Many clients and advisors are surprised to discover that life insurance is possibly the most unique estate planning tool available to the financial planning team, especially for larger estates. This is true even in today's uncertain estate planning climate with the political debate over the permanency of estate tax repeal. Regardless of whether you believe that the estate tax will be permanently repealed, or whether you think it more likely that future legislation will freeze the phased-in applicable exclusion amount, life insurance owned outside of the insured's estate is one of the most effective planning arrangements for the payment of taxes.
Moreover, whether you predict that the estate tax will be around in 10, 20, or 30 years, anyone who wants to do prudent planning can come to only one conclusion: A family's financial security should not be gambled on the potential repeal of the estate tax. Instead, good planning should ignore the distraction of politics and go forward by including strategies that are designed to build as much flexibility as possible into a client's estate plan--flexibility that can address nearly any tax scenario.
Fortunately, there are several planning strategies incorporating life insurance that can provide this flexibility. Most of the strategies revolve around the use of an irrevocable life insurance trust to remove the life insurance from the insured's estate but there are also alternatives that do not initially require the use of an irrevocable trust.
Advantages of an ILIT
Life insurance that is properly structured in an irrevocable life insurance trust (ILIT) can provide liquidity to an estate when needed for the payment of taxes, administrative expenses, and creditors. This is a strategy that can avoid the forced liquidation of estate assets. It allows the client to budget cash flow through the current cost of the policy premiums instead of having to keep a large quantity of liquid assets on hand at all times. Life insurance also provides the ability to use tax-exclusive dollars rather than tax-inclusive dollars to pay taxes.
Through effective use of the annual gift tax exclusion to avoid gift tax on premium payments, the client can protect assets and maximize wealth, while avoiding all or at least a significant portion of transfer taxes. Beneficiaries also receive life insurance proceeds without paying income tax on the benefit. Few, if any, other planning tools offer the same results at the same cost.
The major reason for making an ILIT the owner and beneficiary of a life insurance policy is to remove the policy proceeds from the grantor's estate. To accomplish this, the ILIT must be irrevocable. This means the grantor cannot have the ability to amend or revoke the ILIT. He or she must also give up all control over or incidents of ownership in any trust assets.
Is there a way for a grantor to have access to trust assets while also keeping those assets out of his or her estate? For years, clients and their advisors have been looking for ways to add this flexibility to irrevocable trust documents to address potential changes in financial and family circumstances. Several techniques can be used to create a flexible ILIT. Careful drafting by a competent and experienced estate-planning attorney is the essential key to successfully avoiding technical legal and tax traps that may result in unwanted estate inclusion. Here are the techniques:
A spousal access ILIT permits a married couple to keep the life insurance proceeds needed for estate liquidity out of their taxable estates while at the same time permitting one of the spouses to have indirect access to the cash value of the policy. One spouse is the grantor of the ILIT and the other spouse is a beneficiary of the trust. The ILIT owns a life insurance policy on the life of the grantor of the trust. The trust includes a distribution provision that allows the trustee (who is not one of the spouses), in his or her absolute discretion, the right to distribute trust income and principal to the grantor's spouse during the grantor's lifetime. The trustee may even be given the authority to use policy withdrawals and/or loans to provide the cash flow for these payments.
In a stable marriage, the grantor could then count on piggy-backing on the cash flow to his or her spouse. It must be noted that this approach may not work effectively if the insured/grantor and the spouse are both the insureds (e.g., if a survivorship policy is used). In such a case, the use of a spousal support ILIT requires very strict compliance with technical requirements in order to be effective for estate tax purposes (see PLR 9748029).
Loans to the Trust
In some cases where the ILIT owns a life insurance policy for estate liquidity purposes, there may be an advantage for the insured to loan the annual premiums to the ILIT rather than gifting the premiums. This strategy enables the trust to receive the death proceeds income-tax-free and without inclusion in the estate of the insured. The loan is repaid when the death proceeds are received by the ILIT. While a portion of the death proceeds will be included in the insured's estate when the loan is repaid, the remainder is received estate-tax free.
This strategy provides substantial gift tax leverage, as only the loan interest is considered an annual gift under IRC ?7872 rather than the entire premium. If the ILIT is a so-called "defective" trust for income tax purposes, the deemed payment of interest to the grantor should not create taxable interest income for the grantor, as the insured/grantor and the ILIT are considered a single entity for income tax purposes (IRC ??671, 675, IRS Reg. 1.671-2(c), and Rev. Rul. 85-13). This strategy can be used with either single life or survivorship policies.
Loans From the Trust
Another possibility is for the ILIT to be drafted to give the insured/grantor the right to borrow from the ILIT, provided that he or she executes a demand note secured by sufficient other property and pays interest at a fair market rate. The loan interest can be paid in cash or, with sufficient collateral, accrued to be paid after the grantor's death. The insured/grantor's power to borrow from the ILIT using secured demand notes at fair market interest rates is similar to the right to substitute property of equal value approved in Estate of Anders Jordahl vs. Commissioner, 65 T.C. (1975), acq. action on decision 1977-129 (April 15, 1977).
Again assuming that the ILIT is a so-called "defective" trust for income tax purposes, the payment of interest to the ILIT should not create taxable interest income for the ILIT, as the insured/grantor and the ILIT are considered a single entity for income tax purposes. (IRC ??671, 675, IRS Reg. 1.671-2(c), and Rev. Rul. 85-13.) There is no direct authority for the use of this technique and the client's attorney must evaluate its suitability under all of the facts and circumstances of the client's situation.
Use of a Trust Protector
The ILIT might be drafted to provide for the appointment of a Trust Protector. A trust protector is usually an independent trusted friend or third party who is not a beneficiary of the trust. The trust protector's power is exercisable at that person's absolute discretion during the insured's lifetime to appoint trust income or principal to anyone other than the trust protector, the trust protector's estate or creditors of either. The trust protector also should not have the power to appoint trust income or principal in any manner that would result in a direct economic benefit to the grantor.
Careful drafting might also expand the trust protector's powers to include the ability to add and remove trust beneficiaries, as well as the ability to distribute any life insurance owned by the ILIT to the ILIT's beneficiaries. In addition to the appointment of a trust protector, the trustee can be given the power to reduce the face amount of any life insurance owned by the trust and keep and/or use the cash value for trust purposes.
Using a Survivorship Policy Outside of an ILIT
There is another possible strategy that does not initially require the use of an irrevocable trust. If a husband and wife wish to obtain a survivorship policy, but also wish to be able to have ready access to the policy's cash values during the joint lifetimes of both, the insured with the shortest life expectancy can apply as the owner of the policy. The beneficiary and contingent owner of the policy is an ILIT. In such a case, the insured with the shortest life expectancy (in this case, let's assume it is the husband) is also the grantor of the ILIT.
While both insureds are alive, they have access to the cash values inside the policy. As long as the husband dies first, the policy's death benefit passes to the ILIT estate tax free at the death of the surviving insured (the wife). The policy ownership and ILIT must be properly structured and the cash value of the policy would be included in the husband's estate.
The same result would occur if the insureds die simultaneously if, under the applicable state law, the husband is presumed to have died first. On the other hand, if there is an "out of order" death and the wife dies first under this arrangement, if the husband would like the policy removed from his estate, he must then gift the policy to the ILIT. After three years, he may then avoid estate inclusion. The husband would also possibly incur gift tax consequences as a result of this gift to the ILIT.
Not for Short-Term Needs
Although these techniques can potentially provide clients with the peace of mind that they have not lost access to the funds contributed to an ILIT, it must be clearly understood that the use of the life insurance policy's cash value or any other trust assets should be considered as emergency money only. All of the planning efforts made to keep the trust assets out of their taxable estates will be lost if they strip out trust assets to meet short-term cash flow needs. What these techniques may do is permit maximum flexibility in an arrangement that can also achieve maximum estate tax savings.