Estate Enhancement Plan [CPA Journal, The]

A Case Study of Its Process and Benefits

As financial advisors, CPAs are often asked to guide business owners on increasing their profits, cash flows, and - ultimately - the value of their business. As estate planning advisors, CPAs are also asked to counsel individuals on how to decrease the size of a taxable estate. The more successful individuals are in growing the value of their assets, specifically their closely held businesses, the more difficult it can be to reduce the estate for transfer-tax purposes. Advisors utilize several different planning techniques, such as sales to intentionally defective grantor trusts (IDGT); other types of trust planning; discounted giving; structuring of grantor-retained annuity trusts (GRAT); charitable planning, including private foundations; donoradvised funds; and charitable remainder and lead trusts. These techniques, and many others, normally result in either a freeze or reduction in the taxable estate, while still transferring assets to the desired heirs or charities.

The "estate enhancement plan" discussed below is a different planning technique, designed to increase the assets that are available to the heirs while, at the same time, reducing the estate tax liability. This plan is not for everyone; it works best for an individual who has assets - preferably in a qualified plan - that are not needed for lifetime use. In addition, it benefits an individual who desires to increase the assets that will be transferred to heirs. The plan utilizes two insurance products: a singlepremium immediate annuity (SPIA) and a permanent life insurance product, usually a universal life (UL) policy. The plan derives its advantages from the favorable income taxation of life insurance and the detrimental taxation of individual retirement accounts (TRA) and 401 (k) plans in an estate.

The following case study illustrates the benefits of the estate enhancement plan.

Case Study

This plan could work in several situations, but this sample case will assume that a CPA's clients, John and Judy, are a healthy, financially successful couple. (Exhibit 1 shows their net worth.) John and Judy - 64 and 63 years old, respectively - have four children; three are active in the family business, with plans to inherit it, and their fourth child, James, jointly owns a medical practice with his wife. John and Judy draw substantial wages from the business, which will continue throughout their lives and meet their cash flow needs.

John and Judy have decided that they want to leave approximately equal amounts to each of their four children, but they also want the family real estate - a vacation residence passed through the family for generations - maintained in the family for all to use. The problem is that after paying estate tax on their assets, segregating the real estate, paying income tax on their IRA, paying off their debt, and allocating the business to each of their children involved in it, there is only a residuary of $250,000 for James, plus his share of the real estate (Exhibit 2).

This could be resolved by leaving part of the business to James and having his siblings purchase his interest. But John and Judy do not want the other three children to incur any debt; moreover, they do not want to lower the business's worth as a result of the purchase of James's shares.

The estate enhancement plan, however, will turn the $1 million IRA owned by John - currently included in the taxable estate and ultimately subject to income tax - into a $3.9 million after-tax asset attributable directly to James. As an added benefit, the asset will be included in a trust that will afford liability protection to James and potential estate tax savings upon his demise.

The plan will use the IRA to purchase a SPIA, take the annuity amount received each year, pay all associated income and gift taxes on the distribution, and transfer the balance into an irrevocable life insurance trust (JUT) to purchase a second-todie life insurance policy. No gift taxes will be due on the gift to the trust due to Crummey withdrawal rights built into the trust. As indicated above, it is critical that John and Judy do not need the IRA to meet their lifetime income needs.

As can be seen in Exhibit 3, the estate enhancement plan provides James with a significant enhancement in his inheritance, with no detriment to the three children involved in the business. John and Judy are aware that the business interest could continue to grow in value or could decline, and they are comfortable with establishing the attached amounts in current dollars as meeting their desires. Alternatively, they could decrease the insurance amount by allocating a lower gift into the life insurance trust.

In this case study, the estate enhancement plan increases the after-tax assets available to the family by $3.65 million.

Estate Enhancement Plan Process: Preimplementation

The estate enhancement plan process consists of a preimplementation phase and an implementation phase. The sections below detail the steps to take during the preimplementation phase of the process.

Step 1 - life insurance underwriting. Financial advisors should verify, by appropriate underwriting, the life insurance status of the clients, such as John and Judy in the example above. If they are not insurable, or are poorly rated, mis planning technique might not be beneficial. Once it is known what their insurable status is, then the following process can be structured. Nothing should be implemented unless life insurance underwriting has been completed.

Step 2- detailed computations of the entire plan. Once underwriting is complete, the entire plan can be summarized for the client. The summarization would include an illustration of the annuity proceeds, computing related income and gift taxes to determine the net gift to an ILIT, and then determining the amount of life insurance those net gifts can purchase. Each of these computations will be shown in the implementation steps below.

Estate Enhancement Plan Process: Implementation

The second phase of the process - implementation - has four steps.

Step 1-form an ILTT. An HIT is a trust mat is implemented primarily to hold life insurance, normally on the grantor of the trust When properly structured, an KIT will provide a death benefit, payable to the trust, for distribution to the beneficiaries, with no estate inclusion by the grantor of the trust. Assets owned or controlled at an individual's date of death are normally subject to federal and possibly state estate tax, including life insurance proceeds. Because an ELIT is an irrevocable trust, the life insurance policies and proceeds (and any other assets) held by the trust are considered owned by the trust entity and not owned by the grantor or the insured.

Wim appropriate legal counsel to make certain that the trust meets all of the requirements necessary to avoid estate tax inclusion, John and Judy will form the trust and select an appropriate trustee. The primary beneficiary of the trust will be James and his wife, and their heirs. Because two individuals are needed to have Crummey rights, James and his wife will be granted that right; alternatively, a child of James could be used as the second Crummey power, if desired. The trust could also be drafted to allow James's wife to have Crummey rights only while she is married to James. The insurance proceeds in the trust will be used to meet John and Judy's goal of roughly equalizing James's inheritance to that of his siblings.

Step 2- purchase a SPIA. In the case study, John will use the $1 million in his IRA to have the ERA purchase a SPIA with a joint life payout for him and Judy. An immediate annuity is a contract between the annuitant and an insurance company. The basic terms are simple: an individual gives a single lump-sum of money to an insurance company that, in turn, pays the individual a fixed income for a fixed period of time, for the rest of the individual's Hfe, or for the joint lives of the individual and another person. In the case study, the insurance company will pay for the joint lives of John and Judy. Note that all guarantees are based on the claims-paying ability of the annuity issuer.

As the name implies, an immediate annuity begins to pay a stream of income immediately. The amount of income an individual receives is based on several factors. First, immediate annuity payments are computed using the actuarial tables of the insurance company. These tables take into account the annuitant's or joint annuitant's life expectancy; the annuitant's age determines the amount of the payments. Second, the payments are based on the underlying interest rate that the annuity issuer pays on the premium; higher interest rates lead to higher payment amounts.

Because the annuity in the case study is in an ERA account, the full payment received by John from the annuity will be taxable. In cases where the funding for the annuity comes from nonqualified assets, then the payments received from the annuity are divided into two parts: a nontaxable portion that represents return of capital and a taxable portion mat represents the earnings on the annuity.

If an individual selects a single life-only payment option, the annuity payments cease at death. There are no estate tax implications, because no part of the annuity is transferred. If one buys a joint and survivor immediate annuity, payments will continue for the remaining life of the surviving annuitant at the death of the other annuitant The value of the joint and survivor immediate annuity mat the deceased annuitant paid for will be includible in the estate of the deceased annuitant The amount included is the amount mat the same annuity issuer will charge the survivor for a single life annuity, as of the date of the first annuitant's death. In addition, the surviving joint annuitant will receive an income tax deduction for any estate tax attributable to the annuity; if the joint annuitant is the surviving spouse, however, the interest qualifies for the marital deduction. In the case study, John's spouse is the joint annuitant and, because she is a U.S. citizen, there will be no impact on estate taxes at the first death, due to the marital deduction.

Utilizing insurance company rates as of March 2012, the joint annuity payout for John and Judy will be $53,300 per year. Assuming a 30% income tax rate, which could be withheld directly from the ERA payment, a net after-tax cash flow of $37,310 will be available to the couple.

Note that the ERA will no longer be an available asset for John and Judy because they have exchanged the $1 million in the IRA for the payment stream. The payment stream will automatically meet all required minimum distribution rules, will be offset by the marital deduction in the first estate, and will not be includible in the estate of the second to die because the payment stream terminates.

Step 3- giß the net annuity proceeds each year to the TUT. The next step in the process is to use the net annuity proceeds gifted to the HJT. The amount to be transferred to the IDT will be $37,310. This is the gross annuity amount ($53,300), less income tax ($15,990), less any gift tax. (There are no gift taxes in tìiis case study, but gift taxes could be significant) Transfers of cash to an HIT would normally be subject to gift tax; however, John and Judy will have no gift tax liability by structuring the transfer so that it qualifies for the annual gift tax exclusion (currently $13,000 per beneficiary).

Generally, a gift must be a present-interest gift in order to qualify for the exclusion, which allows an individual gift of $13,000 (indexed for inflation) per beneficiary, giftlax free. The recipient of a present-interest gift is able to immediately use, possess, or enjoy the gift. Gifts made to a trust, however, are usually considered gifts of future interests and do not qualify for the exclusion, unless they fall within an exception. One such exception is the right of the beneficiaries to demand, for a limited period of time, any amounts transferred to the trust; this is referred to as Crummey withdrawal rights or powers. For the gift of $37,310, both John and Judy can use their annual exclusions for James, as well as James's wife; these allow up to $52,000 to go into the trust with no gift tax liability.

Jt is strongly suggested that financial planners make certain that clients such as James and his wife are given formal notice each year of the gifts to the trust and their withdrawal right; however, a recent tax court case indicated that this notice is not required (Estate of Turner v. Comm'r, T.C. Memo 2011-209).

Step 4- purchase life insurance in aie ????. The final step is to put the insurance in place; the underwriting will have already been completed. In the case study, John and Judy should never have any ownership of the policy, because all applications for the insurance should be made by the trust as owner. Jf the insurance is initially owned by John and Judy, then for three years after the transfer of ownership to the trust, the insurance would be included in their estates.

John and Judy chose a survivorship UL policy guaranteed by the insurance company until age 121, because their primary concern was to ensure that the policy would remain in place at their demise. For a premium of $37,310, the trust could purchase a policy from a highly rated company with a guaranteed death benefit of $3.9 rnillion (as of March 2012).

Survivorship UL is a form of permanent insurance. The cash value receives a guaranteed minimum interest rate, plus an excess interest rate when the insurance company's investments perform well, making the returns more competitive than those of some other policies. As with the annuity, guarantees are subject to the claimspaying ability of the insurer.

UL insurance also offers flexibility in changing the level of insurance and premium payments. With the estate enhancement plan, this would allow some level of insurance to stay in force even if John and Judy decided, at some point, to stop fully funding the JLIT and instead chose to retain the annual annuity for their own needs. As indicated, if John and Judy were likely to need the IRA for lifetime needs, the estate enhancement plan would not be recommended; however, the flexibility of a UL policy allows John and Judy to use some or all of the annuity proceeds for their own needs if their situation changes in the future.

Comparison to Holding an IRA

A comparison must be made between the net after-tax distribution to James of $3.9 million, and retaining the IRA and naming James as the beneficiary. While there is no exact way to compute this without knowing annual returns and the dates of death, the comparison can be performed with certain assumptions. While not fully illustrated in this example, minimum distributions would be required from the IRA after the attainment of age 70 Vi. These distributions would result in a decreased IRA balance, income taxes on the required distributions, and an additional asset outside of the IRA (equal to the net after-tax withdrawals). It is presumed that the amounts illustrated would closely approximate the after-tax result of the IRA and funds withdrawn from the IRA over the 25-year life expectancy shown.

If no additional planning is done, the $1 rnillion asset held would continue to grow within the IRA. Assuming that John survives Judy and that he dies in 25 years, and assuming a fixed 6% return each year, then this asset will grow to $4,291,871 at the time of the second death. After payment of estate taxes at an assumed rate of 45% and income taxes at an assumed rate of 30%, James would receive $1,072,968; of course, upon an early demise, the amounts passed to James would be less than this. On a longer life, the amounts passed to James would continue to increase.

Using these estimated returns and life expectancies, James's inheritance using the estate enhancement plan has increased on an after-tax basis from approximately $1.07 million to $3.9 millioii - an increase of 265%. Exhibit 4 shows the IRA after-tax value at different assumed rates of return.

Practical Considerations

The estate enhancement concept can be used in many situations. What is needed is a desire by an insurable individual or couple to have ready access to assets that they do not need during their lifetime and to maximize their after-tax estate. Factors that work in favor of this plan are high estate or income tax rates, healthier individuals, and assets in qualified plans that are not needed as a resource. Ancillary benefits - such as using a generation skip, estate benefits for the second generation, and liability and marital discord protection - are not explored in this discussion, but should be considered as well. The estate enhancement plan should be used in the correct circumstances; it is important to note that this planning technique would be inappropriate if it negatively affected the lifestyle of the individuals to be insured.

William T. Kriesel, CPA/PFS, CFP, AEP, is a New York State life, accident, and health agent; a partner-in-charge of ? & C Planning Services LLC; and a partner in the tax department of Bowers & Company, CPAs, PLLC, in Syracuse and Watertown, N.Y.