Understandably, they will now expect their planners to offer less complexity and lower costs than they had to endure in the past.
So what do you offer a client no longer threatened by the federal estate tax in this new normal of estate planning? Consider the new Swiss Army knife of planning: the multipurpose irrevocable life insurance trust, or MILIT.
Many wealthy clients already have irrevocable life insurance trusts, or ILITs, to hold life insurance. An ILIT protects life insurance proceeds for a surviving spouse and minor children, prevents creditors from reaching proceeds and has other benefits. Regardless of the estate-tax machinations in Washington, ILITs will remain a common estate planning tool.
But this old stalwart needs a makeover to become the keystone of planning in the new era. The bottom line will be to offer clients a single multipurpose trust to handle many planning goals.
STATE ESTATE TAXES
If your clients live in a state that has a tax exemption that is lower than the federal amount, they may face a significant state estate tax. Nevertheless, the potential savings in state estate tax and possibly an inheritance tax pale in comparison with what clients might have faced if the federal estate-tax threshold had been lowered, and clients may have very little appetite for a highly complex plan of action.
The combination of a 20% capital gains rate, the 3.8% Medicare tax on passive income, the phaseout of exemptions and itemized deductions for high-income taxpayers and possibly a state capital gains tax could push the marginal capital gains rate to 28%. That can be greater than the state estate tax rate.
So if you take the traditional approach and fund a bypass trust on the death of the first spouse, rather than relying on portability (using a simple outright bequest and having the surviving spouse use the first-to-die spouse's unused exemption), you may save state estate taxes on the second death.
But the assets in the bypass trust won't get a step-up in basis - an increase in the amount on which the gain is calculated for income tax purposes - to the fair value of the property at the time of the death. That could cost the heirs more.
Connecticut is the only state that has a gift tax. So for residents of the other 49 states, giving away assets while you are alive can minimize or even avoid the state estate tax.
Here's one example of some of the factors that come into play: Consider clients who live in a state that has an estate-tax exemption of only $1 million. They have a family net worth of $6 million as well as a $2 million term life insurance policy. With the new exemption and portability, there is no worry about federal estate tax. But the life insurance should probably go into an ILIT just to protect such a large sum.
Upon death, the traditional plan would be to finance a bypass trust on the first death with $1 million, so no state estate tax would be incurred. The balance of the estate passes to the surviving spouse directly or in a trust qualifying for the marital deduction. On the second death, there is a second $1 million state exemption. But that leaves $4 million (assuming the insurance is in the trust or lapsed) subject to state estate tax. That hurts, but not as badly as the combined federal and state estate tax used to hurt.
For most wealthy taxpayers under the federal exemption, the new higher income tax rates are actually more of a worry than estate taxes, given the large permanent, inflation-adjusted exemption. Seeking income tax shelter inside a permanent insurance policy is nothing new, but the numbers should look better for those clients in the highest income tax bracket.
So perhaps the standard term insurance plan and ILIT of old might give way to an ILIT holding a permanent life insurance policy, the cash value of which the client might access during retirement.
Spousal lifetime access trusts, or SLATs, have been a preferred approach, and grew especially popular in 2012, when many wealthy clients stormed their planners' offices late in the year seeking estate planning solace. That is because a SLAT provides a mechanism for a client to grow assets outside their estate, but in a manner that the family can access. A common SLAT might designate the spouse and all descendants as beneficiaries so expenses and needs of the spouse and heirs could all be paid out of the trust.