Life insurance – has long been an important financial planning tool for those who desire to provide income protection for their loved ones. However, life insurance can also play a vital role in the estate planning arena, particularly for persons of high net worth whose estates face potentially significant estate taxes. The Irrevocable Life Insurance Trust ("ILIT") is a powerful estate tax planning strategy that is often used to (1) keep life insurance proceeds outside of a person's taxable estate while (2) benefitting the insured's loved ones and providing an important, often critical, source of ready cash to help pay estate taxes..
How the ILIT Works – The ILIT is an irrevocable trust (i.e., a trust that, once established, cannot be changed or terminated) created for the specific purpose of owning one or more life insurance policies. The ILIT is also designated as the sole beneficiary of the policies it owns. During the insured's lifetime, he will periodically contribute funds into the ILIT to enable the trustee to pay the premiums required to the keep the policy in force. Upon the insured's death, the life insurance death benefit is then paid directly to the ILIT. The terms of the ILIT direct the trustee as to how those proceeds are administered and distributed. Often, the ILIT will allow the trustee the option to make the life insurance proceeds available to the estate of the deceased insured so that estate taxes can be readily paid. If the proceeds are not required for estate taxes, the death benefit may be distributed to the beneficiaries of the ILIT (such as the insured's family) according to the terms of the ILIT. Providing liquidity to pay the estate tax preserves other assets so that they will not have to be liquidated in order to pay the federal estate tax.
Benefits of the ILIT –Because the ILIT is structured as an irrevocable trust with a third party trustee (such as a family member; a close, trusted advisor or friend; or a bank trust department or independent trust company), the life insurance proceeds paid into the ILIT on the insured's death are completely excluded from the insured's taxable estate and will not be subject to high estate tax rates – with one exception: if an existing life insurance policy owned by the insured is transferred from him to an ILIT and the insured dies within three (3) years from the date of the transfer of the policy to the ILIT, the life insurance proceeds will be included in the insured's estate for estate tax purposes and potentially subject to estate taxes. Conversely, if the insured lives beyond the 3-year period following the transfer of the policy to the ILIT, the life insurance proceeds will be excluded from his estate and will escape estate taxation entirely. Because of the potential difficulties involving this so-called 3-year rule, a person contemplating the purchase of life insurance for income replacement or estate tax liquidity is well-advised to establish an ILIT first and then have the ILIT purchase the policy instead of the insured purchasing the policy in his name. The 3-year rule does not apply where the ILIT purchases a new policy directly from
an insurance company. However, despite the 3-year rule, it is often smart planning to remove an existing policy from an insured's estate by transferring it to an ILIT in any event, so that if the insured outlives the 3-year period, the policy will have been removed from his or her estate, saving potentially hundreds of thousands, even millions, of dollars in unnecessary estate taxes.
Illustrating the ILIT's Power –To demonstrate the power of the ILIT, suppose Mr. Jones, whose taxable estate is valued at $5,000,000, establishes an ILIT. The trustee then purchases a $2,500,000 life insurance policy on Mr. Jones's life. During his lifetime, Mr. Jones will periodically transfer sufficient funds to the ILIT to enable the trustee to pay the premiums on the policy as they come due. Upon Mr. Jones's death, the insurance company pays the $2,500,000 death benefit to the ILIT, all of it outside of Mr. Jones's estate and therefore estate tax-free. Those tax-free proceeds can then be made available to Mr. Jones's estate to pay any federal estate tax liability that may accrue as a result of his death. If that tax liability is $2,500,000 (assuming a 50% estate tax rate), the life insurance proceeds can be used to completely satisfy the tax obligation, relieving the estate of having to liquidate assets to pay the tax and thereby maximizing the inheritance to Mr. Jones's family.
Had Mr. Jones neglected to establish the ILIT for the life insurance policy and instead opted to own the policy himself, then upon his death his taxable estate would have increased by the amount of the death benefit – $2,500,000 – to a total of $7,500,000, resulting in a federal estate tax liability of $3,750,000, leaving only $3,750,000 to pass on to his heirs. Keeping the life insurance outside of his taxable estate effectively saves his beneficiaries $1,250,000 in additional estate taxes, and allows his entire $5,000,000 estate to pass to his loved ones.
The law firm of Boyce & Gianni, LLP has experienced estate planning attorneys who can help you structure and create an ILIT that will facilitate the transfer of your life insurance in the most tax-efficient way, saving your heirs substantial estate taxes and creating a tax-free legacy for your family.
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