Obama’s Tax Proposal Regarding Grantor Trusts

Dear Clients, Colleagues, and Friends,

As we mentioned in our recent CLIENT ALERT, the Obama Administration’s 2013 Revenue Raising Proposals contained several suggestions that, if enacted, would eliminate commonly-used estate planning techniques that have been effective in significantly reducing an individual’s estate and gift taxes and, in some instances, even eliminate all gift and estate taxes. Earlier this month, we discussed the proposal to reduce the effectiveness of dynasty trusts. In this CLIENT ALERT, we address a proposal labeled “Coordinate Certain Income And Transfer Tax Rules Applicable To Grantor Trusts.” This relatively innocuous-sounding provision would, in effect, put an end to a technique that has become the most important cornerstone of modern estate planning. And, indirectly, this proposal would eliminate the use of life insurance as an estate planning technique. Grantor trusts have been particularly important to the life insurance industry because almost all life insurance trusts (an “ILIT”) are, by their very terms, grantor trusts.

Although no one can realistically predict if or when Congress will eventually enact any of the proposals suggested by the Obama Administration, and some doubt that the grantor trust proposal will ever be enacted, there is always a possibility that the grantor trust proposal, and more likely several of the other proposals, will become law. Interestingly, proposals that eliminate tax planning techniques have a better chance of being enacted because Congress can thus raise tax revenues without raising tax rates.

As with any changes in the tax laws, the legislation would only apply to grantor trusts created after the legislation is enacted (the “Effective Date”). Therefore, all existing grantor trusts, and any grantor trusts created and funded before the Effective Date, would not be subject to this legislation. Individuals with a net worth exposed to the estate and gift taxes should consider the creation of a grantor trust, or make additional wealth transfers to an existing grantor trust, in order to take advantage of this and other planning opportunities that may be eliminated before the end of this year. Since Congress will address the Obama Administration’s proposals after the November elections, it is possible that the use of grantor trusts for estate planning may be eliminated by the end of this year. Rather than wait to see what happens with the Congress, we recommend that individuals considering estate planning create a grantor trust before it is too late to use this technique. There is no downside risk in acting now to adopt a technique that one would also use in the future. As such, you should work fast to avoid subjecting your estate planning to these proposals, which, if enacted into law, would probably take effect starting in 2013. Even more importantly, anyone considering the use of life insurance as part of their estate plan should act now!

This is how a grantor trust currently works. Because a grantor trust is disregarded for income tax purposes, the grantor is obligated to pay the income taxes earned by the grantor trust. The grantor’s payment of the income taxes attributable to the grantor trust eliminates the income tax cost that a trust would otherwise incur; this increases the accumulation of the funds in the grantor trust increasing the amount of tax-free wealth transfer. Interestingly, the trust creator’s payment of the income taxes on the grantor trust’s taxable income is not treated as a “taxable gift to the grantor trust.”

Example: Assume an individual creates an irrevocable grantor trust and makes a gift of corporate bonds worth $5,000,000 to the trust using his $5,120,000 gift exclusion to avoid any gift tax. The bonds pay an annual interest payment of $300,000 (a 6% yield) of taxable interest income each year to the grantor trust. Assuming the donor is in a 40% income tax bracket, the income taxes on $300,000 of interest income would be $120,000. If the trust had to pay the income taxes on its $300,000 of income, the trust would net only $180,000 after taxes. By treating the trust as a grantor trust (disregarded for income tax purposes), the individual who created the grantor trust would have to pay the $120,000 of income taxes, thus increasing the accumulation of funds in the trust by $120,000 and decreasing the donor’s taxable estate by $120,000 per year. Since the income tax paid by the grantor is effectively a “gift tax free” transfer of wealth to the trust, the trust income will continue to accumulate in the grantor trust free of all gift and estate taxes. Over a 25 year period, the extra $120,000 of income earned in the grantor trust without the income tax burden will accumulate an additional $3,000,000 free of gift and estate tax.

Assume that at the end of 25 years, the Grantor dies and that the funds in the grantor trust have grown to $15,000,000 because all trust income is reinvested by the trust. The reason for much of this growth is that the grantor trust accumulates all $300,000 of interest income each year instead of paying income tax and netting only $180,000 each year. Under the Obama Administration proposal, all $10,000,000 of the growth in the grantor trust’s assets over the original $5,000,000 gift in trust would be subject to estate taxes at the proposed 45% estate tax rate for an additional estate tax cost of $4,500,000. By creating a grantor trust grandfathered by the Effective Date, the potential estate tax savings in this example is $4,500,000.

The impact of this proposal on irrevocable life insurance trusts is even more profound as the following example illustrates.

Example: An individual creates an ILIT and each year makes gift taxfree annual exclusion gifts to the ILIT to be used for the ILIT’s payment of the premiums on a life insurance policy on the individual’s life with a $5,000,000 death benefit. Under current law, upon the insured’s death, none of the $5,000,000 received by the ILIT is subject to estate tax. Under the Obama Administration proposal, the entire $5,000,000 paid on the life insurance policy is subject to the estate tax.

As you can see, two of the most effective estate planning techniques would be eliminated. Therefore, one should not take the risk of possible adoption of any of these proposals by Congress given that they can implement these techniques by year end and be grandfathered by the Effective Date.

If you have any questions regarding this important information and would like assistance in exploring your estate planning options, please contact us.


Jeffrey M. Verdon, Esq.

Jeffrey M. Verdon Law Group, LLP

Wealthiest Americans Fearful of Liability Lawsuits, Survey Says

Dear Clients, Colleagues, and Friends,

In previous Client Alerts, we have described the necessity and benefits of instituting effective “firewalls” in your estate planning to protect assets and lifestyle from an unforeseen financially ruinous lawsuit. Often this advice goes unheeded until an incident arises which makes it too late to do any planning. We recently came across this following article in which the insurance industry similarly acknowledges the risks of high-stakes liability lawsuits:

March 05, 2012

Wealthiest Americans Fearful Of Liability Lawsuits, Survey Says

America’s wealthiest families increasingly worry that their wealth makes them a prime target for a high-stakes liability lawsuit in the current unstable period of high unemployment and weak economic growth, according to an ACE Private Risk Services survey released Monday.

But despite their concern, those same wealthy families are poorly prepared for such lawsuits and fail to recognize that their lifestyle can lead to a lawsuit. They underestimate the cost of the potential damages, and they misunderstand the affordability of effective protection. As a result, the survey contends that wealthy families often lack the proper types and amounts of liability insurance.

The survey, “Targeting the Rich: Liability Lawsuits and the Threat to Families with Emerging and Established Wealth,” polled individuals from households with more than $5 million of investable assets about their perceptions and behavior regarding the threat of personal liability lawsuits.

“Wealthy families feel increasingly targeted, especially given the national discourse over disparities in wealth, income, and taxation,” said Bob Courtemanche, division president of ACE Private Risk Services, the high net worth personal insurance business of the ACE Group.

Based on the study, more than two-thirds of the respondents surveyed think public perceptions of the wealthy have grown more negative since 2008. “Almost 40 percent believe they are more likely to be sued in the aftermath of the economic crisis, compared to only 7 percent who say they are less likely to be sued,” Courtemanche said. “And more than 80 percent agree their wealth alone makes them an attractive target for liability lawsuits.”

Jim Hageman, senior vice president of claims for global personal and small commercial insurance for ACE, said many of those families underestimated the risk. “Half of the people we surveyed thought the worst-case lawsuit would be less than $5 million,” he said. “But our experience is that awards for lawsuits involving serious injury can equal many times that amount.”

Wealthy families tend to underestimate their potential liability from a car accident or other incident, they often lack sufficient liability insurance, according to the study. More than 40 percent of survey respondents reported carrying less than $5 million in umbrella liability insurance, including 21 percent who have none.

According to ACE executives, umbrella liability insurance is a critical part of a personal insurance program because the liability coverage in automobile and homeowner policies rarely exceeds $500,000. An umbrella policy provides additional coverage on top of those policies. Insurance companies specializing in insuring high net worth families usually offer coverage ranging from $1 million up to $100 million, and the cost can be offset by increasing the deductible amounts in the underlying homeowner and auto policies.

Relying on an umbrella policy or your general liability policy as your sole source of protection could be a miscalculation. Often insurance policies cover you if you “fall off the roof” but not if you “hit the ground” meaning carriers have been known to deny coverage where coverage questions arise. The insurance company that insured the Twin Towers denied coverage as to some of the buildings using certain express policy exclusion provisions with the owner and the carriers litigating the issue of coverage.

It is socially responsible to carry a reasonable level of umbrella coverage, but the larger the policy limits, the larger the “target” you become for specious lawsuits.

Protecting you and your family with the appropriate type and amount of insurance and asset protection is critical to building effective firewalls to protecting your assets. Please give us a call so we can assist you in evaluating your total protection from proper insurance planning to proper total asset protection. At Jeffrey M. Verdon Law Group, LLP you get more than you expect, but exactly what you need.

Jeffrey M. Verdon, Esq.

Jeffrey M. Verdon Law Group, LLP