|
THE
ADVANTAGE OF USING IRREVOCABLE LIFE INSURANCE TRUSTS (ILIT)
 This Irrevocable
Life Insurance Trust can be an important estate planning tools.
This trust is like any other trust. It is usually
irrevocable and is permitted to buy insurance as an investment. Why do you
need a trust to hold life insurance? Because life insurance is not
tax-free. If you owned the policy, the proceeds will be taxed in your
estate. If your spouse was the beneficiary of the life insurance policy
then there would be no tax because of the marital deduction. However, when
the second spouse dies, 50% of the remaining proceeds could be paid in
estate tax. A life insurance trust is designed to minimize these taxes.
To avoid estate taxes, the estate owner/insured has to
avoid all "incidents of ownership" in life insurance policy. The
insured should not own the policy outright. The following types of
"incidents of ownership" could be detrimental to the trust:
- The right to
designate or change beneficiaries;
- The power to
prevent a change in beneficiary;
- The option to
repurchase insurance from an assignee in some instances;
- The right to
borrow against the policy.
The Problem with Estate Taxation:
Most people purchase life insurance to provide
financial security to their surviving spouse and children. Life insurance
is not tax free. It is income tax free, but it is not estate tax free. The
proceeds are included in a decedent’s gross estate for estate tax
purposes. Insurance proceeds are subject to estate tax, as much as 50% of
the insurance proceeds can end up going to the government rather than
benefitting the intended family members. Before examining how the
irrevocable life insurance trust shelters insurance proceeds from taxation,
it is helpful to understand the two primary reasons insurance proceeds are
subject to estate tax in the first place. Most people are surprised to
learn that death proceeds of their life insurance are subject to federal
estate taxation when they die, if they own the policy. There seems to be a
common misconception that life insurance escapes estate taxes and passes to
loved ones in tact. One contributing factor to this confusion may be that a
strong selling point for life insurance is that your beneficiaries receive
the death benefit "income tax free". Unfortunately, many
well-intentioned insurance salesmen, and consumers too, shorten this to
"tax free". While it is true that life insurance proceeds
normally pass to beneficiaries "income tax free", it is equally
true that life insurance proceeds normally do not escape federal
"estate (death)tax".
1. Ownership: First, under current tax
law, insurance proceeds are subject to
estate taxation if the insurance policy is owned by the
insured at the time of his or her death regardless of who the beneficiaries
are. If a third party owns the policy (including an irrevocable life
insurance trust), the proceeds escape taxation so long as the surviving
spouse is not named as the beneficiary.
2. Spousal Beneficiary Problem: Second,
if the surviving spouse is named as the
primary beneficiary under the policy, the proceeds are
not immediately taxed due to the unlimited estate tax marital deduction,
however, they are ultimately subject to estate tax at the spouse’s
death, again diminishing the amount available to benefit the children and
other family members.
Both of the above problems are easily solved by the
use of an ILIT.
Irrevocable Life Insurance Trust:
Establishing the Trust: The
irrevocable life insurance trust (ILIT) is a legal entity separate and
apart from the person who creates it (called the "settlor"). It
is created by signing a "Trust Agreement" where the settlor
irrevocably transfers property (i.e. cash or an existing insurance policy)
to a third person called the "trustee" (usually the
settlor’s spouse, or a family member) who holds that property for the
benefit of certain named "beneficiaries" (i.e. the
settlor’s spouse, children, grandchildren, etc.). In the case of an
ILIT, the trustee will either hold the transferred insurance policy or, if
cash is transferred to the trust, use the cash to purchase a policy on the
life of the settlor. In both cases, the policy will name the trust as the
beneficiary which will ultimately collect the insurance proceeds upon the
settlor’s death.
If cash is transferred to the trust and the trust buys
new insurance policies, the insurance proceeds are immediately sheltered
from estate taxation. If, on the other hand, the settlor already owns
existing insurance policies and transfers them to the ILIT, the settlor
must survive for 3 years after putting the policies into the trust before
the insurance proceeds escape estate taxation. For this reason, it is best
to have the ILIT buy new policies whenever possible.
Making Premium Payments:
As annual premiums come due, the settlor must transfer
enough money to the trust to enable the trustee to make the premium
payment. This annual contribution to the trust is considered a gift to the
trust’s beneficiaries and can be exempt from tax under the annual
gift tax exclusion. This is achieved with the use of a short term withdrawal
power known as a Crummey power. The Crummey power provides the
beneficiaries of the trust (ie settlor’s spouse, children, and
grandchildren (if any), a short period of time (ie 30 days) during which
they can withdraw the annual premium contributed to the trust. After the 30
days are over, the trustee is free to use those funds to pay the insurance
premium. Each year similar gifts are made to the trust. Although the tax
laws normally allow you to give up to $10,000 tax free each year to an
individual, complicated tax rules limit the tax exempt gift to each
beneficiary of an irrevocable insurance trust having a Crummey power.
Generally, you can only give each Crummey beneficiary the greater of $5,000
per year or 5% of the value of the trust principal. Therefore, if the
annual insurance premium is $15,000, you need at least 3 trust
beneficiaries to avoid gift tax on the contribution of annual premium
deposit to the trust. If the insurance premium exceeds the above
limitation, additional language called a "hanging power" can be
added to the trust document to increase the amount of the Crummey gifts to
maximum annual gift of $10,000 per individual. The IRS does not look
favorably at the us of "hanging Crummey powers" so caution
advises against this approach unless absolutely necessary.
Note that all transfers of property to the trust are
irrevocable and that the settlor cannot compel the return of any
transferred assets. The trust can empower a third person to direct the
trustee to liquidate the trust and distribute the assets to persons other
than the settlor.
After the Settlor’s Death:
Upon the death of the settlor, the ILIT collects the
death benefit under the insurance policy and the trustee then invests the
insurance proceeds (called the "trust principal"). The trust
agreement provides that the trust must pay to the surviving spouse (i) all
of the income generated by the trust principal and (ii) so much of the
trust principal necessary to pay for his or health care, education,
support, and maintenance in his or her accustomed style of living. Despite
the fact that the surviving spouse has use of the insurance proceeds, the
trust is structured to keep the proceeds out of his or her estate and,
therefore, sheltered from estate tax. Upon the surviving spouse’s
death, the trust can distribute the proceeds outright to children,
grandchildren, or other named beneficiaries, or retain the trust assets and
continue to hold them for the benefit of those beneficiaries in accordance
with the settlor’s instructions (ie assets will only be distributed
to children after they reach a specified age).
ILIT Offers Solutions to Both Estate Tax Problems:
As stated above, both the Ownership problem and the
Spousal Beneficiary problem are easily solved with the use of an ILIT.
1. Ownership Problem: Because
the ILIT is an entity separate and distinct from the settlor, when the
settlor dies he or she does not own the policy. Therefore, the tax laws
that require estate taxation of insurance owned by the insured will not
apply.
2. Spousal Beneficiary Problem: As
explained above, the ILIT is structured to provide for the settlor’s
spouse without causing the proceeds to be included in his or her estate.
Therefore, upon the death of the surviving spouse, the full trust principal
(including any appreciation) passes to the beneficiaries without being
diminished by taxation.
By using the ILIT, all proceeds of any insurance
policy can pass to your spouse, children, grandchildren or other named
beneficiaries completely free of taxation (both income and estate).
Remember that this is in addition to the $3 million (or 2x the federal tax
exemption amount) you can otherwise shelter by establishing a basic estate
plan to take advantage of both spouse’s unified credit equivalent or
federal tax exemption amount.
FAQs About ILITs (Irrevocable Life Insurance Trusts)
Can I Change My Mind: The ILIT
is an "irrevocable" trust. You cannot change its terms after it
is established. The IRS looks for "incidents of ownership" to see
if your ILIT is valid. If you retain any "incidents of ownership"
the ILIT will most likely fail. The ability to "change your mind"
(revoke or amend) is an incident of ownership.
How Much Control Can I Exert: As
stated, the IRS looks for what it calls "incidents of ownership",
if it decides it would like to pull the insurance back into your estate for
death tax purposes. Other incidents of ownership which will cause life
insurance death proceeds to be included in your taxable estate when you die
are the right to borrow the cash value, the right to change the
beneficiaries, and the right to change how the proceeds are ultimately
distributed to the beneficiaries.
Who Can Be the Trustees: You
cannot serve as trustee of your ILIT and in many cases it is not a good
idea to have your spouse serve as trustee either. The trustee can be almost
anyone else, such as a parent, sibling, adult child, bank or trust company.
Who Can Be Beneficiaries of My ILIT: You
cannot be a beneficiary of the trust, but your spouse and children can be
(and usually are) beneficiaries. Further, the ILIT should not be payable to
your estate or to your revocable living trust. Your ability during your
lifetime to change your will or trust would result in your ability to
change the beneficial enjoyment of the insurance proceeds. That would pull
the policy back into your taxable estate. Often the ILIT parallels the
provisions of your other estate planning documents regarding beneficiaries,
although there is no legal requirement for the ILIT to do so.
Can I Transfer My Existing Policies to My ILIT: If
existing policies are contributed to your ILIT, the death proceeds will be
drawn back into your taxable estate if you die within three years of the
completed gift. For that reason, it is sometimes advisable to obtain a new
policy, if you are insurable. If an existing policy is transferred to the
trust, the cash value (technically the terminal reserve value) of the
policy on the date of transfer constitutes a gift. This too, can create a
problem. There are usually ways to work around this, but you should speak
to your advisors about it prior to any transfer being made. Finally, the
transfer of an existing policy can trigger a taxable event if policy loans
exceed the total premiums paid.
Is My Annual Transfer to the ILIT for Premiums Subject
to Gift Taxes: The usual approach is for you to transfer
funds to the trust each year to be used to pay the premium on the life
insurance. Your contributions to the ILIT represent gifts. As you are
probably aware, you may give $10,000 per year to as many different
recipients as you wish without incurring a gift tax. However, this
exclusion is only available to gifts of a present interest. Gifts to a
trust generally do not qualify as a gift of a present interest, because the
beneficiaries of the trust do not get the immediate use and benefit of the
property.
To avoid this limitation, your ILIT will provide that
each beneficiary has the right to withdraw his/her proportionate share of
your annual contributions to the trust for a limited period of time after
each contribution is made. Usually the trust agreement provides that after
a contribution is made each beneficiary will be notified of his/her right
of withdrawal. After the expiration of the withdrawal period (usually 30 -
60 days) the trustee can use the contribution to pay the premium on the
life insurance policy.
What Happens When I Die: When you
die, the trustee receives the death benefit from the life insurance policy.
These proceeds can then be distributed to your family, held in trust, or
used to purchase assets from your estate or from your revocable living
trust.
The last option would be important if your estate had
insufficient liquid assets to pay estate taxes. The federal estate tax on
your estate is due nine months after the date of death and the amounts can
be staggering. For instance, on a five million dollar taxable estate, the
estate taxes would be over two million dollars. Those with large estates
often do not have that much cash or liquid assets which could readily be
converted to cash in nine months. The need to pay estate taxes has caused
many a farm, family business, or major real estate holding to be sold at
discounted prices to pay the estate tax.
Life insurance can provide the money needed to pay the
estate tax. By having the policy purchased and held in an ILIT, the
proceeds can be used to provide the needed liquidity for your estate and
yet not compound the estate tax problem by being included in your taxable
estate.
Married couples may wish to consider using a
"second to die" policy which pays the death benefit only after
both spouses are deceased. That is usually the exact time, that the
proceeds are needed to pay the estate taxes. Because no death benefit is
paid on the first death, the premium is usually much lower than purchasing
a policy which insures just one life. A special type of ILIT can be drafted
to hold such a policy.
What Doesn’t Work: Often
people try to exclude life insurance from their estates without using an
ILIT by having their children or other family members own the insurance.
Many problems can arise under such an arrangement. A child can die; the
policy can be attached and liquidated by a child’s creditors; the
policy could be considered as the child’s property in the event of a
divorce; the child may refuse to pay the premiums; or may wish to borrow
the cash value. These and other issues ca be addressed in a properly
drafted ILIT.
Summary: The ILIT
is an IRS approved means of removing your life insurance proceeds from your
taxable estate, while still having the proceeds available to provide for
your spouse and children according to your desires. Gifts made each year to
the ILIT can be exempt from gift tax. For those with taxable estates, the
savings in estate taxes can range from 37% to 55% of the death proceeds.
In
addition to avoid the estate tax on your life insurance, the ILIT can
provide other benefits as well. The ILIT can include arrangements for the
insurance proceeds to be returned by your Trustee after your death and used
for the benefit of young, disabled or financially immature beneficiaries.
In these instances, turning over a lump sum death benefit to the
beneficiary at your death could spell financial disaster. The ILIT provides
an effective alternative whereby the beneficiary can be provided for
without the risk of dissipation of your hard earned assets.
|
