Many clients are surprised to learn that the death proceeds of their life insurance are subject to estate taxation. They believe that life insurance escapes estate taxes and passes to their loved ones intact.
This confusion probably began when the client was told that life insurance is income tax-free. For married clients, the confusion is compounded by the belief that the unlimited marital deduction somehow magically insulates the client’s death proceeds from ever being taxed. Often the marital deduction merely postpones the heavy tax burden on such death proceeds until the second spouse dies.
For clients who have taxable estates, estate taxes may consume up to fifty-five percent of their life insurance proceeds.
The proceeds from your life insurance are generally includable in your taxable estate if you owned the policy or had any “incidents of ownership.” (as defined by the IRS) This is true for term insurance, cash value insurance, and even insurance provided by your employer.
“Incidents of ownership” which will cause life insurance death proceeds to be taxed as part of the insured’s taxable estate include not just policy ownership, but also the right to borrow the cash value, the right to change beneficiaries, and the right to change how the proceeds are ultimately distributed to the beneficiaries.
The Irrevocable Life Insurance Trust (or “ILIT” as it is frequently called) has proven to be a highly effective method of avoiding estate taxes without the many problems of transferring ownership of the policy to the client’s children or other heirs. An ILIT is created to own one or more policies insuring your life. The ILIT is irrevocable, meaning you cannot generally change the terms once it has been signed. You must also choose someone else as trustee of the ILIT besides you and your spouse (a knowledgeable professional is the ideal choice).
You cannot be a beneficiary of the trust, but your children may be (and usually are) beneficiaries. Quite often, the ILIT parallels the dispositive provisions of your revocable living trust or other estate planning documents, although there is no legal requirement for the ILIT to do so.
Moreover, the ILIT cannot be payable to your estate or to your revocable living trust, as your ability during lifetime to change your will or trust would result in your ability to change the beneficial enjoyment of the policy proceeds, thus bringing the policy back into your taxable estate. In addition, if you die within 3 years of placing an existing policy into the trust, it will be brought back into your estate. Hence, it is more favorable for the trust to the insurance on your life than you placing an existing policy in.
Your contribution to the ILIT represents gifts which you cannot get back. The gifts are usually used to pay the premiums on one or more policies insuring your life and which are owned by the trust. Because you cannot reclaim the policies, or receive any benefit from the trust, it would be inappropriate to have the trust own policies whose cash values you had planned to use for retirement income.
Currently, you may gift up to $14,000 per year per donee (recipient) without any gift tax implications. This exclusion is only available to gifts of a present interest, which is something you may enjoy or use now, and gifts in trust generally do not qualify, as they are gifts of a future interest, or one that will be enjoyed or used later. To avoid this limitation, your ILIT should provide that each lifetime beneficiary (who must also be beneficiary or contingent beneficiary at your death) has the right to withdraw his or her proportionate share of the contribution for a limited period of time after each contribution is made. This is known as a Crummey power and is named after a famous tax law case. A Crummey power forces what would otherwise be a future interest into a present interest that will fit the annual exclusion if the beneficiary has been given notice of a right to a withdrawal period that lasts at least 30 days.
After the expiration of the withdrawal period, the trustee may use the contribution to pay the premium on a life insurance policy. The IRS has approved the ILIT concept when all the technical requirements are met, but the IRS is notorious for challenging ILITs when the requirements are not met. Even the order in which the documents are signed is critical.
The trustee receives the death benefit upon your death. These proceeds may be distributed to your family, held in trust, or used to purchase assets from your estate or from your revocable living trust. This last option would be important if your estate had insufficient liquid assets to pay estate taxes.
The tax on your estate is due nine months after the date of death. Those with large estates often do not have sufficient cash or other assets which could be easily converted to cash within the nine month time frame. 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 may provide the money needed to pay the estate tax, and by having the policy purchased and held in an ILIT, the proceeds may be used to provide the needed liquidity for your estate and yet not be subject to estate tax on your death.
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 much lower than purchasing a policy which insures just one life.
Often clients try to accomplish similar results to the ILIT by having, say, their two children own the policy equally. Many problems may arise under such an arrangement. A child may predecease the parent; the policy may 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; one child may refuse to pay the premiums or may wish to borrow the cash value. The outright gift of a policy makes no provisions for your children or grandchildren. These and other issues may be addressed in a properly drafted ILIT.
If you have a taxable estate and own a large insurance policy, or are contemplating purchasing one, you would be well advised to consider how the ILIT might benefit you and your family.