This is another in a series of blogs on the basics of estate planning. Last week, we looked at the importance of client control. This week, we’ll look at Irrevocable Life Insurance Trusts.
Irrevocable Life Insurance Trusts (sometimes referred to as “ILITs”) are a commonly used strategy designed to keep life insurance out of the taxable estate of the insured and owner.
Sometimes, life insurance is purchased in large amounts. Thus, it can easily create a taxable estate where none existed prior to the life insurance. Let’s look at a typical situation. Let’s say that John has $3 million of assets in his estate. John could have up to $5.49 million in his estate in 2017 without a tax. However, John also has a life insurance policy with a death benefit of $4 million. If the policy is a term policy, it may not be worth much at all, especially if John is young. The value of a term policy on a person who is not terminal is the prorated pre-paid premium. So, if he pays the premium upfront each year by January 1 and the premium is $12,000, at the end of June the policy would be worth about $6,000. However, if John dies, the full value of the death benefit would be included in his estate because of section 2042 of the Code which includes the value of any life insurance which is payable to the decedent or their estate, or over which the decedent had “incidents of ownership.” Since John had such ownership, the full value of the policy of $4 million is in his estate. In addition to the other $3 million, this brings John’s estate to $7 million, or $1.51 million over his exclusion. At the 40% estate tax rate, that results in a tax of $604,000.
If, however, John does not own the policy at his death, nor has the incidents of ownership, then it would not be included in his estate. There are different ways to accomplish this. If John gives the policy to someone else, then it would not be in his estate. However, he could not be sure they would use the property as he desired. Also, the value of the death benefit would be in the recipient’s estate (assuming they are the beneficiary).
If John sets up a trust, and has the trust own the policy, it would not be in his estate, as long as the trust does not have John or John’s estate as the beneficiary. Also, John could not be the trustee of the trust, because the trustee has “incidents of ownership” of the policy. John’s spouse could be the trustee of the trust and even a beneficiary.
If John contributes money to the trust, it is a gift of a future interest unless the trust gives a beneficiary a right to withdraw the money. This is called a Crummey power.
If John contributes a life insurance policy to the trust and then dies within three years of the contribution, the proceeds are still in his estate because of section 2035. As a result, it’s advisable for John to contribute other assets to the trust and have the trustee purchase the policy on John’s life.
This area can be quite complicated and there’s much more detailed information about Irrevocable Life Insurance Trusts in the Academy’s Core 2 material.
In upcoming blogs, we’ll look at more of the basics of estate planning.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555
www.aaepa.com
Steve Hartnett
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