Using Life Insurance As An Estate Planning Tool

Here we are again, nearly half of the way through 2012, and as the situation was in 2009, if Congress does not act with regard to the temporary provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 which expire December 31, 2012, taxpayers will find themselves losing $4 Million of Federal Estate Tax Exemption (the Exemption Amount is scheduled to decrease from $5 Million to $1 Million), and will face a Federal Estate Tax rate of 55%. With the current uncertainty surrounding the Federal Estate Tax Exemption levels, and the very real possibility that Congress will not come to an agreement by the end of the year, it is a great time to take a look at your current estate plan, and transfer some assets out of your estate before it is too late.

One powerful mechanism that can be used to transfer wealth with little or no gift tax implications is the Irrevocable Life Insurance Trust (an “ILIT”). Many people do not realize that life insurance owned on your own life is included in the value of your estate at death. A taxpayer who owns a life insurance policy on his or her own life could easily find himself or herself exceeding the $1 Million Exemption limit, and incurring a hefty Federal Estate Tax liability on the excess. By owning life insurance in an irrevocable trust, the entire value is removed from the estate, and can be distributed to beneficiaries both Estate and Income Tax free.

The gift tax implications of creating an ILIT depend on timing. Ideally, the taxpayer would first have the Trust drafted, and then have the life insurance policy purchased by the Trustee. To do so, the trust would be assigned its own Taxpayer Identification Number which would be used to open a bank account in the name of the Trust. The insured would transfer the funds necessary to pay premiums into that bank account, enabling the Trustee to pay the insurance premiums from the trust account. Having the Trust own the life insurance policy from its inception avoids having to transfer any value from the taxpayer to the Trust, resulting in a deemed gift from the taxpayer to the Trust. If the policy is already in force, it may still be transferred to the Trust by using a portion of the insured’s current $5 Million lifetime Gift Tax Exemption. It is also possible that the value of the deemed gift could be transferred tax free using the insured’s Annual Gift Tax Exclusion amount, which currently allows a taxpayer to make gifts of up to $13,000 per recipient, per year.

Once the policy is owned within the Trust, the insured’s annual payments of the premiums will be considered gifts; however, if no other gifts are made to the beneficiaries of the Trust, $13,000 per beneficiary will be available as a tax-free gift. Further, if the insured is married, then up to $26,000 per beneficiary may be used to pay the premium with no gift tax consequences. One small glitch in utilizing the Annual Gift Tax Exclusion is that it is only available if the beneficiary actually has an unrestricted opportunity to take outright ownership of the gift, rather than let it be used for payment of premiums. This is called the “present interest rule.” As such, most ILITs are designed to qualify contributions to the trust for the gift tax annual exclusion by requiring the use of Crummey notices. Named after a 1968 Tax Court case approving its use, a Crummey notice is simply a written notice to a named beneficiary, which describes the gift to the ILIT and grants the beneficiary a right to demand his or her share of the contribution. The demand right is usually limited to a number of days, often 30 or less. After the demand right expires, the beneficiary no longer has any present rights to the money. The Trustee may proceed to pay the insurance premium and keep the policy in force.

During the insured’s life, he or she may want to access any cash value that has built up within the life insurance policy (assuming the use of a permanent policy, and not a term policy). Many permanent life insurance policies are purchased so that the build up of cash value can be used as supplemental retirement income. The ILIT can be drafted to permit the trustee to borrow cash from the policy and loan it to the insured person. Although a third party trustee is involved, the cash value remains accessible to the insured. Another option is to establish an ILIT with a survivorship or second-to-die policy that pays out after both spouses die. If the policy is paid for with separate funds of one spouse, the other spouse may remain a lifetime beneficiary, and have the same access to the cash value, if needed. This is referred to as a Survivorship Access Trust. Upon the insured’s death, the proceeds of the policy will be paid to the Trust, and distributed according to the Trust provisions. The Trust can be drafted in a variety of different ways, from making immediate distributions to the beneficiaries and terminating thereafter, to retaining the monies in trust to benefit heirs for future generations without ever being included in the estate of the insured or the beneficiary. The trust can be used to restrict access to the proceeds by the beneficiary, thus protecting the wealth both from creditors and possible bad habits of the beneficiary himself. Another benefit upon death is that if the taxpayer’s estate is mostly illiquid with a substantial Estate Tax liability, the proceeds of the life insurance can be used to satisfy the taxes, and the illiquid assets such as real estate or business interests will not be forced to be sold, or even worse, sold at a substantially reduced value or fire sale type of transaction. The Trust can purchase certain illiquid assets from the estate, further sheltering them from creditors, isolating them from the estates of beneficiaries, while providing the estate with the necessary cash to pay liabilities and distribute inheritance to beneficiaries.

Life insurance continues to prove itself a powerful tool in the overall estate plan. Coupled with an Irrevocable Life Insurance Trust, it can become an invaluable mechanism for transferring wealth to many future generations, or simply avoiding Federal Estate Tax to the current beneficiaries of the estate. With the stalemate in Congress, and the uncertainty of the tax laws after 2012, a little bit of planning can stretch your wealth and protect your family considerably. surrounding communities of Montgomery, Berks, and Chester Counties.

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