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.
WE WILL NEVER SEE THESE TAX PLANNING OPPORTUNITIES AGAIN, SO DO NOT PROCRASTINATE.
Jeffrey M. Verdon, Esq.
Jeffrey M. Verdon Law Group, LLP