Evaluating Planning Options in a Down Economy
A Low Interest Rate Environment Increases the Desirability of Certain Planning Techniques
As the economy experiences a historic downturn and devaluation of real estate and investment securities, many estate planners have discussed how the timing is ripe to take advantage of the current market conditions. In addition to depressed asset valuations, the Federal Reserve continues to keep interest rates at historically low levels. As a result, individuals are in a position to leverage the transfer of assets to the next generation with the anticipation that the values will rebound as the economy turns around.
The historically low interest rates make the following planning techniques more attractive:
First, installment sales to intentionally defective irrevocable trusts (IDITs): When assets are sold to an IDIT in exchange for an installment note, the interest rate on the note is based upon the appropriate AFR in effect at the time the note is created. The lower the AFR used, the greater the likelihood that rate of return on the assets owned by the IDIT will outperform the interest rate charged. Obviously the effectiveness of this technique is dependent upon the asset appreciating at a greater rate than the applicable rate. Therefore, it is important to carefully evaluate the soundness of the assets subject to the sale.
Secondly, intra-family loan arrangements: When funds are loaned by one family member to another, the adequacy of the interest rate charged on the loan is determined by the appropriate AFR. The lower the AFR used, the greater the probability that the rate earned on the loaned money (assuming it is invested) will outperform the interest rate on the loan. Furthermore, it allows such transactions to occur at low interest rates (typically desirable among family members) without the threat of imputed gifts between the parties.
The 7520 Rate has also remained low (1.4% for January 2012) and continues to make estate freezing techniques such as grantor retained annuity and unitrusts, along with charitable lead trusts, more attractive. This is because the lower rate results in a larger present value for the retained interest and a smaller value for the gift transferred to the trust.
In addition to favorable interest rates and depressed values, we are looking at a potential limitation on the use of leveraged gifts. Discounting the value of certain types of assets by 15%-20% for lack of marketability and lack of control is common place, and sometimes these discounts push 50% under ideal conditions. Congress, however, has been looking closely at this practice as a result of several family limited partnership cases in the recent pass that has the IRS crying foul with respect to this practice. For instance, House bill H.R. 436, introduced in early 2009, attempted to eliminate the minority discount for transfers in which the transferee does not have control of the entity, if the transferee and members of his or her family have control of the entity. The bill also sought to eliminate discounts for transfers of entities that hold non-business assets (any asset not used in the active conduct of one or more trades or business). The days of FLPs holding solely investment assets are in jeopardy. Any such legislation will likely be tied to overall estate tax reform and will continue to be monitored.
LIQUIDITY THROUGH LIFE INSURANCE
Unfortunately, as most estate planners can attest to, clients are not always so willing to part with their assets. And in this current climate, this becomes more so as people rely on these assets to live. Therefore, many are looking to increase their liquidity as opposed to reducing it further.
An individual should always consider evaluating his or her life insurance benefits every few years, even more so during economic conditions like those currently upon us. With the depressed asset values and the increase in the federal estate tax exclusion amount to $5 million in 2012, recommending additional insurance may appear counterintuitive as fewer estates become subject to the federal tax. But, given the relatively low state estate tax thresholds that remain in Rhode Island and Massachusetts ($892,865 and $1 million, respectively), the need for post-death liquidity may actually be greater than before. Despite depressed asset values, many still have net taxable estates comprised primarily of illiquid assets (e.g. real estate, closed corporation, etc.) with an aggregate value in excess of these thresholds.
While providing for the payment of estate taxes can be the primary focus with clients, non-tax issues still exist and become more paramount. For example, small business owners are always encouraged to have adequate insurance, especially when he or she is not the sole shareholder. Predictably this gets overlooked many times, especially if the business owner has significant liquid assets outside the business. During economic downturns, however, the need to supplement the non-business assets increases as consumer confidence wanes.
It is not only important to review the amount of existing policies, but the type of coverage as well. For example, if the primary purpose of the life insurance was for payment of estate taxes, then the insurance in place may consist of a second to die policy. In such a case, there was not a concern with providing the surviving spouse with extra liquidity. Now, however, couples may wish to convert to or add individual policy coverage to provide for the surviving spouse.
The increase in the estate tax exclusion was also accompanied by an increase in the annual gift exclusion amount from $12,000 to $13,000 per donee. Therefore, individuals with existing life insurance trusts can increase crummey exclusion gifts to the trust to cover any increase in premiums associated with additional coverage.
It is easy to understand in the current economy how a person is apt to focus more on current concerns than those in the future. As such, evaluating insurance needs will tend to slip down the list of priorities. But, as liquidity concerns continue to increase, the need to evaluate and obtain the proper insurance coverage is more of an immediate concern than one might think.