Preserving the Family Fortune

• Ronald J Panko
• May 2002
• 

by Ron Panko

Insurance offsets uncertainty. So even as Congress gradually repeals the estate tax, with plans to eliminate it in 2010, there is still plenty of uncertainty to go around, and the life insurance industry is already adjusting and selling policies for estate-planning purposes.

The fuss about Congress' action last spring to phase out estate taxes hurt life insurance sales last year, particularly those designed for the estate-planning market, such as survivorship policies, which insure two lives and pay upon the death of the second. But the events of Sept. 11 spurred sales of life products in general, and agents and brokers have found better footing in the new sales environment as they work with estate-planning clients.

A healthy skepticism that the estate tax will never really die is helping to fuel a rebound in life sales. As recently as 27 years ago, government took up to 77%, less exemptions, of a recently deceased's assets. While an eventual full repeal is law, many in the life industry doubt Congress will leave that law intact. (See Near-Death Experience," page 98.) And even if it remains unaltered, the estate tax is scheduled to reappear in 2011 at the pre-2001 top rate of 55%.

"There was a paralysis last year for a time, but we saw a turnaround in September, October and November," said Michael Gilotti, executive vice president at Phoenix Variable Insurance Co., Hartford, Conn. "Now Phoenix is having a banner year in life sales. Life sales have never been better for Phoenix in January and February."

Gilotti said buyers have been motivated this year by both traditional reasons for purchasing life insurance and by estate-planning concerns. Uncertainty about not only estate planning, but the effects of terrorism and the economic downturn, have caused many clients and prospects to hold financial reviews with their advisers, he said.

Add to those motivations the fact that Phoenix and its advisers encourage prospects to view estate planning as more than estate-tax planning. "There's been so much discussion about estate-tax repeal," said Richard Martin, vice president in advanced marketing for the Phoenix Cos. "There's been a constant buzz about estate taxes, but we don't really know if they will ever be fully repealed. Now we're beyond the paralysis and are concentrating on how people can achieve their life's goals."

Here to Stay

Estate planning with life insurance has not gone away and should not go away, said Ted Kurlowicz, the Charles E. Drimal professor of estate planning at American College, Bryn Mawr, Pa. "There are all kinds of new issues along with the basic uncertainty, and the risk of not having coverage is pretty severe," he said.

For example, state taxes on inheritances and estates may survive a repeal of the federal estate tax, Kurlowicz said. Some states' inheritance taxes are independent of federal rules, and even those that are based on federal estate-tax rules could continue to exist, he said. All states currently have the credit estate tax, also known as the "pickup" or "sponge" tax, which allows them to collect an amount equal to the maximum credit permitted on federal tax returns for estate-tax payments to states. This tax is scheduled to be eliminated in 2005 under provisions of last year's Economic Growth and Tax Relief Reconciliation Act, the law that eventually repeals federal estate taxes. But states may decide to create separate inheritance taxes to replace the lost revenue, Kurlowicz said. Arizona, Georgia, Minnesota, New York, Rhode Island, Virginia and Wisconsin already have done this, and others will presumably follow suit, he said.

The largest estates are subject to a marginal rate of 16% under the existing state estate-tax credit. "Even if the federal estate tax is repealed, the largest estates in states that maintain the prior pickup-tax levels will continue to pay state death taxes at a 16% marginal rate," Kurlowicz said. "It is important to keep up to date on the developments for state wealth-transfer taxes in any state in which a client might be domiciled or own property at the time of his or her death."

Life insurance is valuable for estate planning, because it enlarges an estate, thereby providing money to pay estate taxes without diminishing the size of the estate. Kurlowicz said he doubts that many people who own life insurance for estate-planning purposes will cash in their policies. "If you terminate it before you know the final provisions [of estate-tax law], you're taking a risk you shouldn't be taking," he said. Some people might contemplate changing to an accumulation-type of investment if the exemption limits continue to rise as scheduled--from $1 million this year to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009, he said. Of course, the exemption would fall back to $1 million in 2011 and ensuing years if the estate tax returns, but Kurlowicz said he doubts Congress would allow the big exemption increases to happen without clarifying the ultimate result. Even if people hold on to their life policies, and the estate tax is eventually eliminated, the risk of continuing to pay for

the policy "is that your loved ones get a lot more, and that's not such a bad risk," he said.

Wealthy Clients

Gary Cook, an estate planner in Irving, Texas, said he doesn't expect to see the estate tax eliminated, except perhaps for the one scheduled year. "With the monetary demands the government has now, it will be looking for revenue streams," said Cook, director of financial services at McQueary Henry Bowles & Troy, a 76-year-old commercial insurance agency. "I'm estimating a family would be able to pass the first $4 million to $5 million estate-tax-free. Fortunately, we're in a marketplace of clients worth $10 million or more, so they still need planning and assistance."

Cook said he has seen a "resurgence" in estate planning now that clients have "figured out" that estate taxes probably won't go away. They are particularly interested now in leveraging life insurance through the use of trusts, which buy the life insurance, he said. Clients fund their trusts with the maximum allowable gift without incurring gift taxes--$11,000 this year, up from $10,000 previously. The trust borrows money to pay the premium, and the trust pays off the note when the insured dies. "By utilizing this strategy, we eliminate a lot of gifting issues," said Cook.

His wealthy clients also are showing interest in buying life insurance for foundations, Cook said. "It's a means for individuals through private placements or leveraged life insurance to fund family foundations or other foundations for very little expense," he said. The foundations his clients choose commonly benefit children's cancer centers, churches and other religious organizations.

Many of Cook's clients are looking to life insurance to fund the new capital-gains tax in 2010 created by the new carryover-basis rules. Currently, an inherited asset's cost basis is "stepped up" to the value at the time of the owner's death, but beginning in 2010, the cost basis will be the value of the asset at the time it was acquired. Unlike estate taxes, which must be paid within nine months of the deceased's death, the capital-gains tax becomes due in the year the beneficiary disposes of the asset.

But Cook said heirs of small-business owners still will face a liquidity need because much of the wealth is tied up in privately held stock. Not only is there less of a market for such stock, but there's often a fire sale, because the only people interested in acquiring the business are competitors. "We've seen circumstances like that discounted 60% to 70%," said Cook. The heirs of the owner of a closely held business potentially suffer the most without planning, he added.

Diane M. Pearson, a fee-only certified financial planner at Legend Financial Advisors in Pittsburgh, said the planned phaseout of estate taxes probably has increased estate planning at her firm, but not necessarily the use of life insurance, since the average net worth of her firm's clients is about $1.5 million. "Anyone with a net worth of $4 million or more still needs life insurance, and probably within an irrevocable life insurance trust," she said.

"Our clients don't believe the estate tax will go away," she said. "Those with net worth of $4 million and more will keep their insurance. Those with $3 million and less are not as worried about keeping insurance. They're not getting rid of it, but not as many are forming irrevocable life insurance trusts and putting insurance into them."

Pearson's focus since last spring has been to make sure her clients' estate plans are updated to reflect changes in the exemption amount and potential repeal of the estate tax. "That's especially important if we haven't looked at documents for 10 years or more," she said. "Everything has changed dramatically, especially the clients' net worths. People are carrying a lot of gain from that five-year bull market, even with the downturn that followed."

Balanced Assets

One of the biggest mistakes people make is to put so much of their assets into joint accounts. Married couples should ensure that their assets are balanced--with some assets in each spouse's name--so they can each take maximum advantage of the increasing estate-tax exemption and the generation-skipping trust tax-exemption amounts, she said.

She also is encouraging people to keep track of the basis of their assets, including capital improvements to real estate, to make it easier for executors to prove the basis of property in an estate. But Pearson admits to doubts that the planned capital-gains tax will ever take effect. "Due to the sunset provision after 2010, a majority of estate planners believe Congress will change the law before we get to 2010," she said. "The sunset provision will never occur, and we'll probably never get to 2010 with the estate tax gone away. We'll get to a point where we'll put a cap on this, probably a unified credit exemption at $2 million or $3 million."

If the capital-gains tax begins to look more likely, Pearson said clients could take steps to shift those assets out of their estates through gifting, charitable contributions or trust vehicles.

Phoenix Cos. is among several insurers over the past year to give buyers of estate-planning products some flexibility should the estate tax be repealed. Under Phoenix's "LifePlan" program, buyers of survivorship universal life and variable universal life insurance may increase--on their fifth, 10th and 15th anniversaries--their coverage without a medical exam, reduce their coverage without a surrender charge or exchange their policy for an annuity without a surrender charge. They also will be able to convert some of the death benefit into single-life coverage without a medical exam or surrender charge. Among other companies to offer similar options are Lincoln Life Insurance Co., Hartford, Conn., and Manulife Financial, Boston. John Hancock Life Insurance Co., Boston, and New York Life Insurance Co. also have launched products to address certain concerns about estate-tax changes.

Hartford Financial Services Group on April 1 became the most recent company to offer a free estate-tax repeal rider. Under terms of the rider, policyholders can surrender certain policies without charge if the federal estate tax disappears in 2011, and Hartford will pay a benefit equal to the policy's account value, less any indebtedness. The rider is available on Stag Variable Life Last Survivor Life II, Stag Protector Variable Universal Life, Stag Universal Life and Solution Last Survivor Universal Life.

Phoenix, however, has gone beyond tweaking its products under the strategic part of its LifePlan program. The company has created packages of strategies to help its producers address the accumulation, preservation and transfer needs of its high-net-worth clients. The strategies address family legacies, supplemental retirement plans, spousal lifetime support, business succession, retirement distributions and education funding for children and grandchildren. They also address providing for special-needs individuals, charitable funding and creation of trusts.

Most insurers help their producers address such needs, of course, but Gilotti said the difference in Phoenix's program is "the packaging aspect" and the materials around it. "They provide a template for a producer to follow," he said. "Without having something to follow, the nuances would be more difficult to grasp." He added that the company has been working collaboratively on the project for the past few years and that it is a process more than a product.

Using Annuities

Phoenix calls its latest strategy "Phoenix Max." It is designed to help people who have finished the asset-accumulation phase of life to use life insurance to preserve assets through an annuity. The idea is that gains in an annuity are taxable to an estate, so why not make use of the tax advantages to pay for life insurance while the owner is taking distributions? The life insurance ultimately provides heirs with death benefits free of income tax, and free of estate tax if the policy is in a proper kind of trust.

Gilotti said the company chose annuities as the funding source for the plan, because it sells through banks and broker-dealers, and there is a lot of money in those distribution outlets. The second reason is that there are factors in annuity income that make it beneficial for this approach. One is that annuitized streams of income are dependable and are paid on a regular basis, and insurers can set up automatic payments for the life product. Another is that unlike an interest payment, dividend or capital gain, a portion of every annuity payment is a return of principal already taxed. "That means it puts more spendable income into your pocket so you can use less of your asset on buying insurance, or buy more insurance," said Gilotti.

An annuity also offers a multitude of payout options, and a lifetime option is especially appropriate for purchase of permanent insurance. Other options might be useful for alimony or debt reduction, he said.

Phoenix also reasoned that financial advisers who sell annuities are licensed to sell life insurance, so it is natural to couple the two products, Gilotti said.

According to Gilotti, there is anecdotal evidence that the idea of packaging strategies and offering escape options on estate-planning products helped Phoenix to break the estate-planning paralysis that existed last year. "We're glad to have them, and our distribution partners are, too," he said.

The development of an estate-tax calculator also has helped, said Phoenix's Martin. Used by producers, the calculator is a spreadsheet that projects estate-tax liability under certain assumptions.

Liquidity Problems

Even if the federal estate tax is repealed, some people will continue to benefit from the liquidity and wealth replacement that life insurance can provide, Kurlowicz said in a recent paper, "Life Insurance and Estate Planning in the Post EGTRRA Environment." In addition to estate taxes that states may impose, large estates can bear substantial costs for executors, attorneys, accountants and appraisers--even for nonprobate assets. "Generally speaking, the larger the estate, the greater the complexity and need for costly professional help to settle the estate," he said. "One advantage of life insurance is that it avoids probate if it is paid to a named beneficiary."

Kurlowicz said liquidity problems can arise in many ways other than just trying to sell a closely held business. Wealthy individuals may own unproductive real estate that the family wishes to keep or expensive personal property, such as artwork, home furnishings, automobiles or other collectibles. Such assets may be unmarketable or very difficult to sell in the short time required to settle an estate, or they may be treasured items, Kurlowicz said.

In the business world, the need for buy-sell agreements would not be changed in the absence of an estate tax, he added.

In addition, life insurance could help to resolve unexpected dilemmas that families may be saddled with due to the estate-tax phaseout law. These choices may center on when a family member ought to die.

"Will family members keep the estate owner on life support until 2009 or 2010?" Kurlowicz asked in his paper. "Will the family members terminate life support prior to 2011? Will attorneys develop Advance Medical Directives (living wills) or Health Care Power of Attorney forms to permit decisions to be made based on tax consequences? Will the media have a field day with the obvious public-policy nightmare this law creates as time grows closer to the critical dates? I would guess that all of these circumstances will occur to some degree."

Under current law, a large estate would save $675,000 if the client alive in 2008 survives to Jan. 1, 2009, Kurlowicz calculated. A larger savings would result if the wealthy individual lived to 2010, when the estate tax is to disappear, and the law's sunset provision "would seem to provide a tax incentive" for the person to die before 2011, when the 55% rate is to return along with a unified-credit equivalent of $1 million.

Kurlowicz added that he and other experts do not expect the law to survive--there's too much uncertainty.

Estate-Planning Factors to Consider

-- How large is the client's estate?

-- What is the likelihood that the client and/or the client's spouse will survive to the date of the anticipated repeal?

-- What is the potential exposure to capital gains or income taxes if the basis step-up is repealed?

-- Are there special items in the estate (such as business interest, real estate or collectibles) that are targeted for specific heirs?

-- What is the possibility of significant state inheritance or estate taxes where the client is domiciled or owns property?

-- Will the estate be required to pay significant probate or other administrative expenses?

Source: Ted Kurlowicz, The American College