With his ultra wealthy clients, Thomas Giordano-Lascari is used to dealing with complicated tax issues, like eight-figure estate planning for exotic investments. Now he’s telling his rich customers to consider splurging on something decidedly mundane: life insurance.
The tax plan taking shape in Congress would strangle a strategy widely used by the wealthy to shield their estates from taxes and pass on major wealth to heirs. Specifically, it would erase the long-standing benefit of keeping life insurance in certain trusts, by making its value subject to the 40% estate tax when the policy owner dies. That’s a huge change: Currently, the trusts and their assets aren’t subject to the levy.
With that prospect, why pour money into a policy now? Because, the thinking goes, pre-paying a lifetime’s worth of annual premiums by Jan. 1, before the new curb would go into effect if approved, could preserve the trust’s lucrative tax benefits.
“We are advising certain clients to pre-fund premiums,” said Giordano-Lascari, a partner at law firm Karlin & Peebles in Los Angeles who advises high net worth individuals and closely held businesses. While investors who don’t make the move may have other options, he said, those carry risks.
‘Crisis stage’
The blow to life insurance in trusts, a bread-and-butter wealth preservation strategy of the rich for decades, is one of
The draft bill would raise the top individual rate to 39.8% from 37% and bump up the top capital gains rate to 28.8% from 23.8%. It would tax capital gains at the top ordinary rate once income hits $1 million,
It's easy to see what the tax perk has been. Say a person dies owning a $3 million home, $7 million in retirement accounts and $4 million of life insurance not held in a trust. With the current estate tax exemption at $11.7 million, $2.3 million of that $14 million estate would incur the 40% estate tax — a bill of $920,000. Now assume instead that the insurance policy is in a grantor trust. It wouldn’t go into the person’s estate, leaving nearly $1 million more for heirs.
Such savings would no longer be possible under the proposal. In any case, the historically high level at which estate taxes kick in would fall by nearly half to under $6 million in the House plan.
Under the House bill, “the life insurance issue has moved things to crisis stage,” said Steve Parrish, who co-directs the Center for Retirement Income at The American College of Financial Services.
“Right now, webinars, emails and panicked calls are circulating among estate planning professionals.”
One particularly hairy element, he said: Advisors are “trying to draft answers to their clients that avoid professional liability if they’re wrong.”
‘A major impediment’
The legislative proposal has upset financial advisors and estate lawyers because it’s common for life insurance to be held in a widely used type of trust called a grantor trust.
“This problem with insurance is really buried in the legislation,” said Warren Racusin, the head of the trusts and estates group at law firm Lowenstein Sandler in New York.
A grantor trust is a type of trust over which the owner, meaning the grantor, retains control and pays income tax on its gains. It comes in many flavors, including intentionally defective grantor trusts, or IDGTs, and grantor retained annuity trusts, or GRATs — all alphabet soup names well known to estate planners for the rich. Advisors say that most irrevocable life insurance trusts, or ILITs, are set up as grantor trusts, so they’d be hit by the curb, too.
The proposal
While the proposal would “grandfather” existing grantor trusts, that’s small comfort for those with life insurance. According to Mari Galvin, the chair of the trusts and estates group at law firm Cassin & Cassin in New York, it’s not clear from the proposal whether all of a trust could be shunted into the owner’s taxable estate if premiums are paid after this year, or just the portion related to the premium payments starting next year. “Time will tell,” Galvin said.
In any case, the grandpa safety net could be mighty small. Trusts that already exist and whose policies are fully paid would “most likely” remain grandfathered, according to Andrew Bass, the chief wealth officer of Telemus Capital, an independent advisor with brokerage services in Southfield, Michigan, that manages nearly $2.2 billion for high net worth investors. But only, Bass added, if the terms of the trust prohibit it from using its own income to pay premiums. The problem, he said, is that “most trusts were written with language that allowed trust income to be used for payment of premiums, thus forcing a loss of grandfathered status.”
In any case, wealthy individuals who want to create a future trust for their life insurance couldn’t make their spouse a beneficiary without subjecting the trust to estate tax. That’s because such a trust is automatically a grantor trust and thus would have to pay estate tax under the proposal.
“That is a major impediment, as insurance is typically needed by a surviving spouse,” Bass said.
The solution becomes the problem
The proposal has the potential to upend retirement planning.
“Life insurance is used by the well-heeled to both conserve and create an estate,” Parrish said. But if a policy’s death benefit gets hit with a 40% tax at death, “the insurance becomes the problem rather than the solution.”
The idea of pre-paying premiums revolves around using outside funds, not money inside the trust, as the latter would get caught by the proposed curb.
“We are advising clients to pre-fund their premiums now” by contributing cash or other assets before the new law passes so that no additional outlays are required to pay future premiums, said David Handler, a partner in the trusts and estates group at law firm Kirkland & Ellis in Chicago.
That’s easier said than done. Ponying up early premiums for a large “permanent” policy that lasts for life can cost millions of dollars. Where to find those dollars between now and New Year’s Eve? Individuals might have cash on hand, or they might contribute securities to the trust which can be sold over time to pay the premiums, Racusin said.
Handler said that others "might borrow from banks.” But Parrish said many investors would be left out in the cold, because “in many cases, these policies are financed through loans, so it’s impractical to pre-pay the premiums.”
Flying blind
The proposed curb would hit not just the very rich. People of more middling wealth, for whom a life insurance policy is often their trust’s single largest asset, would also feel pain.
For example, a person might have a net worth under the estate tax threshold but also a large life insurance policy to care for their family if they die prematurely and their income grinds to a halt, Handler said. Which means that when the insurance death benefit is paid, the decedent’s total assets can exceed the estate tax exemption.
Wealth advisors and estate planners say they're flying by the seat of their tax pants.
Advisors, Parrish said, “are feeling damned if they do” (pre-paying or taking other moves) and “damned if they don’t" (adopting a wait-and-see approach to whether the proposal becomes law).
Bass said one solution might involve “
Or it could be set up so that beneficiaries other than a spouse would have to approve any distributions out of the trust to the spouse, “but that could cause family rifts and may have gift tax implications for the kids,” Handler said.
Racusin likened the tax contortions to navigating wealth planning with blinders on. “It’s kind of like an architect telling a builder, ‘hey, I need you to build this house right now, but I don’t have the plan, but you need to start building it right away.’”
