The estate tax poses a problem for wealthy but cash-poor Americans. To repay Uncle Sam, their heirs may be forced to liquidate their real estate empires or private businesses.
But there’s another fire sale method: They can use life insurance to cover the debt in a neat trick. Instead of having life insurance directly, they take out a policy and put it into a trust. The irrevocable life insurance trust (ILIT) collects the death benefit, pays the tax liability, and distributes anything left over according to the policyholder’s wishes.
Any payment is also protected from estate tax, even if the insured’s assets and death benefits exceed the payment. (Currently, the 40% federal estate tax applies to estates over $13.61 million). For a very wealthy taxpayer with $10 million in life insurance, using an ILIT can save $4 million in taxes.
“It’s low yield. It succeeds in removing the insurance from the property. It does not prevent anyone from getting anything,” said Robert Strauss, a partner at the law firm Weinstock Manion.
The insured can nominate anyone as a beneficiary such as business partners or friends. Although it is not common now, ILITs have been used – and can be used – to provide for single or non-marital partners.
“Historically, if someone had a special friend they wanted to benefit, life insurance in a trust was one of the ways you could ‘take care’ of that obligation. ,” said Dan Griffith, director of wealth strategy at Huntington Bank.
There are other features. As with other types of trusts, the insured can appoint a trustee who controls how the money is distributed to the beneficiaries. For example, a grandchild may be given a grant to pay for a college education but not a sports car. An ILIT can also limit future beneficiaries, excluding future spouses of the surviving spouse.
If an insurer wants to make sure their heirs are protected from creditors or their spouse divorces, they can use ILITs for double protection, Griffith added. Although the law varies from state to state, trusts and life insurance both have strong legal protections.
“Even if, for whatever reason, the creditor is able to access the trust assets, the insurance can be protected by state law itself,” Griffith said.
Here is how ILIT works
ILITs must be properly filed with the IRS.
The ILIT must be named as the beneficiary of the life insurance policy. It must also be a policy. Although you can transfer the policy to an ILIT as a gift, Strauss does not recommend this as the transfer is ineffective if the insured dies within three years. Instead, he advises the grantor – the person setting up the trust – to give money or a loan to the ILIT so the trust can buy the policy.
When money goes into a trust, there is a 30 to 60 day waiting period in which the beneficiaries can withdraw the money. After the beneficiaries are notified and time has passed, the trust can use the cash to pay the premiums.
With these cash contributions, the donor reduces the size of their taxable estate. They also don’t add gift tax if the donor gives $18,000 or less in a year.
Upon the death of the insured, the trust receives the death benefits. Whether to pay estate taxes should be left to the discretion of the trustee, according to Griffith. If the trustee is liable to pay a tax liability, the death benefit will be included in the taxable estate.
After the tax debt is paid, the remaining amount can be distributed in different ways. For example, an ILIT may name the surviving spouse as the primary beneficiary and the children as secondary beneficiaries. The surviving spouse receives the property, which passes to the children free of estate tax after their death, Strauss said.
There are a few caveats
- Trustees can get into trouble with the IRS by forgetting to notify beneficiaries.
The devil is in the details. It is important to notify beneficiaries of their right to withdraw money from an ILIT at a specified time with what are known as Crummey notices – named after the taxpayer who invented the practice.
Although it is a practice dating back to the 1960s, it is surprisingly common for administrators to forget to notify beneficiaries. Strauss recalled one of his partner’s clients trying to copy Crummey’s skills, printing them on a laser jet printer. The IRS noted that the notices were made after the fact as they existed before the advent of laser jet printing. The ILIT was cancelled, and the property was included in the taxable estate.
- Make sure you get life insurance that makes financial sense.
Strauss advises consumers to be cautious when dealing with life insurance premiums and to think about their future plans. For example, a buyer with $100 million doesn’t need $40 million in insurance to cover property taxes if he plans to give away $60 million, he said.
ILITs also work best with permanent life insurance, which is more expensive than term policies. Multi-million dollar policies have hefty fees, which can break the bank.
Some clients who set up ILITs when they were younger regret that decision, according to Kate Maier, vice president of investment advisory group Wealth Enhancement. Tax policy changes over time, possibly negating ILIT benefits.
“Or in some cases, they need money,” he said. “When they created it, the future looked a lot brighter than it does now. It’s hard to get the money back.”