA., is a professor of business law at Roger Williams University in Bristol, Rhode Island.
While the federal government continues running massive budgetary deficits, many politicians have proposed closing the gap by raising taxes on so-called millionaires and billionaires. However, raising marginal income tax rates is not the only path to raising taxes. Closing loopholes is another strategy. One particular tool of financial planners, the irrevocable life insurance trust (ILIT), is now under attack and may become a victim of the federal government’s need for revenue.
Traditional Uses of Life Insurance
Life insurance is typically used for two purposes in family situations: as a hedge against disappearing human capital, and as a means of funding the costs of wealth transfer. Traditional life insurance needs analysis acts as a hedge against disappearing human capital by providing funding to accomplish financial goals if the insured dies early. Common examples include paying off mortgages and debts, funding college costs for children, ensuring the family’s current standard of living, and funding specific goals that had not been achieved during the insured’s lifetime. This need usually declines over time as human capital is transformed into financial resources that are used to achieve financial goals.
Life insurance also is used to relieve the sting of wealth transfer taxes, a need that, unlike the human capital hedge, may increase over time. Individuals who have saved and accumulated wealth prefer to pass what remains at their death to their families, not to the government. One effective way to do this is to purchase life insurance to pay for estate and inheritance taxes. This objective is particularly important for small business owners who often have illiquid estates because most of the value is the business interest. Death benefits can help transition control of that business to children or partners, or equalize the inheritance among the heirs, for example.
When an individual purchases insurance on his or her own life, however, a major tax issue arises. I.R.C. § 2042 requires the death benefit on a life insurance policy owned by the insured to be included (and taxed) in the insured’s estate at death. Meanwhile, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and its extender, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA), are scheduled to expire January 1, 2013. If they expire, estate tax rates will rise to 55 percent (60 percent for some high-value estates), and that percentage of the life insurance death benefit on policies held by the insured will be confiscated by the government. Consequently, most of the death benefit will not be available to shield the tax liability on other assets.
A Crummey Solution
A very effective fix to this problem became available in 1968 when the Second Circuit Court of Appeals decided Crummey v. Commissioner (397 F.2d. 82). Instead of owning life insurance directly, a taxpayer/grantor can create a trust to own the policy on his or her life and make contributions to the trust to provide for premium payments. These contributions qualify for the gift tax annual exclusion as long as the beneficiaries have the right to withdraw them. The withdrawal right is referred to as the “Crummey” provision for the taxpayer who brought this issue to court. Because the trust—not the insured—owns the life insurance policy, there is nothing to include in the estate of the grantor/insured under I.R.C. § 2042, and the death benefit on the policy is not subject to transfer tax.
Not surprisingly, the IRS was never happy with the Crummey decision, and over the years has attempted, unsuccessfully, to attack this planning technique in a variety of ways. Meanwhile, the ILIT has become a popular technique for clients trying to fund the costs of wealth transfer.
The Budget Proposal
In its 2013 budget proposal to Congress (the “Green Book”), the Obama administration included several proposed changes to the estate tax to avoid the draconian consequences of the expiration of EGTRRA and TRUIRJCA. In particular, the administration proposed a $3.5 million death-time credit, and $1 million lifetime credit, and a 45 percent tax rate. These proposals would be an improvement over the $1 million unified credit and 55 percent tax rate expected to automatically take effect January 1, 2013. However, the administration also proposed closing several loopholes that middle class and wealthy people use to avoid gift, estate, and generation-skipping transfer taxes.
One of those loopholes concerns planning under the grantor trust rules, which requires the grantor of a trust to pay income tax on the trust’s income during the grantor’s lifetime if certain conditions are met. When using an irrevocable grantor trust, it is possible to remove the assets from the estate of the grantor even though the grantor retains the obligation to pay income tax attributable to trust income. The Green Book proposal would require the value of all grantor trusts to be included in the taxable estate of the grantor.
How the Budget Proposal Attacks ILITs
What do the grantor trust proposals have to do with life insurance? Under I.R.C. § 677, any trust that holds life insurance on the life of the grantor or the grantor’s spouse, such as an ILIT, is considered to be a grantor trust. Planners often forget that the typical ILIT is a grantor trust, because the inside accumulation on a life insurance policy grows income tax-free, relieving the grantor of an obligation to pay income tax.
Under the proposal to close the grantor trust loophole, the value of a life insurance trust will be included in the estate of the grantor at its date-of-death value. This means that the entire death benefit of the life insurance policy may be subject to estate tax under the proposal even though the insured never owned the policy, and even though the policy was inside of a properly structured ILIT. This proposed change effectively pierces the shield that ILITs offer, subjecting life insurance death benefits to estate tax. What the IRS historically has been unable to accomplish through court challenges may be accomplished by Congress and the president simply by adopting the Green Book proposal.
What About Beneficiary Defective Trusts?
Some ILITs are structured as either partial or complete beneficiary defective trusts (BDTs). BDT treatment arises by giving the beneficiary of the trust a non-lapsing withdrawal (Crummey) power over annual contributions in conjunction with a health, education, maintenance, and support (HEMS) power. The effect of the BDT is to require the beneficiary, not the grantor, to have the obligation to pay tax on the portion of the trust income over which they had a right of withdrawal.
To the extent that an ILIT is a wholly beneficiary defective arrangement, there should be no inclusion in the estate of the grantor under the grantor trust proposals. To be wholly beneficiary defective, the beneficiary must have the right to withdraw 100 percent of each contribution made to the trust under a Crummey provision, even if those amounts exceed the gift tax annual exclusion. The grantor trust proposal as written does not extend to wholly BDTs if the beneficiary does not engage in a transaction with the trust that avoids a taxable capital gains transaction (such as an installment sale of assets to a BDT). If Congress adopts the Green Book proposal, ILITs would have to be constructed carefully to avoid estate inclusion for the grantor. While a complete discussion of the planning implications is beyond the scope of this article, to avoid harsh estate tax consequences, clients may have to trigger taxable gifts upon funding of the ILIT (which also creates potential estate tax consequences for the beneficiary), or limit the amount of life insurance that can be purchased inside of the ILIT.
This issue has been a topic of discussion for many years but was not formally presented in the Green Book until this year. Should Congress adopt the grantor trust proposals now or in the future, estate planning for moderately wealthy clients and business owners concerned with business succession planning will become much more costly and complex.
The quest to close loopholes for the wealthy may increasingly burden the middle class, and in particular small business owners, who are using estate planning techniques such as ILITs to preserve the wealth they have created. Perhaps more significantly for the financial planning community, life insurance—the product that traditionally has offered protection not only as a human capital hedge, but also as an offset against high transfer tax burdens—will lose some of its luster.