We love it at Life Insurance Strategies Group when an individual client who is seeking an appropriate life insurance solution has done a lot of their personal planning correctly. It makes the inclusion of a properly structured life insurance transaction much easier to do without the need to first unwind and redo the way other assets are held.
For example, many of our clients have business and investment interests which, if kept in their own name, would become part of their taxable estate at death. Currently, amounts over $11.4m for a single person and $22.8 million for a married couple are exempt for estate tax purposes. Over that amount, estate and gift taxes quickly move toward a 40% hit on assets (and that’s just on the federal level).
Fortunately, many of these clients long ago shifted their holdings to an irrevocable trust when the value was within the exemption amount so the assets could grow in value outside of the clients’ estates. Despite this, many clients still have sizeable estates with real estate and assets which could not be put into trust for various reasons, including exceeding the exemption and facing gift taxes or needing to keep assets under individual ownership. Enter life insurance.
Given their familiarity with trusts, these clients understand that a sizeable life insurance policy should be owned by an irrevocable trust so that the value of the policy is not included in the grantor’s estate at death if individually owned.
What is an ILIT?
An irrevocable life insurance trust (“ILIT”) enables a client to reduce or eliminate estate taxes, so the bulk of their holdings can go to their intended beneficiaries. In order to have the power to keep its holdings out of the estate of the grantor, ILIT’s have several rules that must be followed:
· The trust cannot be modified once it is set-up;
· The grantor cannot be the trustee; and
· The beneficiaries cannot be changed by the grantor.
Essentially, the grantor cannot control or influence the assets in the ILIT, including the life insurance policy. If this ‘hands off’ strategy is not followed, the IRS could deem the grantor to have incidents of ownership in the life insurance policy and draw the value of the policy into the estate of the grantor---a structural disaster.
The grantor is usually the insured with or without their spouse as a second insured. The ILIT is typically the beneficiary of the policy which receives the death benefit proceeds tax-free at the death of any insureds and holds and distributes the proceeds as the trust document directs.
That part is fairly straight-forward but how does the life insurance policy get into the ILIT?
The Funding of an ILIT
If there is an existing life insurance policy, the policy may be transferred to the trust or purchased by the trust with assets already inside. If the policy is simply given to the trust, the value of the policy counts against the lifetime estate exemption amount or, if that has been exceeded, a gift tax is assessed on the grantor.
Also, if the grantor dies within three years of moving the policy to the trust, the IRS can pull the value of the policy back into the grantor’s estate.
Usually, the policy is purchased by the ILIT with cash provided to the trust. These premium amounts primarily reach the trust in three ways:
1) A gift to the trust applied against the lifetime exemption amount.
2) An annual gift for an annual premium payment where the annual gift tax exclusion applies and can be off-set through the use of Crummey Letters.
3) A split dollar loan arrangement where the grantor loans the policy to the trust and is either paid back during the grantor’s lifetime or, at the insured’s death, the greater of the cash value or premium paid is pulled back into the grantor’s estate.
There are additional small nuances to the funding of an ILIT to pay life insurance premiums, including the sending of Crummy Letters mentioned in #2. Broadly, the IRS permits annual gifts up to the annual exclusion amount (currently $15,000) to escape gift taxation to the grantor, if the beneficiaries of the trust have a period of time, perhaps 30 days, to withdraw their part of the gift.
Of course, the grantor hopes that doesn’t happen because it would impair the planning process as well as the performance of the life insurance policy.
These are just the basics of the use of an ILIT and there are many more capabilities this trust can provide the HNW client, including leveraging assets inside the trust to finance policy premiums, placing policies on different generations for greater wealth transfer and the ability of a trustee to access policy cash values to make loans to the grantor should there be a liquidity need.