Irrevocable life insurance trusts (ILIT) have been a sought after estate planning strategy. Some may say that this approach be rendered obsolete if the federal estate tax is repealed. Or, is this still an important strategy to consider regardless of looming changes?
What is an Irrevocable Life Insurance Trust?
Irrevocable life insurance trusts are a type of irrevocable trust. as opposed to a revocable trust OR what is commonly known as a living trust. An ILIT is set up by a “trustmaker” to be the holder of a life insurance policy.
The dual purpose of an ILIT is to provide for younger beneficiaries AND enable estate tax planning through what is called “gifting“.
How Irrevocable Life Insurance Trusts are Created
An irrevocable life insurance trust is a trust agreement that should be drawn up by an experienced estate planning attorney. Any trust is complicated to prepare (especially irrevocable trusts). There may be consequences for DIY estate planning if the ILIT is NOT set up correctly.
The irrevocable life insurance trust agreement needs to be written to include the terms and conditions that are important to the trustmaker. The agreement also needs to comply with current tax laws to make sure it will pass IRS scrutiny.
How Irrevocable Life Insurance Trusts Work
The irrevocable life insurance trust agreement includes the terms of the trust AND designates certain younger beneficiaries to receive the trust assets upon death. The beneficiaries are chosen by the person who set up the trust (the “trustmaker”). This is a way to direct assets to younger beneficiaries upon the trustmaker’s death.
Tax Rules and Administration for Irrevocable Life Insurance Trusts
Purchase of Life Insurance
Irrevocable life insurance trusts (or the Trustee of the trust) should purchase the insurance on behalf of the trust RATHER THAN assigning an existing policy. If an existing policy is assigned to an irrevocable life insurance trust, the IRS will require that the proceeds are still part of your estate if you die within 3 years of the transfer. The way to get around this is to have the irrevocable life insurance trust purchase the insurance.
There is some debate about whether term life insurance or permanent cash value life insurance, such as dividend paying whole life OR indexed universal life, should be used for irrevocable life insurance trusts. One argument suggests that because the proceeds are being purchased by an irrevocable trust, the cash value is NOT available to the trustmaker, and thus a term life policy should be used. This position says that the only purpose of the trust is the death benefit and since term life is cheaper, it makes more sense. The opposing argument, that a permanent policy should be purchased, says that the life insurance on the trustmaker’s life will continue to get more expensive. Plus, a permanent policy allows more money to be gifted out of the estate. So the decision may hinge upon how much death benefit the trustmaker qualifies for AND whether a long range term policy is available to cover the lifespan of the trustmaker.
The important thing is to consider the policy and estate goals, costs and death benefit. The key is for the trust to purchase a policy that makes sense for the estate.
Gifting of Premium Payments
In general, gifting money or assets to another person, other than a spouse, is a taxable event. However, each person is allowed to gift a certain amount per beneficiary every year without any gift tax issue. That amount as of this writing is currently $14,000 per beneficiary. Because irrevocable life insurance trusts are a separate legal person (entity), money can be gifted to the trust and then used to pay premiums.
For example, if the irrevocable life insurance trust has 3 beneficiaries, then $42,000 could be gifted to the trust ($14,000 x 3) each year. That $42,000 could be used to pay the premiums on a life insurance policy, on the trustmaker’s life, with the death benefit to pass to the 3 beneficiaries. If money is gifted to an irrevocable life insurance trust, then the life insurance cash value can accumulate outside of the estate, thereby avoiding estate taxes.
This strategy needs to be skillfully managed as discussed in the following paragraph to make sure that IRS rules are followed. Gifting can also be done in larger lump sums. There is a lifetime gift tax exemption that is similar to the estate tax exemption reviewed below so no tax may be owed if within the lifetime exemption. If this option is pursued, a federal gift tax return will likely need to be filed.
Crummy Letter Rule
A complication can occur when gifting insurance policy premium payments to irrevocable life insurance trusts. The IRS only allows this to constitute a gift if the beneficiaries have a current right to the gift. When there is a gift to a trust, the beneficiaries are offered a future benefit which they may or may not realize. This issue turned into a case now commonly known as the crummy case. When assets are gifted to irrevocable life insurance trusts, the trustee must send a crummy letter to the beneficiaries. The crummy letter basically tells the beneficiary that he or she has the immediate right to the gift proceeds. However, the way this works in real life is that the beneficiaries know that if they take the proceeds, they life insurance premiums will NOT get paid and they will no longer be the beneficiary of a life insurance policy.
Irrevocable Life Insurance Trusts for Business Continuity Succession Planning
The death benefit to be received by the trust beneficiaries may be used to cover estate taxes OR PROVIDE FUNDS for business continuity succession planning AS A KEY PART OF family business succession planning. This issue should be considered, especially where irrevocable life insurance trusts designate beneficiaries who are also successors in a family business.
Are Irrevocable Life Insurance Trusts Obsolete Now that the Federal Estate Tax Exemption is Increased?
For awhile there was concern by some that the current administration and the Republicans in the Congress and Senate would abolish the federal estate tax. As a bit of review, the federal estate tax, is also coined the the “death tax” by opponents, and is a lump sum tax based upon the value of your gross estate upon death. The tax rate is approximately 40% and includes the death benefit of any insurance policies or annuities.
This has been in flux for years, and the amount that can be exempted from estate taxes has now increased with the recent Republican tax overhaul. As of this writing, a single person can now pass $11,200,000 without any estate taxes AND a married couple can pass double that amount.
Because the federal estate tax imposes a lump sum obligation upon by the estate that is payable within 9 months of the date of death, a huge estate planning objective has been to avoid it at all costs. One way to avoid the estate tax is to gift assets out of the estate during lifetime in order to keep the estate under the exempted amount. If the federal estate tax were to be abolished, the question is whether this need to reduce the estate would go away and negate the need for planning with irrevocable life insurance trusts.
ANSWER: 3 Reasons Irrevocable Life Insurance Trusts Will Likely Never Become Obsolete
- Asset protection
- Likelihood of future reinstatement of federal estate tax
- Still good planning for future generations
Irrevocable life insurance trusts are still an excellent way to protect assets for future generations and this wouldn’t change if the federal estate tax were abolished. Remember, irrevocable trusts are separate entities from the trustmaker. Thus, even if the trustmaker is later sued or embroiled in financial problems, the nest egg placed in the irrevocable life insurance trust will be secure.
Reinstatement of Federal Estate Tax
We know from history lessons that the federal estate tax exemption and the law in general has bounced around at the whim of our politicians and this isn’t likely to change. So, even if you adopt a planning approach that removes the need for federal estate tax planning, where will you be if it is reinstated. This isn’t fear mongering. Rather, based upon the history of the federal estate tax, its just good common sense.
Good Planning for Future Generations
Holding assets in an irrevocable trust for future generations is good planning. Holding assets in an irrevocable life insurance trust, which requires talking with the beneficiaries about it, including the crummy letters, is just good training for future generations. Because estate planning is about leaving a legacy, this is a great vehicle to train future generations in the importance of investing, planning for the future, and letting things grow over time.
If you’d like to learn more about irrevocable life insurance trusts OR anything else pertaining to life insurance OR estate planning , e-mail or give us a call today.