Don't Make the IRS a Beneficiary of Your Life Insurance...
How to Use Irrevocable Life Insurance Trusts
For a married couple who fully utilizes their estate tax exemptions with "Bypass" Trusts, the Federal estate tax effectively "cuts in" on assets in excess of $4,000,000. For single individuals, this "estate tax threshold" is $2,000,000. For estates in excess of these amounts (including life insurance, employee benefits, jointly owned assets, etc.) you should consider removing life insurance proceeds from the estate by using an Irrevocable Life Insurance Trust.
GREAT EXPECTATIONS
Otto Schmidlap has assets of approximately $2,750,000, primarily consisting of interests in a closely held business and various parcels of raw land. Otto has three children, Siegfried, Sieglinde and Brunhilde. Siegfried is active in Schmidlap Enterprises. Sieglinde and Brunhilde have no interest in the business. In order to allow Sieglinde and Brunhilde to receive cash from his estate, and also to possibly pay some of his estate settlement costs, Otto has decided to buy an insurance policy in the amount of $2,000,000.
Having obtained "expert" estate planning advice from his barber and, knowing that if he owned the policy, it would be included in his gross estate, Otto arranged to have the policy owned by his wife, the exceedingly glamorous and financially astute Lily Marlene. Otto, thinking his affairs are in good order, believes that he can take care of Lily Marlene and, when both of them are in Valhalla, have net assets of approximately $2,000,000 available for distribution to Siegfried, Sieglinde and Brunhilde.
LOVE'S LABORS LOST
Otto's barber (Figaro of Seville) was correct in advising Otto to make gifts of his life insurance, because if he gave away the policy when it wasn't worth very much, he would have removed a large asset from the tax collector's clutches. The barber, a part time estate planning professional, correctly noted that if Otto had any rights to deal in any way with a policy on his life, then the proceeds of that policy would be an asset of his estate when he dies. This principle applies to all life insurance policies, whether they be term, "ordinary," group, etc. However, the shoemaker should have stuck to his last, or the barber to his shears. By giving the policy to Lily Marlene, the proceeds (as cash) will be included in her estate, and the Schmidlap family really hasn't saved anything. By having the proceeds included in Lily Marlene's estate, the $2,000,000 policy will produce net proceeds (after combined federal and state death taxes of approximately 61%) of $1,000,000. Thus, Siegfried, Sieglinde and Brunhilde have each been "cheated" out of $1,000,000 of their inheritance.
THE 1% (OR LESS) SOLUTION
If, instead of having Lily Marlene own the new insurance policy, Otto had created an Irrevocable Trust to be the policy's owner, applicant and beneficiary, the proceeds would have been available for Lily Marlene's use and would not have been taxed in either of Otto's or Lily Marlene's estates. In fact, we can often provide a couple's children with very substantial economic benefits and have the assets excluded from their estates as well. For a cost which is generally less than 1% of the estate tax savings, the entire life insurance proceeds can be available to pay estate taxes with "one hundred cent" dollars and to achieve other liquidity goals. Because the benefits of Irrevocable Life Insurance Trusts are so great, the IRS seems to devote an inordinately large amount of time and manpower, sometimes even trying to resurrect theories which the Congress has explicity repealed, in an effort to bring the life insurance proceeds into the Federal coffers. Because of this unceasing administrative attack, Irrevocable Life Insurance Trusts must be designed, drafted and administered with a great deal of care and foresight.
SOME DESIGN FEATURES
Adequate "Ventilation"
No one would build a house without sufficient doors and windows. No one should build an irrevocable trust without provisions allowing the trust to be "de-funded" if necessary, without considering the human (as opposed to tax) planning considerations of several generations over a prolonged period of time and without flexible trustee removal and replacement provisions.
Don't Waste Tax Exemptions
To the greatest extent possible, your estate tax "exemption" should not be used. Conversely, a transfer of life insurance may be an excellent way to use a portion of the Generation SkippingTransfer Tax exemption.
Watch Out!
Although the Service still appears to be hanging on with bulldog-like tenacity, it appears that, if all of the necessary details are attended to, "newly purchased" life insurance would not be included in the insured's estate if he died within three years of establishing the Trust. However, as to policies which are transferred to an irrevocable trust, the "three year" rule would apply. It is vitally important to have an "escape hatch" built into the Trust Agreement to avoid a situation in which the proceeds would be subject to estate tax, but could not be used to pay those taxes. That could be a genuine disaster, especially in an illiquid estate.
Special Situations
We are not always presented with "clean" fact situations. If an insurance policy is subject to loans or is owned by the insured's closely held corporation, some extra planning steps may be required in transferring the policy to the Trust. It is not too hard to conjure up situations in which one takes an asset out of someone's gross estate and, at the same time, subjects the proceeds to income taxation as a "transfer for value."