TRA: Boom Or Bust For Life Insurance?

Thanks to the Tax Relief Act of 2010, many clients are looking at smaller tax bills - and a reduced need for the life insurance funds used to pay them. Producers shouldn't fret, though. A close examination of the act reveals opportunities for more - not fewer - sales, if you know where to look.

The Tax Relief Act of 2010 (TRA) lessens the estate, gift and generation-skipping transfer (GST) tax burdens for many Americans. But does it lessen the need for life insurance? A closer look at the act's provisions reveals possible negative consequences for life insurance agents. Yet, there's a greater chance that TRA will increase sales opportunities - at least for producers savvy enough to take advantage of them.

TRA could hurt life sales

The TRA offers taxpayers "relief from federal estate, gift and GST tax liabilities in four key areas.

First, the act sets the exemption amount (what is now referred to as the basic exclusion amount) from federal estate, gift and GST tax liability at $5.000,000 per person. It also unifies the federal estate and gift tax systems with a common 55.000,000 per person exemption that can be used for lifetime gifts or testamentary bequests (or both). Thus, together, married couples have $10.000,000 of exemption from all of these tax liabilities. In addition, beginning in 2012. this $5,000,000 exemption amount will be indexed for inflation.

Consider that the exemption amount in 2009 from federal estate and GST tax liability was $3,500,000 per person, and it was only $1,000.000 per person for gift tax liability. If the TRA had not been enacted, the exemption amount in 201 1 from federal estate and gift tax liability would have been only $1.000,000 per person, and it would have been just $1,036.000 per person for federal GST tax liability.

Second, the act introduces a new concept to estate planning - portability. Under prior law, the unused exemption amount of a deceased spouse could not be utilized by the surviving spouse, and the surviving spouse faced a greater potential for federal estate tax liability on death. Under the TRA. the unused exemption amount of a deceased spouse is portable and can be utilized by the surviving spouse for federal estate or gift tax purposes.

Suppose a deceased husband uses only $3,000,000 of his $5,000,000 exemption amount. Under the new act, the $2,000,000 unutilized exemption amount can be used by his surviving wife, who thereby has a $7,000,000 exemption amount to utilize. In addition to reducing the potential for estate tax liability on the death of the second-todie spouse, portability can also simplify estate planning for many taxpayers. Estate planning strategies, such as equalizing the estates of the spouses or funding a credit-shelter, or bypass, trust for the surviving spouse, can become less significant.

The concept of portability is limited; it only applies to the unused exemption amount of the last-deceased spouse with respect to a multiple-married surviving spouse and does not apply for GST tax purposes. In addition, to claim the application of portability, the firstto-die spouse's estate must file a federal estate tax return, no matter how small the estate.

Third, the TRA applies a tax rate of 35% for all federal estate, gift and GST tax purposes. The tax rate in 2009 for estate, gift and GST tax purposes was 45%, and it would have been 55% in 2011 without the act. So, even if a taxpayer exceeds the $5,000,000 exemption amount, he or she is subject to a lower tax rate and thereby lower liability.

Fourth, the TRA does not adopt various proposals to restrict certain popular federal estate tax minimization strategies. The act does not limit grantor retained annuity trusts, or GRATs. It also does not restrict valuation discounts on gifting, such as through a family limited partnership.

To the extent that one motivation for the purchase of life insurance is to fund potential tax liabilities, the abovedescribed tax relief would suggest an adverse effect on the purchase of life insurance.

TRA can also boost life sales

While the previously described provisions of the Tax Relief Act of 2010 significantly reduce the potential for federal estate, gift and GST tax liability, one critical caveat is that they are only effective for two years. Absent other action by Congress and the president, in year 2013, the exemption amount will be reduced to $1,000,000 per person for federal estate and gift tax purposes. For federal GST tax purposes, the exemption amount will be just $1,000,000 per person, subject to indexing for inflation. Portability will end, and the estate, gift and GST tax rate will be increased to 55%.

Thus, it is necessary to proceed cautiously before reducing life insurance in response to the TRA. In light of the potentially increased tax liabilities in 2013, clients may need to maintain life insurance to pay for these future tax liabilities. It would also be very risky for clients to cancel a life insurance policy today, only to find out that they are uninsurable or cannot afford a new policy if they need life insurance coverage in 2013 or later.

The TRA can even offer opportunities for increased life insurance. Specifically, the payment of premiums on a life insurance policy (especially when owned by an irrevocable life insurance trust) can result in a potentially taxable gift. With the gift tax liability exemption increased from $1,000,000 to $5,000,000, clients can pay higher premiums (and thereby purchase more life insurance), free of gift tax liability. In addition, the TRA maintains the current $13,000 annual gift tax exclusion. This can also still be used to avoid gift tax liability on the payment of premiums on a life insurance policy By paying premiums with gifts, clients may be able to avoid more complicated insurance funding mechanisms, such as split-dollar arrangements.

Life insurance important - regardless of TRA

Even if subsequent congressional action were to extend (or even further increase) the tax relief provided by the TRA, there would continue to be a need for clients to purchase life insurance. There are many important purposes for life insurance besides the funding of potential tax liabilities. Replacement of income of a deceased family breadwinner, protection of the value of a business on the death of a key employee and provision of liquidity under a buysell agreement are among the reasons to purchase life insurance, without regard to tax liabilities.

Life insurance can also help a client achieve asset protection objectives and reduce client exposure to unanticipated liabilities and litigation. And it's often subject to more favorable income tax treatment than other investment products.

Finally, clients need to consider the impact of state estate tax laws and may purchase life insurance to fund state liabilities. For example, as Illinois has an exclusion amount of only $2,000,000 from Illinois estate-tax liability, Illinois clients with a taxable estate in excess of $2,000,000 may want to consider the purchase of life insurance to fund Illinois estate tax liabilities.

Thus, while at first blush it may appear that the TRA will discourage the purchase of life insurance, in fact, life insurance producers can make multiple arguments to their clients to support the purchase of life insurance.

"With the gift tax liability exemption increased from $1,000,000 to $5,000,000, clients can pay higher premiums (and thereby purchase more life insurance), free of gift tax liability."

"By paying premiums with gifts, clients may be able to avoid more complicated insurance funding mechanisms, such as split-dollar arrangements."

By Gary J. Stern , J.D.

Gary J. Stern . J. D., is a member of the Chicago law firm Stahl Cowen Crowley Addis LLC (www.stahlcowen.com), where he concentrates his practice in estate planning, wealth transfers, asset protection and taxation, as well as corporate, international and immigration law. He can be reached at gsternidstahlcowen.com.