There was a time when rich people were able to preserve family wealth by creating multi-generation trusts. These vehicles, safe from estate taxes, allowed vast sums of money to accumulate and enabled families to become powerful dynasties.
This scenario changed when the Tax Reform Act of 1986 introduced the generation-skipping transfer (GST) tax. Under this piece of legislation, money that was passed on to grandchildren or great-grandchildren would be taxed at 55 percent. The intention of lawmakers was to make it impossible for the super-rich to avoid estate taxes by designating money that would pass to their grandchildren.
The GST tax is assessed on what is left after estate taxes have been paid. Although it is not popular with the rich, Congress did allow for a $1 million exemption. A couple would be able to leave a total of $2 million, tax-free, to their grandchildren. As a result of the new tax law signed on June 7, 2001, by President George W. Bush, this exemption will now increase further, in stages, until 2009. And in 2010, the estate tax itself will end.
But the long-term picture remains unclear. The new tax law expires on January 1, 2011. And the expectations are that the old rules and limits will return.
Some critics think that the new law will fail to deliver on its promises before reverting to the status quo. If this happens, the only people who will be able to take advantage of its provisions will be those “lucky” enough to die before January 1, 2011. But most people plan to live for some time beyond this deadline. And with life expectancies continuing to increase, even the elderly can look forward to being around for decades to come.
New law unpopular with
The changes in the law have not won the hearts of financial advisors. “We are seeing declining tax over the next nine to 10 years, which is good,” notes Stanley T. Carmichael, CLU, AEP, an independent advisor and a principal in Carmichael Associates, Thousand Oaks, Calif. “But then it [the estate tax] could be repealed or resurrected. And that’s difficult to plan for.”
Gerald R. Veydt, CLU, ChFC, RIA, AEP, REBC, RHU, president of Veydt/King & Co, Inc., of Towson, Md., says he is “terribly unhappy” with the law. “People can’t plan,” he says. “How do they plan?”
Douglas K. Hyer, CLU, ChFC, RFC, CSA, CFS, AEP, MSFS, president of Asset Advisory Services, Inc., in Great Neck, N.Y., adds that a 65-year-old client could easily live for another 30 years. And when the estate tax returns in 2011, he says, “we go right back to square one.”
“The tax code just keeps getting bigger and bigger,” Hyer says. “You ask five guys like me today the same question, and we will have five different answers. If we’re the smart guys who know what we’re doing, how can the public figure this stuff out?”
Ronald F. Karabian, CLU, AEP, a New York Life agent in Fresno, Calif., is also dissatisfied with the changes. “Before you tear a fence down,” he says, “you’d better find out why it was built.”
It’s not just advisors who are unhappy with the new provisions. Karabian says that the consensus among estate planning attorneys is that “this thing is not going to hold water. And that’s the reason why they [Congress] put a 10-year limit on it. They are going to see how it goes.”
Estate planning is only part of overall financial planning.
The overall picture on generation skipping is further clouded by the possibility of shifts in the political landscape. Not only will there be two presidential elections over the next decade, but overall control of both houses of Congress could shift to the Democrats as well. Meanwhile, politicians will be seeking to raise revenues from whatever source they can. For example, advisors are alert to the possibility of increases in the capital gains tax.
The inheritance tax
Even before the new tax law was passed, the inheritance tax was always controversial and many people wanted the tax repealed. Advocates of repeal say that people should be able to pass their wealth on to their children without being “bled” by estate taxes. They argue that many family-owned businesses and farms face liquidation just to raise the money to pay estate taxes.
Supporters of the inheritance tax argue that it is necessary to rebalance wealth and to prevent the emergence of a super-rich, self-perpetuating aristocracy that would exercise a disproportionate, and ultimately destabilizing, influence on American life. They also point out that the existence of the estate tax has been a major factor in the decision of wealthy people to donate to charities. Supporters of the inheritance tax include the financier George Soros and the investment guru Warren Buffett. Last year, President Bill Clinton vetoed estate tax repeal legislation presented by the Republican-controlled Congress.
Veydt suggests that the shape of the new law was influenced by the fears of the politicians that the Social Security system will come under unsustainable financial pressure in the future. There were also concerns about the cost of long-term care for an aging American population. “The politicians understand that the fiscal health of this country is really going to be at risk in the next 50 years,” he adds.
He believes that the government should either have repealed the estate tax or increased the exemption to give relief to people who have been affected by “bracket creep.” For instance, a $5 million unified credit would have been reasonable. Such a limit would have allowed a couple who is worth $10 million to leave everything to their children. “But to do what they did was really worse than doing nothing at all,” he says.
According to Veydt, the law could have unintended consequences for people whose wills stipulate that payments into trusts set up for the benefit of heirs be pegged to the unified credit. The gradual increase in this credit during the next 10 years would mean that such heirs would get money that might have been intended for a spouse. He advises clients in this situation to rewrite their wills.
More term insurance?
Veydt believes the uncertainty created by the new law will cause many people to buy term insurance. “If the estate tax goes away,” he says, “they’ve temporarily met their need. And if it comes back, they’re going to simply convert the policy to a permanent form.”
The legislation has given a boost to the overall marketing efforts of financial planners.
Carmichael endorses this strategy and notes that the policy can either be converted or dropped at the end of the period. “The product was available,” he says. “We have just started to use it on a more intensive basis, with more purpose.” Carmichael would have been pleased to see “a little faster response” to the new situation from the insurance industry. “But we, as independent advisors, are picking and choosing from what is available,” he says.
Hyer thinks that Congress could have provided more stability by declaring, in any legislation it passed, that there be no changes for 15 to 20 years. Also, a flat tax would have made sense.
Seymour Geller, CLU, ChFC, CFP, AEP, a New York City-based Guardian agent, is confident that the estate tax will return after the prescribed period expires. He points to the long history of the inheritance tax. “It goes back to English common law,” he says, “where whatever you own belongs to the state.”
Under the new law, advisors will have to use their planning skills to help their clients reduce taxes. For instance, the law allows a GST trust to be established in the name of the beneficiary, who will not have to pay taxes upon receipt of the money. The grantor can impose stipulations, such as the date the money will become available to the heir.
Trusts offer a number of advantages. They can shield money from creditors, and trustees can be appointed to protect the interests of immature or inexperienced recipients.
New ways of doing business
The changes brought on by the law have affected the way Geller’s firm operates, forcing it to consider a number of planning options. He is, for instance, trying to redirect his thinking toward the use of a lower premium on second-to-die policies to provide larger out-of-estate benefits for heirs. He is also advising clients to transfer assets to charities to generate current deductions.
Geller, who has seen dot.com fortunes lost as quickly as they were made, has been taking careful note of the changes that have occurred this year in the stock market. He has responded to the uncertainty surrounding equities by steering clients toward tax-deferred annuities. “People seem to like that,” he notes. “It’s a way to say, ‘Let’s at least guarantee some of the assets that you’ve accumulated and make sure you have that for your own retirement and for you to pass it on to your children.’”
The problems caused by the new estate tax law are also affecting the strategies of insurance companies. Geller cites insurers’ greater reliance on pension planning and their use of defined benefits for older people. There is also some thought being given to the passage of assets through IRAs.
People are confused by the changes that have taken place. “They’re getting bad advice,” he says, “and they actually don’t know what to do. So it’s a question of trying to redefine what their objectives are and how we can best accomplish them.”
Like other advisors, Geller is unhappy with the law as it stands. “I can appreciate the increase of the unified credit,” he says. “But the elimination of the estate tax is one thing that I don’t like.”
Karabian says that insurance can be used to cover capital-gains problems that may eventually arise. Insurance can also pay the tax on any type of qualified plan, whether it is a pension, a 401(k) or an Individual Retirement Account. He notes that there are a lot of professionals who have significant IRAs and big 401(k) plans.
Veydt performs an inventory of a new client’s assets, complete with projections. One goal of this exercise is to show wealthy clients how they might rearrange some of their holdings to reduce the value of the taxable estate. This is done with an eye on liquidity needs. “Insurance,” Veydt says, “is a very useful way to leverage your credit to be able to pay your taxes.” He also encourages grandparents to buy insurance as a shelter against the GST tax because that tends to leverage the amount payable to the grandchild.
Hyer notes that in some cases, a simple will may replace complicated, generation-skipping arrangements. John F. Glass, CLU, ChFC, AEP, MSFS, president of Glass Financial, in Phoenix, Ariz., is also critical of the new tax law. Glass does not like the idea that the higher exemptions are likely to be eliminated after 10 years. But he says that all of the legislative activity has at least had the effect of raising the profile of estate planning among people who had delayed doing something about it.
Opportunities for advisors
Karabian also senses opportunities from changes in the law. He sent a letter to his major clients outlining those changes, which gave him an opening to discuss their individual circumstances. He works closely with his clients’ lawyers and accountants. “I’m not licensed to make legal mistakes,” he says. “And I’m not licensed to make accounting mistakes.”
Karabian stresses the importance of giving good advice. He notes that the million-dollar gift allowed in generation skipping is a one-time sum divided by as many grandchildren as the giver might wish to include. People who exceed the limit could find themselves in trouble with tax authorities.
The uncertainty of the new law underscores the importance of providing the best advice to prospects and clients.
Advice is critical
As advisors counsel their clients, they must realize that the advice of lawyers and accountants is important, according to Glass. But he avoids CPAs and lawyers who sell life insurance and securities, arguing that a client is best served by a specialist instead of a generalist. And he suggests that a CPA who prepares a client’s taxes while selling securities could be involved in a conflict of interest.
Hyer says that generation skipping is about halfway down the list of topics when he is talking to a wealthy client. “In 1974, when I got my CLU designation, I don’t think we even thought about multi-generational planning,” he adds.
His first objective is to get a sense of the client’s goals and concerns and address questions like: Is the client worried about taxes? Does the client want to look after children or grandchildren or does he want to enjoy life right now? Hyer will also check to see that the right insurance protections are in place.
He argues that estate planning is only part of overall financial planning and stresses the importance, for instance, of acquiring long-term care insurance and liability coverage in line with one’s assets. A $3-million asset base can disappear quickly if one or both spouses are seriously ill or if they are hit by a large liability lawsuit.
For many individuals, the prospect of a much longer life span than previously anticipated might also raise questions about the wisdom of making large gifts to children and grandchildren. Who helps out, for instance, if a great-great grandmother, having been generous with her money, becomes destitute at 93 through a series of misfortunes?
Hyer says that people with more than $3 million in assets should consider whether they have any children with special problems, either physical or psychological. In financial matters, children should not be treated equally. For example, a successful surgeon will need less in the way of an inheritance than a sibling who is a struggling musician and could do with some financial help. What’s more, the surgeon is likely to agree.
He adds that it can be difficult to convince mothers that more money should be given to the child who needs more. Fathers, on the other hand, tend to be more practical in matters of death and planning.
Glass sees evidence that many wealthy people are “getting very charitably inclined” partly because they fear that too much money would be bad for their children and grandchildren. He cites the example of Microsoft’s founder Bill Gates, who plans to give away most of his money. “I think you’re going to see more and more of that,” he adds.
He tries to convey this message to his clients. “We’re dealing with lives,” he says. “Finance is just one part of it. How do you structure it in a way that you have a good person at the other end? Money doesn’t always do that.”
Impact of societal
In putting generation-skipping plans together, advisors must also take account of changes in American society. Karabian says that the high divorce rate calls for safeguards against the co-mingling of assets that are passed on. This means that a recipient grandchild should have his or her own will and that property should be kept separate from that of the spouse. “If there’s one bit of co-mingling—one dollar—there’s going to be a community-property problem, where half of it goes away in the event of a divorce.”
And longer life expectancies are forcing advisors and insurers to reach for new actuarial charts. The Internal Revenue Service uses 1990 tables, which have since become obsolete. The agency figures that a 65-year-old man can expect to live to 82, and a woman can expect to live to 86. While insurance companies will not reveal their projections, financial advisors are now using age 100 as the target. Advisors are willing to consider the possibility that women will live up to age 105.
New rules offer opportunities
The new generation-skipping rules may not be popular with either advisors or their wealthy clients. But they do offer opportunities. By highlighting a difficult and complicated area, the legislation has boosted the overall marketing efforts of financial advisors. And the uncertainty and the temporary nature of the law underscore the importance of providing the best possible advice to prospects and clients.
Robert O’Connor is a London-based freelance writer and a frequent contributor to Advisor Today.