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The Perfect Storm: Prospective Expiration of the Bush Tax Cuts
In December of 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Act”), and which otherwise would have “sunsetted” as of January 1, 2011. Under the 2010 Tax Act, the Bush tax cuts were extended for two years and modifications were made to the estate, gift, and generation-skipping transfer taxes. These extensions and modification end on December 31, 2012. In this must read paper, Leon C. LaBrecque, JD, CPA, CFP®, CFA provides an overview of the ramifications of the expiration of the cuts and the corresponding problems and planning considerations for individuals and nonprofit institutions.
by Leon C. LaBrecque, JD, CPA, CFP®, CFA
In December of 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Act”), which extended the “Bush tax cuts” enacted in May 2001 by the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Tax Act”), and which otherwise would have “sunsetted” as of January 1, 2011. Under the 2010 Tax Act, the Bush tax cuts are extended for two years and modifications are made to the estate, gift, and generation-skipping transfer taxes. The extension ends on December 31, 2012. This paper is intended to provide an overview of the ramifications of the expiration of the cuts and the corresponding problems and planning considerations for individuals and Nonprofit institutions.
The expiration of the Bush Tax cuts affects virtually every individual taxpayer in the United States, as well as corporations and nonprofit institutions. In general, on December 31, 2012, the tax law reverts to the tax law previously in effect in 2001. The expiration will increase taxes on all taxpayers in varying amounts, with some taxpayers experiencing a virtual doubling of income taxes. In addition, a major component of the law is the Estate and Gift tax section. If the estate tax reverts to the pre- Bush tax cut level, there will be a significant increase in estate and gift taxes on Americans with estates over $1M.
Disclaimer and Caveat
Tax law is exceedingly complex, and provides a wide range of individual analysis. This paper is intended to help individuals and nonprofit organizations, with donors affected by potential tax law changes, find issues to discuss with their advisors. Some very important issues should be considered
- The Bush tax cuts are scheduled to expire on December 31, 2012. Unless Congress and the current president act, the reversion to the old tax laws are severe and significant. Note, however, that Congress and the President may solve or partially solve the problem:
- By “kicking the can down the road” (re-extending it to 12/31/2014, for example);
- By partially extending the provisions of the Act; for example, the President may want to impose the Bush tax cut expiration on millionaires. Congress and the President may agree to do that as opposed to letting the entire law expire.
- Fully revising the Tax Code, which seems exceedingly unlikely in today’s political environment.
- All scenarios should be considered within the context of each individual’s situation. Facts and circumstances unique to each family have certain characteristics which need to be considered carefully: see a competent and skilled advisor.
- This problem has a distinct time line: 12/31/2012, unless extended or modified. After that date, the estate, gift and GST exclusion goes from $5,120,000 with portability to $1,000,000 with no portability.
- Finally, a Required Disclaimer Under IRS Circular 230: Internal Revenue Service regulations require us to notify the recipient that any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used, by the recipient or any other taxpayer for the purpose of avoiding tax penalties that may be imposed upon the recipient or any other taxpayer, or in promoting, marketing or recommending to another party, a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
In general, the expiration broadly means:
- The two “marriage penalty elimination” provisions will expire, so that:
- The standard deduction for married couples will fall, no longer double what it is for single filers; and
- The ceiling of the 15% bracket for married couples will fall, no longer double what it is for single filers
- The tax rate on qualified dividends earned by middle- and upper-income taxpayers will rise from 15% to ordinary wage tax rates
- The 10% tax bracket will expire, reverting to 15%
- The child tax credit will fall from $1,000 to $500
- The Earned Income Credit is eliminated
- The tax rate on long-term capital gains earned by middle- and upper-income taxpayers will rise from 15% to 20%
- The 25% tax rate will rise to 28%
- The 28% rate will rise to 31%
- The 33% rate will rise to 36%
- The 35% rate will rise to 39.6%
- The AMT (Alternative Minimum Tax) will revert to 2001 levels
- The PEP (personal exemption phase out) and Pease (itemized deduction phase out) provisions will be restored, rescinding from high-income taxpayers the value of some exemptions and deductions.
- The Estate tax will revert to an exemption level of $1 million (from the current $5,120,000 for 2012) and rates that top out at 55%
- The Gift tax will revert to a $1 million exclusion
- The Generation Skipping Tax (GST) exclusion will revert to $1 million
There are a significant number of other provisions, ranging from the elimination of the student loan interest deductions to the elimination of the temporary repeal of the tax on generation skipping transfers. Rather than create a long list of provisions, this paper is intended to provide an overview of certain situations and how they may affect individuals and nonprofits. In addition, the Patient Protection and Affordable Care Act (‘Obamacare’) also alters the income tax landscape, changing, for example, the deductibility of medical expenses (from a 7 1/2% AGI floor to a 10% AGI floor) to, much more significantly, the imposition of the ‘Unearned Income Medicare Contribution’ (UIMC), a 3.8% tax on interest, dividends and capital gains on higher bracket taxpayers.
The following is a scenario and the possible situations/solutions. An example may allow the reader to find similar scenarios and determine applicability. Note that the effects on the expiration are vast and will affect both high-net worth and working class individuals.
High bracket taxpayers, with both earned and unearned income. Take the example of a couple, with total income of $350,000, including unearned income of $40,000 per year, primarily dividends, interest and capital gains. They make charitable contributions of $25,000 per year. For purposes of this example, let’s assume the following:
- Michigan resident, state income taxes of about $14,000;
- They have two children, one 15 and one 19 at MSU (author bias);
- One spouse makes $180,000, and the other makes $130,000 in wages and bonuses;
- In addition to charity and Michigan income taxes, they pay real estate taxes and personal property tax (in Michigan, license plates). Total itemized deductions are about $51,500.
- They have real estate of $800,000; investments outside of IRAs and 401(k) plans of $1.4M; IRAs and 401(k) plans of $1.2M, and life insurance of $1M. No debt.
Bush tax cuts expire: Income taxes. The couple will pay about $8,700 more in taxes, mainly due to the higher tax brackets and the phase-outs. They will lose a majority of their exemptions and part of their itemized deductions.
Estate taxes. From an estate tax standpoint, if they both died, under the current law, there would be no estate taxes, since the total assets are under $5M ($4.4M). With the expiration, their taxes could be somewhere between $1.3M to $1.8M.
Health Care Bill Effect: The UIMC under the Health Care Bill will add another $1,580 of income-related taxes. Their income tax bill in 2013 would be about $10,300 higher.
Possible Planning Opportunities
Income taxes: Investment asset repositioning. One obvious possibility is to reposition assets between taxable and tax-deferred accounts. For example, moving dividend-paying stocks into the IRA/401(k) and replacing the taxable investment with tax-free municipal bonds in the taxable accounts. As an example, suppose you have a stock with a 3.5% dividend and a municipal bond paying 3%. For 2012, the after-tax yield is approximately the same. In 2013, for an upper bracket taxpayer, the after-tax yield of the stock will be 1.98%, versus the 3% tax-free municipal bond yield.
Income taxes: Capital Gain harvesting. Given the capital gains rate will increase on January 1, 2013, another approach is to harvest gains at the lower 15% rate. Securities can be sold at a gain and repurchased. (For example, if you held a stock for more than one year and had a gain at a price of $600, you could sell it and immediately buy it back, paying tax on the gain at the lower rate.) In addition, some taxpayers may have loss carry-forwards, which are used at the rate of $3,000 per year against ordinary income, or offset against capital gains. Short term gains could be offset against loss carryovers. An individual could even ‘cherry –pick’ a portfolio and select which assets to sell, donate, or reposition.
Example of gain harvesting repositioning: Suppose our couple had a loss carryover of $25,000, a stock worth $50,000 with a short term gain of $15,000, and another stock worth $50,000 with a long-term (more than one-year) gain of $25,000. They might sell the short term gain stock, with no tax consequences, since they would be offsetting ordinary income with the loss carryover. They could then re-buy the same stock (if they liked it) in an IRA or Roth, or even in the same account. Next, they could donate the long-term stock to charity or a Donor-Advised Fund, eliminating the capital gain, and deriving a $50,000 charitable contribution. If the charitable contribution is completed in 2012, it avoids the prospective Pease provision phase-outs on itemized deductions, thereby allowing the full deduction (only subject to other AGI limits).
Income and Estate taxes: Roth Charity Offset. Another planning opportunity is to have the couple convert a portion of their current IRAs into a Roth IRA, and offset the taxable income from the conversion with a corresponding charitable deduction. Borrowing from the previous example, the couple might convert $50,000 of an IRA into a Roth, and donate $50,000 of appreciated stock, held long-term, to their charity. The conversion creates a taxable event, and the charitable donation creates a tax deduction at fair market value. The prospective outcomes of the Roth charity offset include:
- Creation of a $50,000 Roth IRA Conversion:
- All income and appreciation on qualified distributions are tax-free, both to taxpayer and spouse, and to a subsequent individual beneficiary(ies).
- Roth IRAs are not subject to the age 70 ••• Required Minimum Distributions, so the Roth may accumulate until the death of both spouses.
- Retaining the Roth (not taking distributions) reduces subsequent income tax liabilities on the formerly taxable distributions from the previous IRA.
- Offsetting charitable deduction: Using a charitable donation as an offset to the income produced by the Roth conversion has the following tax affects:
- Creates a $50,000 income tax deduction (as an itemized deduction).
- Eliminates the capital gain taxes on the gift of appreciated property (in the foregoing example, 15 % of the $25,000 gain, or $3,750, plus state taxes).
- Reduces the taxable estate by the amount of the charitable contribution.
Income and estate Taxes: Charitable Donation. A simple opportunity in the face of the prospective expiration of the Bush tax cuts is to make charitable contributions in 2012, in anticipation of the Pease itemized deduction phase-outs, plus the reversion of the estate taxes to the 2001 level. Charitable donations could take a variety of forms:
- Direct cash donations to the charity (deductible subject to AGI limits). Reduces income taxes and shrinks the taxable estate.
- Direct appreciated property donations to the charity (deductible subject to the AGI limits). Reduces income taxes and shrinks the taxable estate.
- Cash or appreciated property gift to a Donor Advised Fund (DAF, also called a charitable gift fund, charitable gift trust, or a philanthropic fund). DAF donations allow the donor to make a tax-deductible gift to a fund and designate at a subsequent time the recipient of the donation. In addition, DAFs allow the donor to invest the DAF assets and all subsequent appreciation can be used for the charitable purposes. This reduces income taxes and shrinks the taxable estate. In addition, DAFs receive a more favorable tax treatment than a private foundation.
- Charitable gifts of split interests (‘Charitable Split Interest Trust’), where the life estate and the remainder interests are split and one portion of the interests is gifted to charity (like the life estate) and the other portion is designated by the donor (the remainder interest for example). The life estate is the value of the assets (usually the income) during the life of the donor(s) and the remainder interest is the value after the death of the donor(s). These include the following:
- A Charitable Lead Trust (CLT), where the life estate (or a term of years) of income is gifted to the charity and the remainder can either revert to the donor or a designated beneficiary. The CLT gives the charity an income stream and that stream may be a fixed amount per year (a charitable lead annuity trust) or a specified percentage a year (a charitable lead unitrust). The lead trust can then transfer the remainder to the heirs. Any appreciation is not subject to gift or estate taxes (but is subject to capital gains tax). In the above example, suppose the rate used by the IRS for lead trusts as of April 14, 2012 is 1.4%. The Donors above set up a lead trust to make a donation to their college and the Trust pays the college 1.4% a year and leaves the remainder to the children. The Trust is invested with $100,000 of tax-free municipal bonds paying 3.5%. If the Donors were 56 and 51 respectively, they could take a $36,794 income tax deduction. The tax-free nature of the bonds would preclude any capital gain income to the donors. Upon their deaths, the children would receive the remainder, which, as long as the value of the bonds and accumulated interest increased by more than 1.4%, would be greater than the original donation. The $100,000 would be out of the Donor’s estate. The donors might use higher appreciating property and forego the income tax deduction. This would remove all appreciation and capital gain tax liability from the donor’s estate. The Charitable Lead has a profound saving opportunity in 2012 if the Bush Tax cuts expire: first, the discount rate is extremely low; and second, the current gift exclusion is $5.12M until year end.
- A Charitable Remainder Trust (CRT), where the remainder interest is gifted to the charity and the donor(s) receives income from the life estate. Again there are two forms: one that pays the donor a fixed amount (a charitable remainder annuity trust) and the other which pays the donor a fixed percentage (a charitable remainder unitrust). Using the facts from the foregoing example, the couple could donate $100,000 to their charity, arrange a 5% income stream for themselves (which is ordinary income) for their lifetimes, and get a $20,238 income tax deduction. Their estate would shrink by $100,000, or more, assuming the investment gained in value during the Donors’ lives.
- CRT/ILIT, is where a donor gives property to a Charitable Remainder Trust and uses the income stream to fund an Irrevocable Life Insurance Trust (ILIT, covered later in this paper). The gift to the CRT generates a tax deduction, plus prospectively avoids capital gains taxes on any gift of appreciated property. The ILIT generates an income tax free/estate tax free sum of funds on the death of one or both grantors. The funds from the ILIT can be loaned to the estate to pay estate taxes, or held for beneficiaries. With a significant tax increase looming, this technique will be reconsidered by donors with specific charities they wish to endow. For example, suppose a couple has $10M. They donate $5M to a Charitable Remainder Trust, which pays them a stream of $250,000 a year in income. With that flow, they buy a last-to-die whole life insurance policy (let’s presume it is for a $5M face value), which is purchased through an ILIT. Upon the death of both of them, the ILIT receives the life insurance proceeds income tax free and the ILIT is excluded from the taxable estate. The children also receive the remainder interested from the CRT. The net result on the $5M is no tax.
- A Charitable Gift Annuity provides an income stream for the life of the donor, removes the asset from the donor’s taxable estate, and provides a charitable deduction. Charitable gift annuities can be in one of three forms: an immediate gift annuity (which starts immediately after the gift), a deferred gift annuity (starting at a future date), and a flexible gift annuity (with a range of start dates, like retirement). Gift annuities can be for one life, two lives in succession, or a joint and survivor life expectancy. The payments are computed based on the type of annuity and the ages of the beneficiaries. A portion of the payments are tax-free return of capital, and a portion is ordinary income (if appreciated property was donated to a gift annuity, then a portion would also be capital gain). The charity keeps the funds at the expiration of the period. The donor gets a tax deduction for a portion of the gift. In the above fact situation, the payout on a gift annuity for the couple would be about $3,400 a year, with about $1,249 of that tax-free. They would receive a tax deduction of about $12,189, and remove $100,000 from their estate. Alternately, they could use a deferred gift annuity and start the annuity at a later date (like retirement). They would receive a higher annuity payout and a smaller tax deduction.
Income and estate taxes: Low interest loans. The current interest rate mandated by the IRS to avoid a gift (the ‘imputed interest’ rate) is so low that it provides an interesting opportunity to shift income to children or other beneficiaries.
- Low interest loan to children. The April 2012 short-term federal rate is .22%. This means a donor could loan their child a sum, say $1,000,000, and the child, to avoid a gift, would have to pay 0.22% back to the parent (who would declare it as income). Suppose the child then invests the money in investments paying 5%. Over a three-year term, the child would have received $144,069 of income (and the parent would not have had that income in their estate) and the child would have paid $2,200 in interest each year. The child could even potentially deduct the $2,200 as investment interest. If the parent dies before the note is paid, the note becomes an asset of the estate or trust.
- Low interest loan to charity. This is a similar notion in the above scenario, but where a donor wants a charity to have access to funds and is in a high tax bracket for some period of time. Using the example above, the donor would lend a charity funds (say $1,000,000) and the charity would pay back the loan at 0.22%. The charity would invest the money and generate income, tax free. The donor’s estate would be reduced by the amount of income earned by the charity
- Low interest installment sales to trust. Here, the grantor starts funding an ‘Intentionally Defective’ Grantor Trust (IDGT) to hold an income-producing asset. An IDGT is not a separate taxpayer for income tax purposes but is treated as a transfer for estate tax purposes. For example, suppose the donor has a business (like an LLC or Subchapter S corporation) worth $5M. He creates an IDGT and funds it with $500,000 of stock of his company. The trust then buys $4.5M of his stock under an installment note over 13 years. The long-term AFR for 04/12 is 3.04%. The company distributes $450,000 a year, and the payment to amortize the note is $424,216 a year. Assume the company’s value goes up by 5% a year: at the end of the term of 13 years, the trust will own the company, now worth $9,428,000, plus have other assets of $456,710. The Owner will have gotten $500,000 out of his estate, plus the other $5M of appreciation. In addition, the owner would have paid income taxes on the distributions, which would result in further estate shrinkage.
Estate taxes: Credit Bypass. The current 2011 law provides a $5.12M exclusion per person for gift and estate taxes purposes. A couple can effectively double the exclusion to $10.24M by exploiting the exclusion using a ‘family’ trust and a ‘marital’ share or trust. This arrangement will typically place the credit exclusion amount in a family trust (the ‘bypass’ or ‘B’ trust) and distribute the rest to the spouse to exploit the maximum marital deduction (the ‘marital’ trust or share, or ‘A’ Trust). Many individuals have either created trusts based on the current $5.12M exclusion or do not have an estate plan at all. With the expiration of the Bush Tax cuts, the exclusion goes from $5.12M to $1M. Obviously a couple would want two trusts rather than one, to double the exclusion. In our example above, with a $1M exclusion and 55% rate, the couple would save $550,000 in estate taxes on the second death by using two credit bypass trusts.
Estate taxes: Equalization. Frequently, estates are unbalanced in favor of one spouse, particularly in the instance of significant 401(k) plans or IRAs. Returning once again to the hypothetical couple described above, suppose, spouse A has 401(k)/IRA assets of $900,000 and spouse B has $300,000. Both have named their spouse as the primary beneficiary. Spouse A has life insurance of $800,000 and spouse B $200,000. All other assets (real estate and non IRA/401(k) assets) are jointly held. As long as the exclusion is $5.12M, our couple is safe. If the exclusion reverts to $1M and the couples use the credit bypass trust method, then if spouse A dies first virtually all of the assets except the life insurance flows to spouse B and they wasted $200,000 of exclusion. If spouse B dies first, then the situation is worse and all but $200,000 flows to Spouse A. Starting in 2011, there is a (new) concept called ‘portability’ that allows one spouse to use the other’s unused estate exemptions, but this expires on 12/31/2012.
Estate taxes: Excluded gifts of annual exclusion. With the possibility of reversion to the $1M exclusion upon expiration of the Bush tax cuts, a very simple method is to make lifetime gifts that are excluded from the calculation of gift tax. For 2012, this is $13,000 per donee. A married couple may make a joint gift of double the exclusion, so a couple can contribute $26,000 per donee. So a grandmother with three married children and four grandchildren could gift $26,000 to each child and their spouse, and $13,000 to each grandchild. This would shrink her estate by $130,000 a year and could prospectively save the family up to 55%, depending on the size of grandmother’s estate. Note this is an annual exclusion, and over ten years grandmother could shrink her estate by $1,300,000, and save up to $715,000. Direct payments of tuition and medical expenses are further excluded, so if grandmother gave the grandchildren $13,000, she could also pay their tuition directly (note this exclusion is only for tuition paid directly to the institution and does not include room, board, books, travel, etc.).
Estate taxes: Excluded gifts to §529 plans. There is a special exclusion for §529 plans (for example, the MESP). A 529 plan allows tax-free accumulation of a beneficiary’s investment income in the plan, provided the distributions are used for qualifying higher education expenses. The definition is quite broad and basically includes all costs considered by the Department of Education, including tuition, room, board, books, etc. Contributions to a §529 plan are subject to the $13,000 annual exclusion, but a contributor can make up to a $65,000 contribution and treat the contribution as if it was made over 5 years. For the couple we were illustrating, they could make a one-time contribution for the younger child of $65,000, shrinking their estate by $65,000, and shifting all of the income on the $65,000 to a tax-free investment if used for qualifying education purposes. A grandparent could conceivably make $65,000 in gifts to §529 plans for each grandchild. Such gifts are out of the estate and do eliminate subsequent $13,000 gifts.
Estate taxes: Using the $5.12M exclusion. One very obvious and profound way to reduce the potential burden of future estate taxes in view of any future change (aside from total repeal of the estate tax) is to make transfers during 2012. The first $5M transferred per person during 2012 is not subject to tax, and any (non-charitable) gifts over $5M are taxed at 35%. The prospect of a 55% tax and $1M exclusion provide a myriad of planning opportunities, including the following:
- Outright gifts. Certainly the easiest technique for individuals with estates larger than $5.12M is to make outright gifts to recipients. The first $5.12M of the gift is not subject to gift taxes and shrinks the estate by the amount of the gift. A gift over $5.12M will result in a 35% gift tax and will shrink the estate by the gift and the gift tax. Example: Mother is 84 and has one son. Her total estate is $20M. She makes a gift to him of $10M. $5.12M is excluded from tax, and $4.88M is subject to taxes at 35%. She would shrink her estate by $11.708M (the $10M gift and the $1.708M in gift tax). If the Bush Tax cuts expire, this saves her son as much as $6.46M in additional taxes that would be paid. Note that the gift will carry-over mom’s basis, so the son may be subject to future capital gains. Within the gift, she might include a ‘legacy’ asset like a family vacation home which may not be sold any time in the near future.
- Gifts in trust. An obvious problem with a present interest gift is that it is…a gift. The donor has relinquished control of the property. To provide control, there are variety of trusts that can be used:
- Irrevocable Trust. One technique is to make a completed gift to an irrevocable trust. The trust will have terms of governance, control and management. In the previous example, the mother might make a $5M outright gift to her son, and then make a $5M gift to an irrevocable trust for her son and his children.
- ‘Dynasty Trust’. A ‘dynasty trust’ is a trust created for the maximum period of time allowed by law, possibly 100 years or more (Michigan, for example, has repealed the Rule Against Perpetuities in 2008) and a trust can therefore virtually last into perpetuity. These are trusts that cross multiple generations.
- Domestic Asset Protection Trust (DAPT). A Domestic Asset Protection Trust (DAPT) is a trust set up in a jurisdiction that shelters trust property from creditors and hence does not include it in the donor’s estate. This has the effect of allowing a person to ‘freeze’ the assets and still enjoy the use of those assets. For example, suppose an individual transfers $5.12M to a Delaware DAPT (note that DAPTs must be established in a DAPT state, like AK, DE, MO, NV, NH, WY, UT, TN or HW, with DE the normal venue). The individual and his children are the beneficiaries of the DAPT. He uses the full exclusion, and the assets are not subject to his creditors, so the $5.12M is out of his estate. Suppose he dies in 2020 and the trust assets are worth $10M. If he has been a discretionary beneficiary, the extra $4.88M of appreciation also escapes estate tax.
- Partial trust gifts. Another technique to use up some of the $5.12M exclusion is to make a partial gift to a trust, where the donor gets some income flow or use of the property. This might include having an income flow or retained usage:
- Grantor Retained Annuity Trust (GRAT). A Grantor Retained Annuity Trust, or GRAT, is an irrevocable trust where the grantor (donor) retains the right to receive a fixed dollar amount for a set term of years. The amount paid can be increased by up to 20% each year. For a GRAT to be effective, the grantor must live as long as the annuity term. A GRAT can be ‘zeroed out’ so there is not an actual gift, but the appreciation on the assets is transferred to the beneficiaries. A GRAT term can be very short, e.g. 2 years.
- Qualified Personal Residence Trust (QPRT). A Qualified Personal Residence Trust, or QPRT, is where a donor transfers a personal residence to a trust for a term of years. At the end of the term, the residence will be transferred to the donor’s beneficiaries (spouse, children, etc.). If the donor dies during the period, the property is included in their estate (which it would have been anyway). If the donor outlives the term, the appreciation is out of the estate. For example, suppose the donor is 66 and has a vacation home on Torch Lake worth $1.2 M, which he intended to leave to his children anyway. He establishes a QPRT for a term of 10 years. Assume the IRS rate is 1.4% (which it is for 04/12). The value of his gift (the remainder) is about $801,000, so he would use $801,000 of his $5.12M exclusion to get a $1.2 vacation home out of his estate. If he dies within the next 10 years, the home is included in his estate. If the home appreciates (don’t laugh, it might), then the appreciation is out of his estate if he outlives the 10 years.
- Life Insurance Trust. Life insurance is an interesting asset in that its value is much greater at death than during life. In fact, it can be argued that a term life insurance policy has virtually no value while the donor is alive. Life insurance death benefit proceeds are generally exempt from income taxes, and if an insurance policy is correctly transferred to an Irrevocable Life Insurance Trust (ILIT), the proceeds from the life insurance are not subject to estate taxes. It is usually best to have the ILIT buy the policy directly. If a policy is transferred to an ILIT, the insured needs to survive the transfer by not less than three years to have the policy proceeds not be included in the estate. In our example from the beginning of this paper, the couple had $1,000,000 of life insurance, which is irrelevant under a $5.12M exemption, but subject to estate taxes if the Bush tax cuts expire. It would be in their family’s best interest to either transfer the policies to an ILIT or issue new policies to an ILIT.
- Generation Skipping Transfer (GST) tax. The Generation Skipping Transfer tax, or GST is a tax originally intended to prevent taxpayers from ‘skipping’ generations. For example, under previous law, if I left $10M to my son, my estate paid tax; my son received the after-tax proceeds, and left it to his daughter, and his estate paid tax, and so on. If I attempted to ‘skip’ the generation and leave funds directly to my grandchildren, or great-grandchildren, I would have to pay an additional GST tax on the ‘skipping’ transfers. For 2012, the GST exemption is $5,120,000. This means a married couple could create, for 2012, a ‘Dynasty trust’ for the benefit of the children, grandchildren, great grandchildren and subsequent heirs with $10,240,000 and use their entire gift/GST exclusion but pay no tax. Coupled with Michigan’s repeal of the Rule Against Perpetuities, this trust is now valid. Dynasty trusts can be coupled with life insurance.
The ‘Tax Storm’ of 2012 has a wide-reaching and profound effect on individuals, particularly those with charitable intent. The current historically low interest rates provide an unprecedented opportunity for Charitable Lead Trusts, excluded gifts, or low interest rate loans. The possible expiration of the Bush tax cuts make it an imperative for taxpayers with estates larger than $1M to sit down with advisors and make a determined plan of action. If the cuts expire, individuals will have a very narrow window of opportunity to utilize the $5.12M exclusions, the GST exemptions, and the benefits of the current law. This is a year in which pre-planning is crucially important. And, in the off chance that the estate tax is repealed and the income tax rates are permanently lowered to the tax cut rates (in which case we will have a whole new set of problems), the overall family and charity situation has been reviewed and carefully considered.
Leon C. LaBrecque, JD, CPA, CFP®, CFA; is the CEO and Chief Strategist for LJPR, LLC, a firm that manages over $430M* in assets. Since 1989, LJPR has been providing independent, fee-only wealth management to individuals and nonprofits. Part of LJPR’s mission is to provide nonprofits and their prospective donors with education on how best to serve their goals and objectives. To have Leon provide a presentation to your group, or to have an hour consultation with our team of professionals, please contact LJPR at email@example.com (cc to firstname.lastname@example.org).
*(as of 3-31-12)
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