In order for life insurance to be an effective estate planning tool, it should be owned by an irrevocable life insurance trust (commonly referred to as an “ILIT”), not by the insured or the insured's spouse. If a life insurance policy is owned by an ILIT, the entire policy proceeds payable at the insured's death are typically excluded from the taxable estates of both the grantor and the grantor’s spouse, and, thus, escape estate taxation upon both of their deaths. This transfer tax savings translates into an enormous increase in the amount of policy proceeds passing to the grantor’s heirs.
LIFE INSURANCE IN THE ESTATE PLANNING CONTEXT
When used in the estate planning context, life insurance can provide a means of leveraging annual exclusion gifts into a significant wealth transfer to younger generations. (An annual exclusion gift is a gift that qualifies for the annual exclusion from federal gift taxes. Each individual may use his or her annual exclusion to gift up to $14,000 per recipient to an unlimited number of people each year, gift tax-free.) Relatively small annual exclusion gifts may be used to pay the premium cost on a life insurance policy held by an ILIT, which will ultimately result in a significant death benefit to a grantor’s spouse, children and/or grandchildren, typically while avoiding both gift and estate taxation.
Life insurance can offer solutions to address certain estate planning needs, including:
Providing estate liquidity for expenses and taxes. Estates facing estate taxes must pay the liability in cash, generally nine months after the decedent’s death. Both taxable and non-taxable estates have numerous expenses, including funeral costs, outstanding medical expenses and family support. Further, seemingly liquid estates can become essentially illiquid if marketable assets are at significant lows due to unfavorable market conditions at death. Ensuring sufficient liquidity to pay taxes and expenses can minimize conflict, reduce the family’s stress and avoid “fire-sales” of estate assets to generate cash.
Equalizing amounts passing to beneficiaries. Life insurance can equalize otherwise disproportionate asset distributions by balancing, for instance, bequests of real estate or closely-held business interests to certain family members with distributions to other heirs of cash from life insurance proceeds.
Planning for blended families. For individuals with “blended families,” life insurance can minimize conflict by providing for children from prior marriages while also leaving separate assets to the surviving spouse as needed to maintain his or her current lifestyle.
Equalizing wealth of the spouses. Often, spouses may not have equal assets in their individual names, particularly if one spouse is younger. Acquiring life insurance on a less wealthy spouse can be a simple and cost-effective solution for increasing that spouse’s estate.
ADVANTAGES OF THE LIFE INSURANCE TRUST
An irrevocable life insurance trust is one in which the grantor completely renounces all rights in the life insurance property and any other assets transferred to the trust, and retains no rights to revoke, terminate or modify the trust in any material way. Typically, these trusts are used in estate planning to accomplish these primary objectives:
• Avoid estate taxation of the death proceeds;
• Provide financial security for the grantor's survivors who may be minors, spendthrifts or financially irresponsible;
• Avoid probate costs on the life insurance proceeds and any other assets passing via the trust;
• Maintain privacy and confidentiality, as the trust provisions are not a matter of public record, as they are with a will; and
• Protect assets in the trust at the grantor's death from the claims of creditors.
MECHANICS OF THE LIFE INSURANCE TRUST
An ILIT is created by the insured, as grantor, during the grantor's life. The beneficiaries of the trust are often family members of the grantor, including the grantor’s spouse, children and/or grandchildren. The trust is funded with an insurance policy on the grantor’s life and perhaps other assets.
The life insurance policy should be purchased directly by the trustee of the insurance trust, if possible, in which case the insurance proceeds will be immediately excluded from the grantor’s taxable estate and, thus, not subject to estate tax upon the grantor’s death. Alternatively, an existing life insurance policy may be transferred to the trust by the grantor, in which case the grantor must survive the transfer by three years in order for the insurance proceeds to be excluded from the grantor’s taxable estate.
Unless the policy is paid up, the trustee will have to pay the annual premiums. Typically, the grantor makes annual transfers of cash to the trust to enable the trustee to pay the premiums. These annual transfers are gifts which, with proper drafting and structuring of the insurance trust, typically qualify as annual exclusion gifts and, thus, are sheltered from federal gift tax.
Upon the death of the grantor, the proceeds from the life insurance held by the ILIT may be made available to the executor. The ILIT may authorize either the purchase of illiquid assets from the estate or loans to the estate in order to allow for payment of funeral costs, expenses of the decedent's last illness, death taxes, probate expenses and the claims of creditors. After any necessary estate settlement costs have been provided for, the remaining trust assets can be held for the benefit of trust beneficiaries, free of the imposition of estate tax if the following requirements are met:
• the trust is irrevocable;
• the grantor is not the trustee;
• the grantor has no incidents of ownership over the insurance policy;
• the insurance proceeds are only used to purchase estate assets or to make loans to the estate in reasonable, arm's-length transactions, not to pay estate costs directly; and
• the insured lives for at least three years if a policy is transferred to the trust.
As a result of the enormous transfer tax savings offered by an ILIT, these trusts can greatly increase the amount of life insurance policy proceeds actually passing to the beneficiaries. Moreover, careful drafting of this powerful estate planning device can yield a life insurance trust that is consistent with an individual’s desires and estate plan.