People often make the mistake of naming their estate as the beneficiary of their life insurance policy. This makes the proceeds of the policy, known as the death benefit, part of the taxable estate. A simple way to avoid estate tax issues is to transfer life insurance policies into an irrevocable life insurance trust. The value of the insurance remains outside your taxable estate, but you can still name beneficiaries for the trust. ILIT’s can help replace assets donated to charities or place in IIOT’s by providing a lump sum payment to the trust when you pass on.
There are three components in an irrevocable life insurance trust, similar to those found in a living trust:
Trust makers, who control their ILIT’s through their instructions
Trustees and their successor trustees, named by the trust makers
Beneficiaries and contingent beneficiaries, named by the trust makers
Who buys the life insurance on my life or my partner/spouse’s and my lives?
The life insurance is purchased by the ILIT’s trustees.
Can I or my partner/spouse be a trustee?
A third-party, independent trustee should be named in order to keep proceeds out of your taxable estate.
If you own life insurance, it is included in your taxable estate and the proceeds will be taxable for federal estate tax purposes. So, in 2009, an individual is allowed a federal estate tax exemption on their first $3.5 million of assets, including all life insurance policies in their name. (This fact comes as a surprise to many people but this treatment of insurance proceeds dates back almost to the inception of the federal estate tax.) If life insurance policies are owned by a properly structured ILIT, the proceeds will be free of the estate tax.
What if I don’t own my insurance but control it through some one else?
Even if you do not own your life insurance in your name, the IRS may determine you to be the owner and therefore liable for federal estate taxes on the policy proceeds. Your life insurance will be included in your taxable estate as long as you possess any incidents of ownership for federal estate tax purposes. Incidents of ownership include your rights to borrow on a policy or pledge as collateral, name or change the beneficiary, and assign the policy to someone else.
If you maintain any right to a life insurance policy, the IRS will take the position that you retained incidents of ownership and will include the proceeds in your taxable estate. With a properly structured ILIT, you no longer retain any incidents of ownership under the IRS definitions and will not be liable for federal estate taxes.
What is the theory behind an ILIT?
Because the trust is irrevocable, you do not have incidents of ownership in it or in the life insurance policies owned by it. An irrovocable trust is a trust that can’t be modified or terminated without the permission of the beneficiary. The grantor, having transferred assets into the trust, effectively removes all of his or her rights of ownership to the assets and the trust.
This is the opposite of a “revocable trust”, which allows the grantor to modify the trust. While the tax rules will vary between jurisdictions, in most cases, the grantor can’t receive these benefits if he or she is the trustee of the trust. This fact often leads to the consideration of employing a corporate trustee to serve as the fiduciary administrator over the trust assets.
Thus the proceeds of those policies will not be taxed upon your death nor will they be taxed upon the death of your spouse if he or she survives you. They completely avoid the federal estate tax.
You are able to control the disposition of the policy proceeds through your trust instructions as to:
Who the trustees will be while you are alive, upon your disability, and upon your death.
How the proceeds will be distributed to your beneficiaries or left in trust
An irrevocable life insurance trust (ILIT) is an irrevocable trust that is created to own and be the beneficiary of life insurance policies on the trust maker’s life. A reason to use this type of trust is to remove the insurance proceeds from a person’s taxable estate. Remember, that normally when you own a life insurance policy, the proceeds from that policy are included when calculating your taxable estate for tax purposes.
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Contrary to popular belief, Legacy & Estate Planning isn’t just for millionaires – it’s for anyone who cares about what happens to their assets after they pass or who desires to leave a record for future generations to be able to access.
That said, Legacy & Estate Planning is particularly important for people in a number of basic life situations:
Married Couples: Each spouse must have a separate will. Joint wills can create legal issues if you both pass within a few weeks or months of each other.
Divorced Couples: Make sure your assets go to the “right” people, especially if you’d prefer that they not go to your former spouse’s new partner and his or her children. To protect your own children, you may need to establish a trust.
Business Owners: Create a succession plan that specifies what should happen to your business, or your equity in the business, if you become incapacitated or pass away. Be sure that the business has enough cash on hand to survive the transition to new ownership.
Future Millionaires: Currently, the estate tax provides an exemption for estates valued at $2 million or less (it will rise to $3.5 million in 2009). This exemption has historically been $1 million and will most likely revert to that level in the year 2011. As a general guideline, if your estate currently totals $1 million or more – or has a strong prospect of exceeding $1 million in value during your lifetime – you should establish trusts to protect assets you may have beyond the $1 million benchmark.
(Special note: Many people are not aware that life insurance proceeds are included in your taxable gross estate and should be included when calculating potential estate tax liabilities.)
Professional Athletes: The unique demands and rewards of excelling as a professional athlete create unique needs and opportunities for both estate and legacy planning. Most sports stars understand the necessity to protect their hard earned dollars, but often fail to receive proper advice and counsel from those charged with directing their affairs. From issues of caring for your family and loved ones to handling the affairs of off-the-field ventures and charitable foundations require the consultation of expert counsel.
Entertainers & Artists: Those who hold valuable intellectual property rights, (copyrights, trademarks, etc.), or derive income from royalty payments need to consider special plans to deal with these unique issues.
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We offer many thanks to the talented hand of Robert Weber whose work was originally published in The New Yorker August 16, 1999.
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