1st May 2012
Life insurance can serve many purposes. Whether you own a policy as income replacement security for your family, through your employer or as an investment asset, life insurance can be a multi-dimensional tool. However, with all of the financial planning instruments that are available, few owners of life insurance understand all of its potential benefits and even fewer title their policies properly in order to maximize the value of the asset.
This newsletter will discuss some of the benefits of estate planning with life insurance, as well as how to plan with an Irrevocable Life Insurance Trust (“ILIT”) and some of the landmines to sidestep in order to maximize the benefits of an ILIT.
Cash at Death
One of the primary benefits of life insurance as an estate planning tool is that it can replace the income of a deceased earner for the benefit of his or her dependents. Dual-income families should always consider whether the family could continue to make mortgage or college tuition payments if one of the incomes was lost.
Additionally, life insurance creates liquidity when it is needed most for many families—at death—in order to pay the Estate Tax. The Estate Tax is due nine months after death. Therefore, many estates, especially those with a majority of their assets invested in a family business, may have difficulty paying any tax that is due as a result of death. Life insurance can alleviate some, or all, of this tax burden.
Whether planning with an ILIT or not, the availability of cash at death can allow the family to hold on to some of its most valuable assets.
At death, the beneficiary collects the proceeds income tax free. However, many owners mistakenly believe that life insurance is free of all taxes—this is not the case. Without proper planning and execution, a life insurance policy will be included in the policy owner’s taxable estate and will therefore be subject to Estate Tax.
However, planning with an ILIT can remove the policy from the owner’s taxable estate and thus significantly decrease the tax liability at the owner’s death. By establishing an ILIT to own the life insurance policy, the premiums that are gifted to the trust are removed from the taxable estate and the proceeds paid out at death will not be included in the taxable estate, providing a dual benefit.
Similar to a Revocable Living Trust, one of the benefits of an ILIT is that the proceeds of the life insurance do not have to be distributed immediately to the beneficiaries, but can instead be distributed as the Grantor chooses and instructs in the trust document. This can provide security to the Grantor and also protect the assets from the creditors of the beneficiary in case of divorce or debt issues.
In certain cases, a life insurance policy is a protected asset. This protection varies by state. Under Illinois law, death benefits and the cash value of any life insurance policy payable to the insured’s spouse or to a child, parent, or other person dependent on the insured are exempt from the creditors of the insured individual. Fraudulent transfers, however, are not protected. Therefore, such planning must take place before protection is necessary, not after.
Planning with an Irrevocable Life Insurance Trust
An ILIT is a common estate planning instrument that allows the Grantor to purchase a life insurance policy and to have the policy be owned outside of his or her taxable estate.
The first step in planning with an ILIT is to determine the type of policy (whole-life vs. term, individual policy vs. second-to-die) and the amount of coverage necessary to accomplish your goals. Issues such as when the family will need the assets are paramount and must be carefully considered before purchasing the policy. Additionally, the policy premium should not exceed the Grantor’s annual Gift Tax exclusion ($13,000 per person in 2012).
The second step is to have an experienced estate planning attorney prepare the trust document. Issues that must be considered include (a) who the beneficiaries will be, (b) whether the Generation-Skipping Transfer Tax will be an issue, (c) whether the trust or the Grantor will be responsible for any income tax due and (d) when and how the balance of trust assets will be distributed.
The third step is to apply for and purchase the policy. This step involves several intricate IRS rules and guidelines that must be respected in order for the ILIT to be treated as separate from the Grantor, including taking the proper steps in making premium payments and respecting the withdrawal rights provided for in the ILIT (see “Crummey Notices” below). Shortcutting any of these steps will jeopardize the purposes and benefits of the ILIT.
At the insured’s death, the death benefit is paid to the trustee to be administered as provided in the trust document. Proceeds may be used to pay the expenses of an estate or to benefit one or more individuals. When and to whom the assets of the trust will be paid are decisions that must be made by the Grantor when establishing the trust.
Landmines to Sidestep
As is the case with any planning technique that involves IRS compliance, there are many landmines to sidestep with ILIT planning. A few of the important details in planning and execution are discussed below.
Purchasing the Policy – The trustee of the ILIT must be the applicant and original owner of the life insurance policy in order for the policy to be outside of the Grantor’s taxable estate. This is a requirement that is often overlooked by applicants and insurance agents at the family’s peril.
Grantor vs. Non-Grantor Trust – A trust may be setup as a Grantor or Non-Grantor Trust using specific provisions that the IRS has approved for establishing a valid Grantor Trust. The income of a Grantor Trust is included in the Grantor’s taxable income, while the income of a Non-Grantor Trust is not included in the Grantor’s taxable income and must be paid by the Trust.
Crummey Notices – When the Grantor makes a gift to the Trust, the beneficiaries of the Trust must be notified that such gift has been made and must be given a window to withdraw their share of the gift. Without proper notice, the gift will not be considered a present interest gift, possibly causing the entire death benefit to be included in the Grantor’s estate.
Additional issues to be considered when planning with life insurance include the three-year lookback period , the proper procedure for a §1035 exchange, the Reciprocal Trust Doctrine and flexibility in the trustee’s powers. However, the complexity of these issues is beyond the scope of this newsletter.
If you are interested in discussing any of the topics discussed herein, please feel free to contact me at your convenience.