Integrating Life Insurance Into Planning For Ultra-High-Net-Worth Individuals

Integrating Life Insurance Into Planning For Ultra-High-Net-Worth Individuals

These clients must now embrace the permanence of higher estate taxes and the challenging search for tax deferral


Yogi Berra was right: “It ain’t over till its over.” Now that the year-end rush of gift planning has been mostly completed, many ultra-high-net-worth (UHNW) clients (that is, clients with a net worth of $25 million or more) may erroneously assume that they’re finished with estate planning in 2012 and beyond. Not true. 

Now that we’ve stumbled over the first fiscal cliff of the year following passage of the American Taxpayer Relief Act of 2012 (ATRA), the deficit reduction cliff will take center stage. Estate tax reform would raise revenue and has been on President Obama’s agenda for some time, so don’t rule it out in the coming months. Efforts by UHNW individuals and families to push back against Congressional efforts to curtail or eliminate their favorite planning techniques, such as short-term grantor retained annuity trusts (GRATs), valuation discounts, unlimited duration of the generation-skipping transfer (GST) tax exemption and grantor trusts, aren’t likely to gain a lot of traction or sympathy with the public. 

The message is that UHNW clients don’t have much time to plan for the next wave of revenue raisers they will likely be asked to fund. Moreover, UHNW individuals are only now recognizing that ATRA not only increased their top estate tax rate to 40 percent, but also significantly increased their annual tax bill. Moderately wealthy clients now have no federal estate tax worries. However, UHNW clients must now embrace the permanence of higher estate tax rates (at least until Congress needs more revenue) and the challenging search for tax deferral as an alternative to higher income and Medicare taxes for themselves and their trusts. To the disappointment of many UHNW individuals, their estate tax repeal hopes have been permanently dashed, while the train carrying higher income and Medicare taxes has left the station.

How should UHNW clients integrate life insurance with their other planning?


Techniques in Jeopardy

While ATRA brought transfer tax rate and exemption permanence, future legislation tied to deficit reduction may eliminate certain favorite estate-planning techniques of UHNW individuals. Imposition of 10-year minimum GRAT terms, a 90-year limit on GST tax exemption for dynasty trusts, limits on valuation discounts for transfers of interests in family entities and the estate taxation of grantor trusts, all have been raised by the Obama administration as possible revenue raisers. 

Trust-owned life insurance remains a reliable tax- leveraged estate-planning strategy that produces a certain outcome and, except for the Greenbook proposal discussed below, doesn’t appear to be on the estate tax reform chopping block. While there are no new proposals or serious discussions indicating specific changes to the established taxation of life insurance (for example, the tax-free inside build-up of cash value), it’s clear that everything is on the table in Washington.


ILITs Threatened?

One proposal in President Obama’s 2012 Greenbook is apparently aimed at sales to grantor trust transactions but, as proposed, it would incorporate the grantor trust rules into the transfer tax system. Under this overly broad proposal, grantor trust assets would be included in a grantor’s gross estate; distributions from the grantor trust during the grantor’s lifetime would be subject to gift tax; and termination of grantor trust status would cause the entire trust to be subject to gift tax. However, the breadth of the Treasury’s grantor trust proposal would, presumably, also sweep away longstanding tax policy recognizing the differences between the grantor trust and transfer tax systems, especially as they relate to life insurance.

Should this proposal ultimately become law, it would have a dramatic effect on nearly all estate-planning techniques that rely on the use of grantor trusts. For life insurance held by an irrevocable life insurance trust (ILIT), we know that the grantor is treated as the owner of any portion of trust income actually used to pay the premiums. What’s less certain is whether the mere power (authority) of the trustee in a trust instrument to apply trust income to payment of premiums under Internal Revenue Code Section 677(a)(3)—without the use of actual trust income to pay premiums each year—permits the Internal Revenue Service to treat the ILIT as a grantor trust. If so, under the Greenbook proposal, the ILIT-owned death benefit would be included in the grantor-insured’s gross estate. Due to this uncertainty, most advisors are reluctant to rely solely on Section 677(a)(3) power to create grantor trust status; instead, they look to other trust powers (for example, the power of a grantor to substitute assets of equivalent value, the power of a trust protector to add a charitable beneficiary, etc.) to provide more grantor trust certainty. 

There’s no new guidance from the IRS in this area, so it’s not entirely clear that mere trustee authority (“income may be applied” to pay premiums) is insufficient to find grantor trust status. Does the absence of trust income prevent the ILIT from being a grantor trust? If President Obama’s proposal on grantor trusts were enacted and the IRS decided to flex its muscle by concluding that the mere authority to use trust income to pay premiums under Section 677(a)(3) results in grantor trust status, regardless of actual payment of premiums from trust income, this would cause a dramatic shift in current, well-established law governing estate tax inclusion of life insurance death benefits. 

IRC Section 2042 lays out the current estate tax inclusion rules for life insurance and focuses on whether the decedent retained any incidents of ownership over the policy. Under this longstanding provision, the insured has the ability to eliminate any incidents of ownership over a policy by lodging such powers with a third-party ILIT trustee, while retaining the ability to continue to fund premiums through periodic contributions (gifts) to the ILIT. If enacted, this Greenbook proposal would give the IRS an additional avenue to cause estate tax inclusion of life insurance death benefit owned by grantor trust ILITs.

The Greenbook proposal would apply to trusts created on or after the date of enactment and to any portion of a pre-enactment trust attributable to a contribution made on or after the date of enactment. Pre-enactment grantor trust ILITs requiring future premiums would appear to be at risk for some type of proportional estate tax inclusion.  

Current planning flexibility would also be lost. Enactment would effectively eliminate sales of policies between a grantor and his ILIT or among ILITs with the same grantor. Sales and loans by an insured to a grantor trust ILIT today have no income tax consequences, but would under the proposal.

It’s unclear whether the Treasury was aware of the negative impact its grantor trust proposal would have on ILIT-owned insurance, which arguably has nothing to do with a typical sale to an intentionally defective grantor trust transaction. It’s unknown whether the Treasury would be willing to narrow its proposal and allow estate tax inclusion of the death benefit to continue to be tested solely under IRC Section 2042. Some commentators doubt this Greenbook  proposal, in its current form, will become law.


ILITs Going Forward

The following discussion assumes that the Treasury either withdraws its grantor trust proposal altogether or limits it so that traditional grantor trust ILITs are excluded from its crosshairs.

ILITs are more important than ever for the UHNW client. Federal estate tax rates for these individuals have risen, and state estate tax regimes remain in place in many states. A simple traditional ILIT containing Crummey withdrawal powers, GST tax exemption features and fully discretionary distribution terms continues to be appropriate for UHNW clients. Early funding of a new ILIT, perhaps as a complement to other 2012 year-end gift planning, may secure grantor trust and perpetual GST tax exemption treatment for a trust in the event Congress curtails these provisions as part of upcoming estate tax reform.

Non-tax considerations of UHNW families also suggest the continued use of ILITs. Like other third-party trusts containing spendthrift provisions, protecting ILIT assets from beneficiaries’ creditors, including ex-spouses, may be a priority for some clients. (For more information on protecting trusts from ex-spouses’ claims, see “Are Trust Funds Safe From Claims for Alimony or Child Support?” by Barry A. Nelson, in this issue, p. 15.)  Equalizing inheritance among heirs may be important when there’s a family business, but not all the heirs work in the business. After the death of an insured, an ILIT can provide asset and investment management expertise for younger generations. Professional management by an institutional trustee may be called for. An ILIT may provide liquidity in a second marriage situation for either a surviving spouse or children from a first marriage and may minimize disputes over other inherited assets. ILITs avoid probate, and the immediate availability of the life insurance death benefit delivers cash liquidity after death, avoiding the delay and expenses often found in reducing other assets to cash. A multi-generational ILIT may also enable the patriarch to retain indirect influence over the trust assets long after he’s gone.


Funding ILITs

Clients have a number of different strategies available for funding an ILIT, some simple and some complicated.

The conventional approach is to take advantage of Crummey withdrawal powers. Under this approach, the insured makes annual gifts of the premiums to the ILIT and relies on the trustee to send out Crummey withdrawal notices to beneficiaries to take advantage of the client’s 2013 $14,000 gift tax annual exclusion amount. Split gifts with a spouse are recommended to maximize the magnitude of the annual gift tax annual exclusion amount. However, this conventional solution doesn’t leverage the gift tax annual exclusion nor GST tax exemption amounts and is problematic for large premium situations. Some clients also prefer to make annual exclusion gifts of cash that provide a more immediate near-term benefit to family members.

UHNW clients have been encouraged to leverage the gift tax annual exclusion and GST tax exemption amounts through split-dollar arrangements or loans, in which the economic benefit or annual loan interest is the measure of the annual gift. (If their employer or investment entity advances the premiums, there are also income tax considerations.) By making a gift of cash to the ILIT equal to the economic benefit amount or annual loan interest due later in the year, a client can leverage the gift on large premium life insurance programs.

The focus for the 2012 year-end was to maximize large gifts in trust, perhaps of discounted assets using a defined value formula. It’s unlikely that many of these sophisticated 2012 irrevocable gift trusts also contained Crummey powers. Continued use of Crummey withdrawal powers elsewhere in existing or new ILITs may be compatible with their not being used in 2012 year-end trusts.

What’s new under ATRA is the annual inflation adjustment for the $5 million gift and GST tax exemption amounts. For 2013, the inflation-adjusted gift, estate and GST tax-exempt amount is $5.25 million, an increase from 2012 of $130,000. Some project that by 2020, the gift, estate and GST tax exemption amounts could approach $7.5 million. Therefore, a new annual funding opportunity is available for transfers to ILITs, which takes advantage of the increasing gift and GST annual inflation-adjusted exemption amounts. Using the annual inflation-adjusted exemption amounts for gifts may be preferable to dealing with the limitations and detailed administration associated with annual exclusion gifts requiring a trustee to send out annual Crummey withdrawal notices to beneficiaries. While split-dollar plans and loans offer significant transfer tax leverage, they can be complicated to administer and always require an exit strategy to unwind. In funding policies held in an ILIT, the simplicity and ease of completion for a gift using the increasing inflation-adjusted exemption amounts has a lot of appeal.


Complement or Backstop Transactions

Some clients completed their year-end gifts with cash gifts to fund a grantor trust in 2012; they then plan to swap out the cash for hard-to-value discounted assets now awaiting appraisal. As a result, cash back in the hands of the donor may provide opportunities to create a new ILIT funded through either a split-dollar plan or loan that minimizes gift and GST taxes or an inflation-adjusted gift. Alternatively, if discounted assets are returned to the grantor in a swap for cash, and the terms of the 2012 trust are suitable, life insurance might be purchased inside the 2012 trust. 

Many UHNW clients undertook transfers of hard-to-value discounted assets as part of leveraged sales to grantor trusts in exchange for notes at year-end, which often require passage of a long period of time to move significant wealth outside the estate. The success of many of these transactions also depends on the ability to obtain a discount or earn a higher rate of return than the applicable federal rate. One potential risk is that an early death will result in insufficient time to have amortized much of the note, which is an illiquid asset that may have to be included in the seller’s estate at near face value. Another risk is that unexpected subpar investment performance of the discounted asset in the initial years following the freeze will prevent a successful overall outcome, even if performance improves in later years.

Life insurance can fill this gap, virtually assuring that the estate-planning strategy produces a successful outcome no matter how long the plan is in place and regardless of investment performance. If the seller dies prematurely, insurance fills the near-term gap of longevity/mortality. If the asset fails to appreciate over time as hoped, insurance solves the long-term volatility/investment risk issue. Life insurance adds certainty and stability to complement a sale or other freeze transaction.

Life insurance premiums, no doubt, add to the cost of a transaction. If the sale transaction performs as hoped, the premiums are a drag on return. However, the downside risk of these leveraged transactions producing an unsuccessful outcome without use of life insurance is too great for professionals to ignore.


Tax Deferral Planning

Higher income and Medicare taxes for UHNW individuals—and possibly even higher taxes in the future—will motivate this group to seek tax-deferred and tax-efficient investment opportunities. The cash value accumulation in a life insurance policy will grow free of federal income, Medicare and state income taxes, and the policy uniquely provides death benefit leverage that’s income tax-free. If the policy is owned by an ILIT, the death benefit will also be estate tax-free. No other asset combines all theses favorable tax attributes. 

Life insurance will increasingly appeal to individuals looking for higher yields in the current low interest rate environment. The internal rate of return (IRR) on life insurance at life expectancy produces superior returns to other fixed income strategies due to its favored tax treatment. Private placement variable life insurance will again be of interest to UHNW individuals willing to tolerate its complexity and prepared to forego active investment control over the underlying policy investments.

A cash value accumulation policy may be a viable choice, at least for part of a portfolio, rather than enduring the time and expense incurred in managing a traditional taxable stock portfolio in an effort to defer capital gain. While municipal bonds may provide a comparable after-tax return to life insurance after factoring in mortality charges, municipal bonds don’t offer any death benefit leverage. As municipal bond investors chase yield, there’s a greater default risk with marginal municipalities and issuers than with top-rated insurance carriers.

Favorable tax treatment is available on initial lifetime access to policy cash value, especially when compared with the capital gain toll charge imposed on the sale of all traditional portfolio or investment assets. UHNW individuals are now facing a 23.8 percent federal income and Medicare tax on qualifying dividends and long-term capital gains, plus any state taxes. Tax on other passive net investment income is subject to much higher income tax rates, as well as subject to the new Medicare tax. There’s no current tax on the tax-deferred growth in life insurance premiums. 

Accessing the cash value during life also offers some tax advantages. Assuming the life insurance policy isn’t a modified endowment contract (MEC), the owner of a policy can make withdrawals of cash value, up to his investment in the contract, without incurring federal or state income tax or Medicare tax. Withdrawals must be monitored closely, however; otherwise, the policy death benefit will be adversely affected. A policy owner may undertake some borrowing against the policy value without incurring an income tax (regardless of basis), assuming the policy isn’t a MEC. Monitoring policy loans is essential to prevent unintended income tax consequences. Maximizing non-MEC loans isn’t recommended because it will ultimately result in a lapse of the policy with gain to the extent cash value exceeds premiums paid.

Surrendering a policy will generate ordinary income and Medicare taxes on the cash value in excess of the investment in the policy. Sale of a policy in the life settlement market may be appropriate if the health of the insured has declined and a buyer is willing to pay well in excess of cash value. The amount received in excess of cash value is capital gain.


Trust Planning

UHNW individuals will continue to make use of different types of irrevocable lifetime and testamentary irrevocable trusts, including long-term trusts, in their planning. After ATRA, there’s an income and Medicare tax tradeoff for the use of such trusts with traditional taxable investments.

For income tax purposes, investment in a life insurance policy can minimize the income and Medicare tax impact of either a grantor or non-grantor trust. Either way, the underlying asset grows free of income and Medicare tax drag.

Non-grantor trusts reach the top bracket at only $11,950 of taxable income in 2013. For income above this level, there will be a federal tax on the trust on qualified dividends and capital gain of 23.8 percent, plus possible state tax. The tax rates for very young beneficiaries who aren’t working haven’t gone up, creating a tax incentive to make trust distributions of income to these beneficiaries to minimize taxes. But what if the young beneficiary is immature or, if slightly older, has creditor problems? The tax and non-tax reasons for a distribution of income conflict; distribution of income may save taxes, but may be ill-advised for practical reasons. For successful adult trust beneficiaries with high incomes of their own, distributing trust income won’t necessarily save taxes. Moreover, what if the trust instrument or, in default, state law, requires that capital gain be allocated to principal and the beneficiary is only currently entitled to receive trust income? Does the trustee have authority to change this arrangement or convert to a unitrust to distribute capital gain to a beneficiary who’s in a lower bracket to save taxes?

Many ILITs are structured as grantor trusts. Sales of policies between a grantor and his grantor trust can occur without income or gift tax consequences (no three-year lookback concern as with a gift). Interest payments on split-dollar loans and installment sales of policies to grantor trust ILITs have no income tax consequences for either party. Most importantly, payment by the grantor of the trust’s income tax liability isn’t a gift under current gift tax law, enabling the trust principal to grow faster and the grantor to reduce his estate without transfer tax consequences.

Some cautious UHNW individuals may find that a grantor trust structured as a spousal lifetime access trust provides additional flexibility. The client’s spouse could have access to the trust funds (cash value accumulation) if needed during life. The death benefit would be protected from estate and GST tax if the policy remains in force through the death of the insured.

UHNW individuals may find existing grantor trusts that own a combination of life insurance and taxable investment assets increasingly problematic, due to the ever-increasing income and Medicare tax burden placed on the grantor. What if the trust instrument doesn’t or can’t (due to state law creditor protection laws) contain a discretionary tax reimbursement provision (authorizing the trustee to reimburse the grantor for payment of his income tax)? At some point, the grantor may ask the trustee to terminate grantor trust status due to this additional tax burden. Not all existing ILITs contain sufficient flexibility to enable the trustee to prevent trust income from being used to pay premiums or from otherwise turning off grantor trust status. Turning off grantor trust status may be difficult when the ILIT contains several different grantor trust powers. Can an existing grantor trust be decanted into a more flexible trust that provides greater flexibility to turn off grantor trust status?

In drafting new ILITs, lawyers will, no doubt, be focused on the need to include a provision to turn off grantor trust status. Turning off grantor trust status during the grantor’s life will cause any unrecognized gain property to be subject to income tax. A new ILIT should contain a power of substitution permitting a swap of high basis assets (cash) for low basis assets (a cash accumulation policy) to ameliorate this gain on termination of a grantor trust ILIT during the life of the grantor.


Product Trends 

Just as ATRA has changed the tax landscape, new products trends are changing the life insurance world.

Persistently low interest rates will continue the current multi-year trend of increased pricing on no-lapse guarantee (NLG) products and shrinking supply. This upward pricing trend will be accelerated by the state insurance commissioners’ recently revised actuarial guidelines (AG 38) for NLG products, which will require carriers to hold greater reserves on both new and some existing NLG policies. Inability to earn profit on NLG products from interest rate spread and tying up excess assets subject to tougher capital reserving have caused carriers to pivot toward new products.

If simplicity and a permanent fixed price are paramount, then NLG products still make sense, especially for older clients. Also, some backloading (deferral of significant escalating) premium payments beyond life expectancy is still permitted, which enhances the IRR on premium outlay at life expectancy. However, NLG offers virtually no cash value, so no meaningful income tax deferral objectives are met. 

Carriers have responded by introducing a variety of new non-guaranteed products that combine upside cash value accumulation and different types of death benefit guarantees. In general, the carriers are encouraging level payment of premiums over life (or frontloading of premiums over at least six or seven years) and durational life expectancy guarantees in these products.

If a generic universal life policy is funded at the same level as an NLG policy, it generally provides significantly better cash values, lower surrender charges and good downside protection because the cash value ultimately equals the death benefit. The generic universal life policy can be designed so that it won’t lapse until the insured is well beyond life expectancy. Of course, the generic universal life policy doesn’t provide an absolute lifetime death benefit guarantee, nor offer the simplicity of an NLG, and it’s a general account product whose performance must be constantly monitored by the insured’s advisors. The flexibility of a generic universal life policy is that a lower level of funding may be considered as providing adequate downside protection beyond life expectancy.

An equity-indexed universal life (EIUL) policy is also a general account product and is viewed as a universal life product with the potential for an enhanced crediting rate. The EIUL product generally must outperform a generic universal life product to justify its higher costs. By linking performance to equity exchanges, the goal is to outperform what the carrier could earn from its traditional general account fixed income portfolio. The EIUL product comes with additional volatility because it’s linked to equity index performance. 

A variable universal life (VUL) policy isn’t a general account product. The policyholder assumes all management responsibility by allocating premiums among different sub-accounts that have varying investment returns and risks. Upside return potentials (and downside problems) are greatest with this most volatile life insurance product type.

Universal life policyholders envisioning eventual higher interest rates want to maximize cash value. For carriers, the higher the cash value at death, the lower the amount they’re at risk for death benefit. By offering a lifetime guarantee rider to an EIUL or VUL product, the carrier is aligned with the policyholder, although each has a different motive in growing cash value. Adding a lifetime guarantee rider to these cash value accumulation products, however, is very expensive. Many middle-aged insureds are gravitating to more affordable durational life expectancy guarantees. Most importantly, in providing a lifetime guarantee through alternative cash accumulation products, the carrier may not be subject to the stringent reserving rules of AG 38, which frees up capital on its balance sheets.