ESTATE TAXATION OF LIFE INSURANCE.
Life insurance proceeds are generally exempt from income tax, but not from estate tax. The proceeds from a life insurance policy (the death benefits) are are not exempt from estate tax in cases where the insured is also the owner of the policy or deemed to have certain “incidents of ownership” (see below). In those cases, the life insurance proceeds are fully includable in the insured’s gross estate, subject to federal and state estate tax which in some instances can result in a blended estate tax rate of over 50%. If life insurance proceeds are paid to the surviving spouse, the marital deduction will shield them from estate tax in the estate of the first spouse to die; however, on the death of the surviving spouse, the remaining proceeds will be taxable along with the rest of his or her property.
“Incidents of ownership” generally include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan or to borrow against the policy.
WHAT IS AN IRREVOCABLE LIFE INSURANCE TRUST?
An irrevocable life insurance trust (“ILIT”) is an estate planning tool that is used to eliminate estate taxes on life insurance proceeds for policies on the insured’s life. The insured will commonly either transfer or sell an existing insurance policy on his or her life to the trustee of an irrevocable trust, the trustee becomes the owner and beneficiary of the policy, and when the insured dies, the proceeds are paid to the trustee, who distributes out the proceeds in accordance with the instructions provided in the trust agreement. Alternatively, the insured will make a cash gift to the ILIT which the trustee of the ILIT will use to purchase a new policy on the life of the insured which is owned and maintained by the ILIT.
The ILIT may provide for distribution of trust assets to or for the benefit of the insured’s spouse, children and more remote descendants. The trust is often times used a source of liquid assets for payment of estate taxes and other debts of the estate.
CREATION OF AN ILIT
In order to take advantage of the tax savings, the insured must create an irrevocable trust. The insured who creates the trust, known as the “grantor,” must depart with ownership and control of the property transferred to the trust. Because the trust is irrevocable, the grantor does not reserve the right to amend, revoke or terminate the trust. The grantor also does not have any interest in the property in the ILIT that would cause the property to be included in the grantor’s gross estate for federal estate tax purposes.
The trustee becomes the owner of the policy, and, as such, holds the incidents of ownership of the policy. The grantor must give up any incidents of ownership and cannot act as Trustee. In most cases, it is generally advisable to use a professional or corporate trustee rather than a family member.
The grantor may transfer an existing life insurance policy to an ILIT. However, if the grantor transfers an existing policy to the ILIT, he or she must survive the transfer by at least three years or the proceeds will be pulled back into the estate for estate tax purposes.
Alternatively, the trustee may purchase a life insurance policy on the grantor’s life. With respect to the proceeds of any policies purchased directly by the ILIT, the three year survivorship rule does not apply. Therefore, it is preferable for the ILIT to acquire insurance on the grantor’s life directly.
The ILIT is designated as the beneficiary of the life insurance policy. When the insurance proceeds are paid to the trust after the grantor’s death, the trustee will collect the funds, make them available to pay estate taxes and other expenses (if so directed), and then distribute them to the trust beneficiaries according to the grantor’s instructions under the trust agreement.
ADMINISTRATION OF AN ILIT
The grantor’s transfer of an existing policy to an ILIT is a completed gift that may be subject to gift tax, as are future contributions to an ILIT. Transfers to an ILIT are, however, generally structured to qualify for the gift tax annual exclusion. The gift tax annual exclusion amount is $14,000 (in 2016 and adjusted annually for inflation). Any individual can give $14,000 to any number of donees each year, or $28,000 per donee if the gift is split between spouses (i.e., someone who is married, with the consent of his or her spouse, may give $28,000 per donee each year, and one-half of the gift is deemed to have been made by the spouse). Because an existing life insurance policy may have a cash surrender value, the transfer of an existing policy to an ILIT may result in a taxable gift unless the gift is sheltered by the grantor’s gift tax annual exclusion.
In order for a gift to qualify for the gift tax annual exclusion, the gift must be a gift of a “present interest.” A “present interest” is an interest in which a beneficiary has possession or enjoyment of the property immediately rather than at some future date. Accordingly, gifts in trust generally do not qualify for the gift tax annual exclusion. Each time a contribution is made to an ILIT (including the original transfer of an insurance policy to the ILIT), however, the trust beneficiaries have a period of time, generally at least 30 days, during which they may withdraw assets of the trust having a value equal to the gift. This temporary right of withdrawal allows the gift to the trust to qualify for the federal gift tax annual exclusion as a gift of a present interest and is known as a “Crummey power” (the name originates from the court case allowing such withdrawal rights).
The grantor will make contributions to the trust in sufficient amounts on an annual basis to permit the trustee to pay premiums on the insurance policies owned by the trust and to cover any administrative costs for the trust such as bank charges, check fees, etc. When the grantor transfers funds to the trust, the trustee must send the beneficiaries notice of such and inform the beneficiaries of their right to withdraw their portion of the transfer for a certain period of time. If the beneficiaries do not withdraw the value of the gift within the allotted time, the Crummey power lapses, and the gift remains in the trust. The trustee then uses the gifted funds to pay the premiums on the life insurance policy owned by the ILIT. Of course, the beneficiaries must understand that by not taking the gift now, the gifted funds would be used to pay the premiums on the life insurance policy, which may result in a larger benefit in the future.
PROS AND CONS OF AN ILIT
The primary advantage of an ILIT is that the proceeds of a life insurance policy may pass to the grantor’s beneficiaries free of estate taxes. Additionally, the proceeds may be available to provide liquidity to the estate for payment of estate taxes and debts of the estate. The use of an ILIT also may allow the insured’s surviving spouse to enjoy the benefits of the proceeds as a trust beneficiary, while keeping the proceeds out of the surviving spouse’s gross estate for federal estate tax purposes. Creditor’s claims and the elective share rights of a spouse (depending on state law) may not be able to reach the funds held in the ILIT.
The primary disadvantages of an ILIT are that, because the grantor cannot hold any incidents of ownership in the policy, the grantor gives up the power to change the trust beneficiaries and their interests, gives up control of the assets (life insurance policies) contributed to the trust, and may not retain any economic benefit in the life insurance policy. For example, the grantor would no longer have the ability to cash in or borrow against the cash surrender value of any policy transferred to an ILIT. Any decision to do so would be made by the trustee.
Additionally, an ILIT may be somewhat difficult to administer because, as discussed above, each time the grantor makes a gift to the trust, the trustee must send notices of withdrawal rights to each holder of the Crummey powers. Another disadvantage is that, for some period after the grantor makes a gift, the beneficiary or the beneficiary’s parent or guardian has the power to withdraw trust assets. In practice, however, beneficiaries rarely exercise their Crummey powers.
An ILIT does, however, provide a flexible vehicle for the administration and distribution of the life insurance proceeds after the grantor’s death, as the grantor of the trust dictates who and when an individual will receive any part of the insurance proceeds. The dispositive provisions of the irrevocable life insurance trust may follow the dispositive provisions of grantor’s other estate planning documents.
INCOME TAXATION OF AN ILIT
The ILIT is a “grantor trust” for federal income tax purposes as long as it owns insurance on the grantor’s life. This means that the grantor will be treated as the owner of the trust and that income and/or deductions of the trust will be reportable by the grantor on his or her personal income tax return. The trust will not file income tax returns as a separate taxable entity. As long as the trust is invested only in insurance policies, the trust will not have any taxable income, and, therefore, the grantor will not report any income.
An irrevocable life insurance trust may not be an attractive tool for everyone, but it may allow individuals with large estates in excess of the available lifetime exemption amount ($5,450,000 for 2016) to save a significant amount of federal estate taxes. Family business owners may also find the liquidity provided beneficial in transferring ownership to the next generation. Estates of smaller size may have little or no tax savings, but the trust may be used to preserve and protect family assets, manage investments and provide income to family members.
DISCLAIMER: This publication is intended to be used as a source of additional information and should not be construed as legal advice or be a substitute for obtaining legal advice from an attorney licensed in the appropriate jurisdiction.