Shareholder
As is the case with smaller estates, larger estates facing state or federal estate tax burdens may benefit from the strategic use of life insurance. Specifically, combining life insurance with an irrevocable trust is frequently used in conjunction with life insurance coverage that is otherwise intended to provide liquidity and hedge key man risk. Like any estate planning tool, however, the use of life insurance and life insurance trusts needs to be considered as merely one aspect of a comprehensive estate plan.
The ILIT
Families are often surprised that death benefits from a life insurance policy will be included in a decedent’s taxable estate, although the policy proceeds are usually not part of a decedent’s probate estate and usually cannot be accessed by the insured during their lifetime. As such, the receipt of a $1,000,000 death benefit in Massachusetts can unexpectedly put an otherwise nontaxable estate over the $2,000,000 filing threshold, and a larger insurance payout can put an estate over the $15,000,000 federal estate tax threshold. This fact can create significant liquidity issues for an estate if the policy proceeds are paid directly to named beneficiaries, as the estate can be left with tax liability and no cash.
Life insurance death benefits are included in a taxable estate whenever the decedent retains control over the policy up until the time of their death. Conversely, if the party seeking life insurance protection does not have control over the policy when they die, the death benefits will not be counted as part of their taxable estate. Assuming a policy owner is willing and able to transfer control of the policy prior to their death, the estate tax can be eliminated entirely.
The irrevocable life insurance trust — known as an ILIT — is a popular tool among estate planning attorneys to obtain life insurance coverage for estates where straight ownership of the policy by the insured would result in tax liability. Setting up an ILIT is relatively easy, and the cost is usually low relative to the anticipated tax savings. At the death of the covered life, the ILIT will receive the death benefit proceeds as the beneficiary of the policy, subject to instructions to distribute the money out to the ILIT’s designated beneficiaries. This approach can therefore be functionally similar to the policy holder simply naming the beneficiaries directly, although there is no tax. Alternatively, the insured may desire that the death benefits be kept in the ILIT and distributed out to the beneficiaries over a longer period of time in order to provide supplemental support. In any event, the ILIT will distribute the funds out to the trust beneficiaries consistent with whatever terms are selected.
Leveraging Gift Tax Exclusions
It should be noted that using an ILIT is not entirely tax free. As is the case with funding an irrevocable trust with any type of assets, contributing a life insurance policy to a trust, and contributing additional funds to pay annual premiums, are considered taxable gifts to the trust for federal estate tax purposes. The effect of transferring the value in a life insurance policy or cash to a trust so that it can pay the premiums is to reduce the amount of exemption remaining at the time of death that would otherwise be available for a decedent’s estate assets. Conceptually, from a time-value-of-money perspective, making taxable gifts to reduce estate tax liability should not result in any actual savings, but the tax code has created preferential treatment to gifts in certain circumstances that are advantageous to using ILITs.
An ILIT will, in most cases, have something called Crummey powers that will give beneficiaries of the trust a limited right to withdraw cash contributed by a grantor before the trustee uses the cash to pay the annual policy bill. Although the beneficiaries will have this withdrawal right, they are strongly encouraged to not withdraw the money and will normally not request a withdrawal. By giving the beneficiaries of an ILIT Crummey powers, contributions by the grantor become eligible for the $19,000-per-beneficiary annual gift tax exclusion. This per-beneficiary exclusion can be doubled if the grantor is married. Including Crummey powers in an ILIT usually reduces the grantor’s overall estate tax burden, because gifts under the annual exclusion amount are not counted toward the grantor’s lifetime combined federal gift and estate tax exemption. In instances where an ILIT has multiple beneficiaries, adding Crummey powers allows a grantor to pay the premiums on a large life insurance policy without consuming any lifetime gift and estate tax exemption.
Life Insurance in Estate Plans
Using an ILIT is undisputably a simple and effective way to make the cost of life insurance lower from a tax perspective. This does not necessarily mean an estate will always benefit from adding life insurance coverage, though, and it is important to not let the “tax tail” wag the dog in designing an estate plan. In particular, large policies will normally be expensive to maintain when an insured makes it to age 80 and beyond. If cash is needed at that point to pay for the insured’s long-term care, there is a risk there may not be enough money to pay the increased premiums. Clients will sometimes seek to offset life expectancy risk by obtaining life insurance coverage that contains an investment feature that will build up a store of value that can be used later to cover annual premiums. These sorts of features can sometimes defer the need to come up with cash when the insured reaches old age but can still be exhausted if the insured lives to ages 90 and beyond. An additional observation is that policies with complex investment components often make the total cost of the insurance coverage opaque. Ultimately, clients need to understand that if they are intending to buy life insurance as a type of lottery ticket for their family, then the conditions of winning that bet necessarily involve an early death for the insured person. These sorts of economic realities are inherent limitations to using coverage for speculative or investment purposes in an estate plan. A sophisticated estate planner will advise a client that life insurance is most appropriate for estate plans where there are defined risks to protect against, such as the risk that the insured’s death will result in a loss of earnings needed to support a family, or as a source to honor a cross-purchase commitment. In the latter case, the death of a business partner will sometimes trigger a surviving partner’s obligation to purchase the deceased partner’s interest in a business. This sort of financial obligation may be funded with life insurance so that the deceased partner’s estate can walk away with cash instead of illiquid equity in a business. Depending on what sort of coverage is needed and where the contractual commitments lie, an ILIT may or may not be advisable in a cross-purchase situation.