Post-EGTRRA life insurance planning: the Economic Growth and Tax Relief Reconciliation Act of 2001 promises repeal of the estate tax in 2010, but will it ever come to pass?

• Author: Esperti, Robert A.

Rather than resolving the question of the estate tax's future, the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) created uncertainty, by slowly phasing out the tax, then repealing it only for one year. This raises doubts about whether repeal will actually occur. As a result, there is a greater opportunity to use life insurance in estate and wealth strategies planning. (1)

Estate Tax Provisions

Rate Reductions

EGTRRA Sections 501(a) and 511(c) reduce the estate tax rate slowly--down to 45% in 2007-2009--and eliminate it entirely in 2010. (2) At the same time, the exemption equivalent amount (now the applicable exclusion amount)--the amount that can pass free from estate tax--is scheduled to increase as follows, under EGTRRA Section 521 (a):

Year Amount 2002 and 2003 $1 million 2004 and 2005 $1.5 million 2006-2008 $2 million 2009 $3.5 [million.sup.3] 2010 unlimited 2011 and thereafter $1 [million.sup.4] Exclusion Increase

EGTRRA Section 521(b) increased the gift tax exclusion to $1 million in 2002; it will remain $1 million through 2010 (and thereafter indexed for inflation), (5) Arguably, Congress retained the $1 million exclusion, even after eliminating the estate tax, to prevent taxpayers from avoiding income tax by shifting assets to individuals in lower tax brackets and to those with no state income tax. Or perhaps, not convinced that estate tax repeal will take effect, Congress limited the gift tax exclusion to $1 million, to discourage lifetime transfers that would otherwise avoid the estate tax at death. (6)

Commentators have suggested that it is unlikely that the current law will remain in effect long enough for full repeal to take effect. Total estate tax repeal may never occur, given the tremendous strain baby boomers will place on Social Security and Medicare in 2010 and beyond. (7) According to the Joint Committee on Taxation, the one-year revenue loss resulting from the EGTRRA's estate and generation-skipping transfer tax provisions will approach $55 billion on total repeal in 2010. (8) Recent budget revisions from the White House and the Office of Management and Budget further support the position that total repeal is unrealistic.

Carryover Basis at Death

Under the current system (subject to some exceptions), assets owned at death receive a basis step-up to fair market value (FMV) at a decedent's date of death (DOD), under Sec. 1014(a).

Example 1: X died in 2002 owning a painting he purchased for $10,000 in 1993, worth $10,000,000 at his DOD. Y inherited the painting and under Sec. 1014(a), took a $10,000,000 FMV basis. Y sells the painting in 2003 for $10,000,010, and reports just $10 of capital gain.

Under the EGTRRA, in 2010, after estate tax repeal, a beneficiary inherits property with an adjusted basis equal to the lesser of the decedent's basis or the asset's FMV on the DOD. (9) To offset the loss of the basis step-up, EGTRRA Section 542 provides that an executor (or other person responsible for the decedent's property) (10) may allocate a $1.3 million "aggregate basis increase" on an asset-by-asset basis up to a particular asset's FMV at the DOD. (11) Under new Sec. 1022(c), assets left to a spouse may receive an additional $3 million "spousal property basis increase" (also asset-by-asset, up to the particular asset's FMV at the DOD).

However, only assets the decedent owned at death are eligible for the aggregate basis increase or the spousal property basis increase. (12) Significantly, unless affirmatively proved otherwise, the Service presumes under Regs. Sec. 1.1015-1(a)(3) that an asset's basis is its approximate FMV on the date acquired by its last owner. Thus, accurate record-keeping is critical.

Need for Life Insurance

Life insurance provides numerous estate planning benefits. Because the estate tax's future is unclear, advisers can use life insurance to help clients plan for increasing exemption amounts, estate tax repeal and institution of modified carryover basis.

Increasing Exemption Amounts

As was discussed, the applicable exclusion amount is scheduled to increase to $3.5 million in 2009, be unlimited in 2010, then revert back to $1 million in 2011. Except in the unusual circumstance of deathbed planning, a tax adviser cannot know when a client will die. As a result, the adviser cannot determine in advance the extent to which a client's estate will be subject to estate tax at death (if at all) or whether the client's heirs will be subject to capital-gain tax as a result of the institution of modified carryover basis. Life insurance provides the only certainty--and liquidity--in either case, and provides the only combination of full basis step-up and tax-deferred or tax-free growth.

Estate Tax Repeal

If a client is subject to estate tax, use of an irrevocable life insurance trust (ILIT) could remove significant assets from the client's estate while providing the liquidity to pay estate tax. The...