Protecting one’s estate from creditors, predators, in-laws, and outlaws is a key reason clients with larger estates may consider establishing an Irrevocable Life Insurance Trust, or ILIT.
Acronyms can be mystifying, so let’s start with a definition. An ILIT is a trust wherein the grantor gifts assets (and thereby gives up all incidence of ownership) so that the ILIT itself becomes the owner of the asset(s). That effectively removes the asset(s) from inclusion in the grantor’s estate. So if all goes as it should, upon death there could be less or no estate taxes because the estate is smaller. This makes the ILIT an essential tool for financial and estate planning.
As with many things that sound too good to be true, there are downsides.
- Benefits of Ownership
Top is that the grantor typically also irrevocably forfeits the incidents of ownership. This may include control as well as economic benefits such as cash flow. The extent to which this occurs may depend on state law and the trust language.
2. Pull Back
If an individual owner dies within three years of gifting the asset, the value of the asset is pulled back into the estate for tax purposes. It is important to remember that it is the death of the owner, not the insured, that influences the clock for this three year rule.
Depending on the client’s goals, ILIT’s often have either one or both of these objectives:
If the estate size is large enough to potentially be taxable, an ILIT can provide cash at death that could be used to pay estate taxes and estate settlement costs. Under this scenario, life insurance on either one or both spouse’s lives is often used as the funding vehicle. This contrasts with life insurance that is owned by the grantor and would thus be included in his or her estate for
tax purposes. It also provides a leveraged effect in that the dollars paid for premium are typically a fraction of what the actual death benefit can be. The goal is to make sure the estate has sufficient liquidity so there is no pressure to liquidate assets at an inopportune time just to settle the tax bill.
4. Estate Reduction
Since an ILIT can hold virtually any asset of value, another goal may simply be to transfer the asset out of the estate. This will make the estate smaller at death and thus subject to less or no estate taxes. The strategy can be even more effective if the asset is expected to appreciate in value, since that appreciation would hopefully be out of the grantor’s estate and therefore also not subject to estate taxes.
So if the husband owns an insurance policy on his wife, as an example, and she dies, the proceeds that would be available to the estate at that time would not be subject to estate taxes. However, upon the husband’s subsequent death, the value would be included and possibly taxable.
Using life insurance within an ILIT can offer an alternative. First, life insurance proceeds are generally received income tax free by the policy beneficiaries. Also, there can be creditor protection, since in many states life insurance proceeds paid to a named beneficiary are not subject to the claims of the policy owner’s creditors. The specific rules of course can vary from state to state.
If the estate is named as beneficiary, the proceeds are still paid income tax free. However by doing this we have converted a non-probatable asset into one that is subjected to the probate process. This can create several disadvantages, including:
- Expenses are greater due to attorney and court fees;
- More time is needed to go through the probate process as opposed to just a beneficiary payment;
- Estate creditors could have access to the insurance proceeds depending, again, on prevailing state laws. Hence a reason we would not usually recommend the estate as beneficiary of an insurance policy. This also speaks to the prudence of always naming a contingent or secondary beneficiary;
In short, an ILIT is really a financial bucket designed to hold assets. In dealing with life insurance, the policy’s value is not the insurance proceeds but rather the cash value or the market value, as determined by an IRS formula. So when dealing with existing coverage, it is a simple matter of having the owner transfer or assign the policy to an ILIT by filing a change of policy ownership and beneficiary form with the insurance company. Once the ownership change has been recorded by the insurer, it is also important to now name the ILIT as the new owner as well as the policy beneficiary. Since this is a gift, a gift tax return form 709 should also be filed with the IRS even if there is no tax due.
Clients often ask how gifting an insurance policy to an ILIT could affect their annual gift exclusion. In considering this, it is important to remember that the exclusion applies to present interest gifts which can be enjoyed now. By contrast, gifts to an ILIT are of a future interest so they do not typically qualify for the exclusion.
As an alternative, we use a technique called the “Crummey” provisions. The Crummey provision is based on prior case law and allows an exception when the ILIT trustee sends a letter to the trust beneficiary saying they have a specific time, say 30 days, to claim their portion of the gift. Although they may not opt to do so, that the option exists effectively creates a “present-interest” gift exclusion.
Another option is to allow for spousal access. This means that the trustee in his or her sole discretion may distribute money to the spouse or the grantor for health, education, maintenance or support. We usually see this in the form of separate ILIT’s for each spouse with the non-insured spouse being the beneficiary. If done properly, the provision can allow the spouse to withdraw dividends and interest earned by the policy at, say, retirement, while keeping a majority of the death benefit available to the estate.
With any irrevocable trust, and ILIT’s are no exception, there can be an issue of retaining too much control over the transferred assets. When this occurs, we face the danger of having the policy being pulled back into the estate for tax purposes. That is why it is often advisable to spend the additional expense in order to involve a professional trustee. Professional trustees, often a trust company or bank, typically bring a high competence to the table that may help assure all functions as it is intended.
Uncertainty over the economy and financial markets has many people concerned about their financial futures. For friends, relatives and colleagues who may find this information helpful, please feel free to share with them. Remember, for those who could benefit we offer a complimentary, no obligation “Second Opinion” that can offer an objective financial review. Keep us in mind for those who may be seeking a wealth advisory firm like ours—one that delivers services according to the needs and perspectives of its clients.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Wells Fargo Advisors Financial Network LLC (WFAFN) does not provide tax or legal advice. We strongly recommend an advanced tax and estate planning expert be contacted for further information. Any opinions are those of Mitchell Kauffman and not necessarily those of WFAFN. The information has been obtained from sources considered to be reliable, but Wells Fargo Advisors Financial Network does not guarantee that the foregoing material is accurate or complete. Prior to making a financial decision, please consult with your financial advisor about your individual situation.
Mitchell Kauffman provides wealth management services to corporate executives, business owners, professionals, independent women, and the affluent. He is one of only five financial advisors from across the U.S. named to Research magazine’s prestigious Advisor Hall of Fame in 2010, and among a select list of 100 over the past 20 years.
Inductees into the Advisor Hall of Fame have passed a rigorous screening, served a minimum of 15 years in the industry, acquired substantial assets under management, demonstrate superior client service, and have earned recognition from their peers and the broader community.
Kauffman’s articles have appeared in national publications, and he is often quoted in the media. He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara and Santa Barbara City College.
For more information, visit www.kauffmanwm.com or call (866) 467-8981. Kauffman Wealth Management and serves clients from two office locations: 140 South Lake Avenue, Suite 217, Pasadena, CA 91101 and 550 Periwinkle Lane, Santa Barbara, CA 93108 (by appointment only). Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFN), Member SIPC. Kauffman Wealth Management is a separate entity from WFAFN.