The role of life insurance in estate and gift tax exemptions

By James G. Blase

With the November election rapidly approaching, discussion about the need to grandfather the current $13.61 million federal estate and gift tax exemptions has heightened. “Use it or lose it” is the common pronouncement. But for high net worth individuals, are large lifetime gifts as beneficial as they may first appear? Is there any other alternative out there that can produce better overall results for the individual and their family?

Grandfathering the exemptions

The sunset of the current large federal estate and gift tax exemption is scheduled to take place in 2026. It is likely that when we get to that sunset, the federal estate and gift tax exemptions may be reduced by 50% or more — from as much as $14 million or more to less than $7 million. For a married couple, these numbers double from as much as $28 million or more to less than $14 million. At a federal estate tax rate of 40%, the resulting estate tax differential for a married couple may be $5.6 million or more.

With tax savings this large, isn’t it a no-brainer for high net worth individuals to gift away the large federal estate and gift tax exemption before any potential sunset takes place? After all, estate planning attorneys have developed techniques, such as the spousal limited access trust (or SLAT for short), as a way for married couples to gift away a large amount of assets and still retain use of the same, directly or indirectly, during their lifetimes. The answer may not be clear-cut for several reasons, and at least one other alternative should first be explored.

One of the reasons? Because of the way the tax code is structured, lifetime gifts around $6 million or so per person have zero grandfathering effect. Individuals must gift more than this amount in order to produce any grandfathering of the current $13.61 million exemption. The problem is that this is a lot of assets to gift away during the taxpayer’s lifetime, especially if a married couple seeks to double this amount.

Further, and despite the best-laid plans of estate planning attorneys, it is questionable whether any estate plan designed to allow a married couple guaranteed access to all the transferred assets during their joint lifetimes will survive a successful attack by the IRS. Even if a “reciprocal” plan were to pass IRS muster during the couple’s joint lifetime, there is a good chance that after the first spouse dies, the surviving spouse will have at best access to only one-half of the transferred trust funds and potentially have access to none of them.

Another reason is that the after-tax benefits of large gifting are more limited than they may appear at first blush. Assume, for example, that a single individual makes a $10 million gift of securities in 2024 and that the 2026 exemption ends up at $6.5 million. The individual has thus grandfathered $3.5 million of the larger federal estate and gift tax exemptions and saved $1.4 million in estate taxes in the process. Also assume that the individual’s income tax basis in the $10 million of gifted securities was $4 million and that the donee’s combined net capital gains tax rate, including the net investment income tax and net state income taxes (i.e., after the federal tax deduction then is in effect) is 23%. The built-in capital gains tax on the gifted securities is $1.4 million, or the same as the federal estate tax savings.

Of course, the facts involved will be different than these, but you get the picture. Large gifts of securities or business interests typically carry with them a significant amount of built-in capital gains taxes, taxes that would be avoided if the taxpayer held the assets until death. And if sunset does not occur, or if the tax laws are later changed during the taxpayer’s lifetime to reinstate the large federal estate and gift tax exemptions, taxpayers making a large transfer may have only hurt their family, at least in the short term.

The potential adverse income tax consequences compound if the individual has a significant “portability election” amount available from a predeceased spouse. The portability election amount essentially is already grandfathered, and lifetime gifts by the surviving spouse use up the portability amount before they use up the surviving spouse’s own exemption amount. As a result, there is zero tax savings immediately after the transfer of the portability amount there, but as with all lifetime gifts, there can be a significant carryover income tax basis involved.

What if one of the purposes for making the grandfathered gifts is to remove future appreciation from the taxpayer’s gross estate at death? Would this make the decision to make a large gift simpler? At the assumed 23% effective capital gains tax rate, the net tax advantage in favor of a large lifetime gift should be approximately 17% (or 40% minus 23%) of the future appreciation. Now assume the original $10 million in transferred assets doubles in value each 10 years, or to $80 million after 30 years. Of the $70 million in growth, the net tax savings to the taxpayer’s family by investing the original $10 million in an irrevocable trust would be $11.9 million ($70 million plus 17%).

The life insurance alternative

The question is whether there is an alternative that will produce the same or greater overall financial benefits to the taxpayer and the taxpayer’s family but without causing the taxpayer to lose the full economic benefit and/or control over the transferred assets.

Assume, for example, a couple with a 62-year-old husband and a 61-year-old wife who both are in preferred health. Instead of gifting $10 million in securities, the couple decides to keep full control over the securities and use a portion of the ordinary income generated by the same each year, or approximately $148,700 (based on their ages and health status), to pay the annual premium on a $12 million second-to-die life insurance policy owned inside of an irrevocable life insurance trust. The $148,700 annual premium would be covered by the couple’s $18,000 per Crummey power donee annual gift tax exclusions.

Because the proceeds of the second-to-die life insurance policy will be free of income tax and estate tax, at an annual cost of $148,700 the couple has effectively nullified the need to give up control over the $10 million in assets, even if they live into their 90s. The question is: Is this effective nullification worth the cost to achieve it?

If the couple pays the $148,700 premium for 30 years, or until the husband is age 92 and the wife is age 91, the total amount expended would be $4,461,270. The same $148,700 annual amount, compounded monthly for 30 years at an annual rate of 7%, could have grown to $14 million. If the $14 million were part of the surviving spouse’s taxable estate, the net amount, after 40% estate taxes (and assuming no state estate taxes on the same) would be $8.4 million, or approximately 70% of the $12 million of income- and estate-tax-free life insurance proceeds inside of the irrevocable life insurance trust, payable when the surviving spouse dies.

Now assume that the same $148,700 was instead invested annually for 30 years inside of an irrevocable trust outside the couple’s taxable estate. The net amount, after the assumed 23% capital gains rate (that could be much higher because a trust gets to the 20% basic capital gains rate much faster than an individual does) on all growth, would be $11.8 million. This is about the same as the $12 million of income- and estate-tax-free life insurance proceeds inside of the irrevocable life insurance trust, payable when the surviving spouse dies.

Although the facts will obviously vary in each situation, what the above analysis demonstrates is that grandfathering the current high federal estate and gift tax exemption may not always be necessary or even financially beneficial. Before proceeding down a path of lost control and potentially higher future capital gains taxes, studying the use of life insurance as an alternative to grandfathering the current high estate and gift tax exemptions should be considered