Post-EGTRRA life insurance planning: the Economic Growth and Tax Relief Reconciliation Act of 2001 promises repeal of the estate tax in 2010, but will it ever come to pass?

Rather than resolving the question of the estate tax's future, the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) created uncertainty, by slowly phasing out the tax, then repealing it only for one year. This raises doubts about whether repeal will actually occur. As a result, there is a greater opportunity to use life insurance in estate and wealth strategies planning. (1)

Estate Tax Provisions

Rate Reductions

EGTRRA Sections 501(a) and 511(c) reduce the estate tax rate slowly--down to 45% in 2007-2009--and eliminate it entirely in 2010. (2) At the same time, the exemption equivalent amount (now the applicable exclusion amount)--the amount that can pass free from estate tax--is scheduled to increase as follows, under EGTRRA Section 521 (a):

Year                    Amount

2002 and 2003           $1 million
2004 and 2005           $1.5 million
2006-2008               $2 million
2009                    $3.5 [million.sup.3]
2010                    unlimited
2011 and thereafter     $1 [million.sup.4]

Exclusion Increase

EGTRRA Section 521(b) increased the gift tax exclusion to $1 million in 2002; it will remain $1 million through 2010 (and thereafter indexed for inflation), (5) Arguably, Congress retained the $1 million exclusion, even after eliminating the estate tax, to prevent taxpayers from avoiding income tax by shifting assets to individuals in lower tax brackets and to those with no state income tax. Or perhaps, not convinced that estate tax repeal will take effect, Congress limited the gift tax exclusion to $1 million, to discourage lifetime transfers that would otherwise avoid the estate tax at death. (6)

Commentators have suggested that it is unlikely that the current law will remain in effect long enough for full repeal to take effect. Total estate tax repeal may never occur, given the tremendous strain baby boomers will place on Social Security and Medicare in 2010 and beyond. (7) According to the Joint Committee on Taxation, the one-year revenue loss resulting from the EGTRRA's estate and generation-skipping transfer tax provisions will approach $55 billion on total repeal in 2010. (8) Recent budget revisions from the White House and the Office of Management and Budget further support the position that total repeal is unrealistic.

Carryover Basis at Death

Under the current system (subject to some exceptions), assets owned at death receive a basis step-up to fair market value (FMV) at a decedent's date of death (DOD), under Sec. 1014(a).

Example 1: X died in 2002 owning a painting he purchased for $10,000 in 1993, worth $10,000,000 at his DOD. Y inherited the painting and under Sec. 1014(a), took a $10,000,000 FMV basis. Y sells the painting in 2003 for $10,000,010, and reports just $10 of capital gain.

Under the EGTRRA, in 2010, after estate tax repeal, a beneficiary inherits property with an adjusted basis equal to the lesser of the decedent's basis or the asset's FMV on the DOD. (9) To offset the loss of the basis step-up, EGTRRA Section 542 provides that an executor (or other person responsible for the decedent's property) (10) may allocate a $1.3 million "aggregate basis increase" on an asset-by-asset basis up to a particular asset's FMV at the DOD. (11) Under new Sec. 1022(c), assets left to a spouse may receive an additional $3 million "spousal property basis increase" (also asset-by-asset, up to the particular asset's FMV at the DOD).

However, only assets the decedent owned at death are eligible for the aggregate basis increase or the spousal property basis increase. (12) Significantly, unless affirmatively proved otherwise, the Service presumes under Regs. Sec. 1.1015-1(a)(3) that an asset's basis is its approximate FMV on the date acquired by its last owner. Thus, accurate record-keeping is critical.

Need for Life Insurance

Life insurance provides numerous estate planning benefits. Because the estate tax's future is unclear, advisers can use life insurance to help clients plan for increasing exemption amounts, estate tax repeal and institution of modified carryover basis.

Increasing Exemption Amounts

As was discussed, the applicable exclusion amount is scheduled to increase to $3.5 million in 2009, be unlimited in 2010, then revert back to $1 million in 2011. Except in the unusual circumstance of deathbed planning, a tax adviser cannot know when a client will die. As a result, the adviser cannot determine in advance the extent to which a client's estate will be subject to estate tax at death (if at all) or whether the client's heirs will be subject to capital-gain tax as a result of the institution of modified carryover basis. Life insurance provides the only certainty--and liquidity--in either case, and provides the only combination of full basis step-up and tax-deferred or tax-free growth.

Estate Tax Repeal

If a client is subject to estate tax, use of an irrevocable life insurance trust (ILIT) could remove significant assets from the client's estate while providing the liquidity to pay estate tax. The possibility (even likelihood) that total estate tax repeal will never occur reinforces life insurance's usefulness for liquidity purposes. If the estate tax is repealed, liquidity needs will not disappear; the need for liquidity to pay estate tax will likely be replaced by liquidity needed to pay the capital-gain tax and the desire for high-basis assets. Below is a discussion of the increased utility of life insurance after estate tax repeal in the context of particular life insurance usage.

Using life insurance: Given EGTRRA's effect on the estate tax, life insurance remains an important planning tool when used in combination with many estate-tax-saving techniques. For example, use of a grantor retained annuity trust (GRAT) allows a grantor to remove assets from his gross estate. Similarly, use of a qualified personal residence trust (QPRT) allows the grantor to remove a personal residence from his gross estate. The longer the GRAT or QPRT term, the smaller the value of the gift to the GRAT or QPRT beneficiaries for gift tax purposes. (13) However, if the grantor dies during the GRAT or QPRT term, the value of the trust assets are included in his gross estate. (14)

Life insurance is an effective tool to eliminate the financial risk that the grantor will die during the GRAT or QPRT term. At a minimum, level term-life insurance (15) for the GRAT or QPRT term (e.g., a 10-year term policy for a 10-year GRAT) will provide liquidity to pay the estate tax if the grantor dies during the trust term. Alternatively, permanent life insurance (16) can provide liquidity for the GRAT or QPRT term if the grantor dies during the trust term and thereafter provide the benefits of insurance generally (i.e., tax-deferred or tax-free growth). If the permanent policy is variable universal life, a client can achieve tax-deferred or tax-free growth in a mutual-fund-like investment. (17)

Income replacement: Even if a client is not subject to estate tax, life insurance could replace lost income if he dies unexpectedly Most policies pay out for income replacement rather than for liquidity to pay estate tax. (18) For these policies, estate tax repeal has no significance.

Planning unaffected by Federal estate tax: Prior to the EGTRRA's passage, clients often used life insurance for planning completely unrelated to the estate tax. Life insurance can still be helpful in these situations:

* Buy-sell planning.

* Key-employee coverage.

* Nonqualified deferred compensation.

* Death-benefit-only plans.

* Liquidity to pay debts.

* Liquidity for state death taxes.

* Wealth replacement (e.g., in conjunction with a charitable remainder trust).

* Inheritance equalization.

As the estate tax exemption amount increases beginning in 2002, advisers will focus less on estate tax issues and more on the "people" issues of planning. As they do, life insurance will become even more significant.

Carryover-Basis Ramifications

The institution of modified carryover basis raises interesting questions as to life insurance's continuing relevance. Arguably, if the question were simply whether a client would be willing to gamble on the existence of an estate tax at death, some clients might accept this risk. However, modified carryover basis eliminates the potential "gain" from the gamble; clients who needed life insurance for estate tax liquidity will likely use insurance proceeds to make up for the portion of their estate that heirs will use to pay capital-gain tax.

The EGTRRA will potentially subject assets to significant capital-gain tax for heirs of decedents dying in 2010 (and thereafter, if carryover basis remains).

Example 2: The facts are the same as in Example 1, except that X was unmarried at his death. Even if X's executor allocates the entire $1.3 million basis step-up to the painting, its basis will be only $1,310,000. If X's heirs sell the painting shortly thereafter, they will be subject to income tax on $8,690,000 ($10,000,000-$1,310,000). Assuming a 20% capital-gain rate, X's beneficiaries will owe $1,738,000 in capital-gain tax, clearly emphasizing the importance of liquidity.

Arguably, clients will be less concerned with capital-gain tax, because the maximum rate is only 20%.With higher-net-worth clients, however, this rate may result in heirs paying significant income tax. Further, there is no guarantee that Congress will not raise the capital-gain rate in the future, particularly if there are significant budget shortfalls.

Of course, heirs do not have to sell highly appreciated assets, thereby avoiding significant capital-gain tax. But even heirs with independent wealth may have financial or liquidity needs.

Income Tax Planning

Death Benefits

EGTRRA's carryover-basis provisions also increase the usefulness of income tax planning, particularly for assets that combine basis step-up with tax-free or tax-deferred growth. Sec. 101 excludes life insurance proceeds paid on an insured's death from gross income. Sec. 101 (a)(1) excludes proceeds attributable to investment appreciation on a policy's cash-value portion. As a result, cash-value life insurance avoids the carryover-basis issue altogether; clients can purchase such insurance to pass leveraged assets that step up to the value of the death proceeds.

ILITs: Under current law, many clients create ILITs to own life insurance, including variable universal-life products for mutual-fund-type investments controlled by the policy owner. Even though the insurance steps up to the value of the death benefit, a properly drafted and maintained ILIT removes life insurance proceeds from a client's gross estate, providing liquidity or wealth replacement.

As long as policy proceeds remain income tax free, life insurance is the only asset class (other than cash) that a grantor can remove from his gross estate, yet still use for liquidity (e.g., for state-death or capital-gain tax) or wealth replacement (e.g., to make beneficiaries "whole" for large items of income in respect of a decedent (IRD), Sec. 401(k) account balances and pension plans) without incurring income tax. All other assets removed from a grantor's gross estate for estate tax purposes must be sold and gain realized to net the amount required.

Example 3: Z dies in 2010 with $1,000,000 in his Sec. 401(k) account. This asset is IRD; assuming a 35% income tax rate, the income tax is $350,000 (if accelerated). If Z instructed in his will that his beneficiaries receive the account balance undiminished by income tax, but there are no liquid assets in Z's estate, the executor or personal representative must either sell assets to make the beneficiaries whole or allocate sufficient basis to the appreciated assets. If the personal representative sells long-term appreciated securities, the capital-gain tax will be 20% (higher if the decedent held these assets for less than one year). Thus, the personal representative may have to sell securities worth more than $420,000. Alternatively, a life insurance policy with a $350,000 death benefit (in or out of an ILIT) could satisfy the tax bill.

Tax-deferred policy loans: The owner of a cash-value life insurance policy can achieve tax-deferred growth of the cash-value build-up as a result of the favorable income-tax treatment afforded policy loans. Under Secs. 72(e)(5) and 7702(f)(7), a loan from a life insurance policy is included in gross income only to the extent that it exceeds the investment in the contract. The aggregate premium payments determine the policy investment. Thus, loans are not subject to income tax until the cumulative withdrawals exceed the aggregate premium payments on the policy. (19) This allows policy owners to take tax-free loans, while the cash-value build-up continues to grow tax free.

Thus, the increased emphasis on income tax planning makes cash-value life insurance even more attractive than before the EGTRRA.

One additional factor bears consideration. The uncertainty created by the EGTRRA may suggest the use of universal life, the most flexible type of cash-value policy. (20) This policy permits the policy owner to vary the amount of premium payment, the level of death benefit and the amount of cash value (in exchange, the owner gives up that the premium will provide a guaranteed death benefit for the policy's life). Thus, the policy owner could maintain the death benefit until estate tax repeal (for liquidity) and, on repeal, increase the cash value to avoid carryover basis. No other single asset provides the same degree of planning flexibility. However, tax advisers must ensure that the product selected fits the client's needs.

Existing Policies

For policies purchased only for liquidity to pay estate tax, the question is whether a client is willing to gamble that he will not need the liquidity after estate tax repeal. Initially, some clients may be willing to take this risk. However, before they cancel existing policies, they should understand that the liquidity need will not disappear. Even with no estate tax, the focus will shift from paying the estate tax to paying the capital-gain tax.

Given the uncertainty discussed above, clients should not let policies lapse. What if estate tax repeal does not occur? What if a client cancels a policy, then becomes uninsurable? If permanent estate tax repeal does not take place, the client will face higher insurance costs (assuming he can obtain insurance at all). With a new policy, the client must also meet the requirements of new incontestability clauses.

Even if repeal occurs, life insurance is one of the only assets that provides the combination of basis step-up with tax-deferred or tax-free growth. Thus, clients should weigh the alternatives: if the estate tax remains, the client will have the necessary liquidity for the estate tax burden; if it is repealed, the client's family will have more income and wealth than they would have otherwise.

Conclusion

The EGTRRA created great uncertainty for tax advisers and clients. Unfortunately, much of the uncertainty cannot be avoided; it is impossible to know what Congress will do between now and 2010. Advisers should suggest to clients planning opportunities that have the greatest likelihood of success in each of the possible scenarios: increasing estate tax exemptions, no estate tax and carryover basis.

Life insurance is the only asset that provides absolute certainty in all three cases. If a client purchased a policy for estate tax liquidity, the policy can remain in effect until the estate tax disappears. If the estate tax remains, the client will have the policy for liquidity purposes. If the estate tax does disappear, the client will have the only leveraged asset that is income tax deferred or tax free and that receives a full basis step-up at the insured's death. Given the options, life insurance provides a "win-win" for clients and the advisers who recommend it.

(1) For a general discussion of the EGTRRA estate tax provisions, see Blattmachr and Detzel, "Estate Planning Changes in the 2001 Tax Act--More Than You Can Count," 95 J. of Tax'n 74 (August 2001); Sawyers and Whitlock, "Estates, Trusts & Gifts: Post-EGTRRA Analysis and Planning," 32 The Tax Adviser 822 (December 2001).

(2) See Secs. 2001 (c)(2)(B) and 2210(a), as amended by EGTRRA Sections 511(b) and 501(a).

(3) See Sec. 2010(c), as amended by EGTRRA Section 521(a).

(4) EGTRRA Section 901(b) provides that after 2010, the Code will be applied and administered as if the EGTRRA had not been enacted.

(5) See Sec. 2505(a)(1), as amended by EGTRRA Section 521(b); EGTRRA Section 901(b).

(6) The gift tax was originally instituted to prevent taxpayers from making lifetime transfers to avoid the estate tax.

(7) The Academy of Multidisciplinary Practice, Inc., Panel Discussion of the Tax Act of 2001 (6/13/01) (hereinafter, "Panel Discussion"), available at www.mdpacademy.com.

(8) See Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 1836 (5/26/01).

(9) See Sec. 1022(a), as added by EGTRRA Section 542(a); Sec. 1014(f), as amended by EGTRRA Section 541.

(10) Sec. 7701(b)(47) defines "executor" as "the executor or administrator of the decedent, or, if there is no executor or administrator appointed, qualified, and acting within the United States, then any person in actual or constructive possession of any property of the decedent."

(11) Sec. 1022(b), as added by EGTRRA Section 542(a). The $1.3 million aggregate basis increase may be increased by (1) any capital loss carryover (Sec. 1212(b)) or net operating loss carryover (Sec. 172) that, but for the decedent's death, would have carried forward to a future tax year(s); and (2) the sum of any losses allowable under Sec. 165 had the decedent sold the property immediately before death.

(12) Sec. 1022(d), as added by EGTRRA Section 542. A discussion of property eligible for either step-up is beyond the scope of this article. However, this is an area in which practitioners must change their thinking entirely. For example, the EGTRRA treats property in a marital trust over which the surviving spouse has a lifetime general power of appointment as not owned by that spouse for purposes of the $3 million spousal property basis increase. Thus, many existing plans risk potential loss of this step-up for marital trust property. See Esperti, Peterson, Cahoone and Mintz, "The Impact of the Economic Growth and Tax Relief Reconciliation Act of 2001 on Existing Planning," 56 J. of Fin. Svce. Prof'ls 37 (March 2002).

(13) To determine the value of the gift for gift tax purposes, the IRS uses the applicable Federal rate (the Sec. 7520 rate) in effect at the time of trust funding (the assumed growth rate). If the GRAT or QPRT assets appreciate faster than the Sec. 7520 rate, the grantor can leverage the transfer to beneficiaries. In other words, the lower the Sec. 7520 rate at the time of trust creation, the more likely that the GRAT or QPRT will transfer assets with a value greater than the gift tax paid.

The Sec. 7520 mid-term rate for June 2002 was 5.8%. GRATs are more attractive at low interest rates; a low Sec. 7520 rate reduces the girl tax value of the remainder interest. It makes QPRTs less attractive, however, because a low Sec. 7520 rate reduces the value of the property transferred out of the grantor's estate.

(14) A detailed discussion of GRATs or QPRTs is beyond the scope of this article; see Esperti and Peterson, Irrevocable Trusts: Analysis with Forms (Warren Gorham & Lamont, 1998), clients with sufficient wealth should take advantage of the $1 million gift tax exclusion as soon as possible; techniques that leverage the gift tax exclusion (including GRATs and QPRTs) will play a significant role for these clients. Moreover, grantors can now create "zeroed-out" GRATs (GRATs with no girl tax consequences). In Audrey J. Walton, 115 TC 589 (2000) (see Whitlock and McNamara, "Significant Recent Developments in Estate Planning (Part II)," 32 The Tax Adviser 618 (September 2001)), the Tax Court held invalid Example 5 of Regs. Sec. 25.2702-3(e), which prohibited zeroed-out GRATs. As a result, GRATs should become an even more significant planning tool after the EGTRRA.

(15) With level term-life insurance, the annual premiums remain the same for a specified number of years (e.g., five, 10, 15, 20 or 30). The initial premium is higher than with annual renewable-term insurance, but the insured is willing to pay more in the early years in exchange for stable premiums.

(16) permanent life insurance is designed to last the insured's life, rather than a term of years. As long as the policy owner pays the necessary premiums, the death benefit will be available.

(17) Variable universal-life policies are similar to universal-life policies (see note 20 infra), with one major exception. With the former, the policy owner can allocate the policy's cash value among a number of equity (stocks) and fixed income (bonds) sub-accounts for the highest return consistent with the owner's risk tolerance. These sub-accounts operate very much like mutual fund accounts; unlike other types of permanent insurance, assets in the sub-accounts are not subject to the claims of the insurance company's general creditors.

(18) See Panel Discussion, note 7 supra.

(19) For policies issued after 1984, a withdrawal in which the policy owner receives cash in exchange for a reduction in policy benefits is subject to income tax under Sec. 7702(f)(7)(B), if made within 15 years of policy issuance. After 15 years, there is no immediate income taxation on a policy withdrawal; the general role applies. The 15-year rule does not apply to policy loans.

(20) With universal life insurance, the policy owner purchases a permanent policy based on computer projections of future premiums, cash values and death benefits. After the initial premium payment, the owner can pay premiums at any time, in virtually any amount, subject to certain conditions. The owner can adjust the death benefit, up or down. If annual premiums paid exceed expense and mortality charges, the excess is deposited in a cash-value accumulation account and grows at the rate set forth in the contract. As long as the policy has cash value, the death benefit will continue. If the policy cash value reaches zero, however, the policy lapses.

RELATED ARTICLE:

EXECUTIVE SUMMARY

* The possibility that total estate tax repeal will never occur reinforces life insurance's usefulness for liquidity purposes.

* The institution of modified carryover basis does not negate the need for life insurance.

* An ILIT removes life insurance proceeds From a client's gross estate, providing liquidity or wealth replacement.

Robert A. Esperti, J.D. Co-Chancellor

Renno L. Peterson, J.D. Co-Chancellor

David K. Cahoone, J.D., LL.M. Director of Curriculum and Adjunct Professor

Jonathan A. Mintz, J.D. Director of Programming and Adjunct Professor

The Academy of Multidisciplinary Practice, Inc. Sarasota, FL