August 2010 Archives

The Irrevocable Life Insurance Trust (ILIT)

August 13, 2010,

by Michael Ettinger, Esq.ilit.JPG

Many clients are surprised to learn that the death proceeds of their life insurance are subject to federal estate taxation. They believe that life insurance escapes estate taxes and passes to their loved ones intact.

This confusion probably began when the client was told that life insurance is income tax-free. For married clients, the confusion is compounded by the belief that the unlimited marital deduction somehow magically insulates the client's death proceeds from ever being taxed. Often the marital deduction merely postpones the heavy tax burden on such death proceeds until the second spouse dies.

For clients who have taxable estates (meaning, at the time of death, over $1,000,000 for single persons and over $2,000,000 for married persons who have implemented proper estate tax planning), estate taxes can consume anywhere 55% of their life insurance proceeds.

These clients have far less insurance than they think they have or, alternatively, they are paying far more for their coverage than they should be paying.

The Irrevocable Life Insurance Trust (or "ILIT" as it is frequently called) has proven to be a highly effective method of avoiding estate taxes without the many problems of transferring ownership of the policy to the client's children or other heirs (as discussed more fully below).

The proceeds from your life insurance are generally includable in your taxable estate if you owned the policy or had any "incidents of ownership." This is true for term insurance, cash value insurance, and even insurance provided by your employer.

"Incidents of ownership" which will cause life insurance death proceeds to be taxed as part of the insured's taxable estate include not just policy ownership, but also the right to borrow the cash value, the right to change beneficiaries, and the right to change how the proceeds are ultimately distributed to the beneficiaries.

An ILIT is created to own one or more policies insuring your life. The ILIT is irrevocable, meaning you cannot generally change the terms once it has been signed. You must also choose someone else as trustee of the ILIT besides you and your spouse (a knowledgeable professional is the ideal choice).

You cannot be a beneficiary of the trust, but your children can be (and usually are) beneficiaries. Quite often, the ILIT parallels the dispositive provisions of your revocable living trust or other estate planning documents, although there is no legal requirement for the ILIT to do so.

Moreover, the ILIT cannot be payable to your estate or to your revocable living trust, as your ability during lifetime to change your will or trust would result in your ability to change the beneficial enjoyment of the policy proceeds, thus bringing the policy back into your taxable estate.

Your contribution to the ILIT represents gifts which you cannot get back. The gifts are usually used to pay the premiums on one or more policies insuring your life and which are owned by the trust. Because you cannot reclaim the policies, or receive any benefit from the trust, it would be inappropriate to have the trust own policies whose cash values you had planned to use for retirement income.

You can gift up to $13,000 per year per donee (recipient) without any gift tax implications. This exclusion is only available to gifts of a present interest, which is something you can enjoy or use now, and gifts in trust generally do not qualify, as they are gifts of a future interest, or one that will be enjoyed or used later.

To avoid this limitation, your ILIT should provide that each lifetime beneficiary (who must also be beneficiary or contingent beneficiary at your death) has the right to withdraw his or her proportionate share of the contribution for a limited period of time after each contribution is made.

Usually the trust agreement provides that, after a contribution is made, each beneficiary will be notified of their right of withdrawal. After the expiration of the withdrawal period (usually not less than 30 days), the trustee can use the contribution to pay the premium of a life insurance policy.

The IRS has approved the ILIT concept when all the technical requirements are met, but the IRS is notorious for challenging ILITs when the requirements are not met. Even the order in which the documents are signed is critical.

Existing policies can be transferred to your ILIT, but the death proceeds will be drawn back into your taxable estate if you die within three years of completing this gift. Also, the transfer of existing policies may trigger a taxable event. If you are insurable, it is sometimes advisable to consider a new policy.

The trustee receives the death benefit upon your death. These proceeds can be distributed to your family, held in trust, or used to purchase assets from your estate or from your revocable living trust. This last option would be important if your estate had insufficient liquid assets to pay estate taxes.

The tax on your estate is due nine months after the date of death. Those with large estates often do not have sufficient cash or other assets which could be easily converted to cash within the nine month time frame. The need to pay estate taxes has caused many a farm, family business, or major real estate holding to be sold at discounted prices to pay the estate tax.

Life insurance can provide the money needed to pay the estate tax, and by having the policy purchased and held in an ILIT, the proceeds can be used to provide the needed liquidity for your estate and yet not be subject to estate tax on your death.

Married couples may wish to consider using a "second-to-die" policy which pays the death benefit only after both spouses are deceased. That is usually the exact time that the proceeds are needed to pay the estate taxes. Because no death benefit is paid on the first death, the premium is much lower than purchasing a policy which insures just one life.

Often clients try to accomplish similar results to the ILIT by having, say, their two children own the policy equally.

Many problems can arise under such an arrangement. A child can predecease the parent; the policy can be attached and liquidated by a child's creditors; the policy could be considered as the child's property in the event of a divorce; one child may refuse to pay the premiums or may wish to borrow the cash value.

The outright gift of a policy makes no provisions for your children or grandchildren. These and other issues can be addressed in a properly drafted ILIT.

If you have a taxable estate and own a large insurance policy, or are contemplating purchasing one, please contact us to discuss how the ILIT might benefit you and your family.

The Worst Estate Plan I Ever Saw

August 9, 2010,

by Michael Ettinger, Esq.

piggybank.gifRecently, a couple came in to see me. They were people of means, having accumulated an estate in excess of two million dollars. Sadly, the husband, a fine gentleman, had contracted an incurable form of cancer. They knew it was time for a review of their estate planning documents.

The couple had two sons, both in their fifties. One was an established professional, the other a successful entrepreneur.

The client produced their current will, written nine years earlier. Since their estate was over one million dollars, the will contained a "credit-shelter" or "bypass" trust. This means that, upon the death of the first spouse, the deceased spouse's assets would be held in a trust for the surviving spouse. This technique allows the surviving spouse to have the use and enjoyment of those assets without having them includable in her estate. On her death, husband's assets pass to the children, thus taking advantage of his one million dollar exemption.

I read the trust. The I read it again. I could not believe what I was reading. The will set up the credit shelter trust for the wife, with the Bank as trustee. This technique is sometimes used by attorneys to ingratiate themselves with the Bank. It is often not in the best interests of the client, since one or both of the sons could have been chosen as trustee thus saving the Bank's fees of approximately 1% of the trust annually, plus other fees as will be shown below.

But that was not the unusual part. The will also set up trusts for the sons, with the Bank as trustees FOR THEIR LIFETIMES, giving the Bank the following authority:

"The Trustee is granted the further absolute discretion to determine when, how, and whether to make any distribution of principal, the amount to be distributed, the specific purpose for making any distribution, and whether any distribution is advisable."

The Bank was also given authority to collect its fees as trustee "without offset or reduction for any other fees or other compensation paid to it or any other "affiliated entity" including fees or other compensation paid by any mutual fund or other investment vehicle agent. "Such compensation may be made without court approval." This means that the Bank, in control of the assets, would also collect fees as the investment advisor, effectively a "double-dip" and specifically excludes court scrutiny of the arrangement. There was no provision to change the trustee.

So, what happened under the trusts for the sons when they died. The assets were then put into trusts for the grandchildren with the Bank as trustee all over again! The Bank was also given control of the assets over the grandchildren's lifetimes with the following "suggestion":

"The Trustee may consider distributing: one fifth (1/5) of the trust estate upon the grandchild's attaining the age of thirty (30) years; three-eighths (3/8) of the trust estate upon attaining the age of thirty-five (35) years; and the balance of the trust estate upon the grandchild's attaining the age of forty (40) years. Nothing set forth herein shall be construed as providing a grandchild with the authority to require any distribution to be made from the trust at such ages" (emphasis added).

The client was appalled. They had no idea whatsoever these draconian provisions were in their documents. In our experience, most people do not know or understand what is in their estate planning documents.

Given the circumstances of the husband's health, within the week we had replaced all of the documents with trusts controlled by the family alone, much to their relief. There was a great deal of satisfaction on their part knowing that had the husband died without having the plan reviewed, they would have been stuck with the Bank, irrevocably, forever. All's well that ends well.