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 Regardless of whether you believe that the estate tax will be permanently repealed, or whether you think it more likely that future legislation will freeze the phased-in applicable exclusion amount, life insurance owned outside of the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.