Q: We own a small business that has become quite valuable. We are in the process of updating our estate plans and found that we have a significant liquidity and estate tax problem, when my husband and I pass on. We are looking into additional life insurance and possibly using a life insurance trust. Can you provide us with some background information and guidelines on this type of trust? — B.J.M., Connecticut
A: A life insurance trust may be your best way to make sure the money from your life insurance policy gets used the way you want. And if it’s drafted and managed properly, the trust can even allow your insurance benefit to avoid estate taxes! You owe it to yourself and your family to learn more about life insurance trusts.
You can name a trust as the beneficiary of your life insurance policy. This allows you to establish how the trust funds are managed and how they can be distributed to your heirs. But, it might not keep the proceeds out of your taxable estate.
One of the primary reasons to put your life insurance policy into an “Irrevocable Trust” is to reduce your estate taxes. Your estate is valued by adding together your property, your investment accounts, your retirement accounts, and the proceeds of your life insurance. As the estate tax laws stand today (6/1/2010) estate taxes are not an issue. But they could be a problem in the future as your wealth grows or the laws change.
Caution: New Estate Tax Development
Congress adjourned its 2009 session without addressing the expiring estate tax rules. Under the law that was enacted in 2001, effective January 1, 2010, there is no longer an estate tax or a generation-skipping transfer tax. The tax rate on taxable gifts is now 35%. Additionally, under 2010 rules, when inherited assets are sold, the heirs can only exclude $1.3 million of gain and the surviving spouse receives an additional $3 million exclusion; thus there is no longer an increase in the decedent’s asset-cost-basis to date-of-death-asset values. As a result, this could generate larger income taxes than under the 2009 estate tax rules. These changes may affect many more households than the previous rules, and could create a much larger advisor fee for reconstructing decedents-cost-basis.
There is a general consensus among estate planning professionals that Congress will have to address this issue. Look for changes in the estate tax laws in 2010 that could be retroactive to January 1, 2010. Or a choice could be given to use 2009 rules, or the one year estate tax repeal.
If Congress doesn’t take action in 2011, effective January 1, 2011, the estate tax and generation-skipping transfer tax will return at a 55% top tax rate and a $1 million estate tax exemption. This will result in a substantial increase over the 2009 rules, which had a top estate tax rate of 55% and a $3.5 million exemption.
Check with your advisors for updated estate tax information.
If you have a taxable estate that has significant illiquid assets, such as real estate and / or business interests, properly creating a “Irrevocable Life Insurance Trust” as the owner and beneficiary can keep the your insurance proceeds out of your estate while creating the liquidity to pay estate taxes and / or the cash to distribute to selective family members and other beneficiaries.
Using an Irrevocable Life Insurance Trust
If the total value of your estate is greater than the estate tax exemption amounts you should take action to reduce the amount of estate taxes your heirs will have to pay. One action you can take is to keep your life insurance ownership out of your estate. To do this, someone other than you needs to own your policy. It is usually not a good idea to have your spouse as the owner because the insurance benefit might end up in his or her estate when your spouse dies.
To make sure your children inherit as much as possible and pay the least in estate taxes, one of your options is to create an “Irrevocable Life Insurance Trust.” Be sure you understand this strategy before signing this type of trust agreement, because you cannot change, amend, or cancel an irrevocable trust after it is created.
If you make the trust revocable, the policy benefit will be included in your estate when the time comes to calculate estate taxes.
Transfering Your Existing Policy into a Trust
If you have an existing insurance policy, you can transfer ownership to the trust. Be sure to make this change soon, because the IRS has a three-year rule that comes into play if you make this type of transfer. You must live at least three years from the completed transfer date for the death benefit to be free from estate taxes. If you anticipate transferring ownership of existing life policies be sure to get professional advice before doing so, as there are a number of potential financial and tax pitfalls here.
Buying a New Policy and Putting it In the Trust
If you are thinking of getting a new life insurance policy for a trust to own, make sure you can obtain life insurance before you spend time and money drafting a special trust agreement.
Once you have the trust agreement signed, have the trustee apply for a life insurance policy on your life. The trust also will be the policy beneficiary and receive the insurance proceeds after you die. Don’t confuse this with the trust beneficiary, which might be your children.
Because you never owned the policy, it is not included in you estate. And because the trust is the beneficiary, the death benefit can be used in ways that you can specify in the trust agreement. The trustee may be authorized to loan money to your estate or purchase assets from your estate. By doing so, your heirs will have cash to pay estate taxes.
Who Pays the Premiums?
You can give money to the trust, but if this is not done properly this might be construed as a sign that you had an ownership stake in the policy. Any signs of your ownership means the policy is will be exposed to estate taxation. Make sure the trust agreement has the appropriate language that allows you make gifts to the trust. You may also have to follow a specific gifting procedure process that requires written notification to and from the trust beneficiaries.
If You Cannot Get Insurance
If you do not qualify for insurance, or the premium is prohibitive, there may be other ways to pass as much as possible on to your children. You may be able to insure your spouse’s life or acquire a second-to-die policy.
Creating the Irrevocable Life Insurance Trust
The drafting, executing, and managing an Irrevocable Life Insurance Trust requires the experience of an attorney that specializes in the area estate and family tax planning. You will pay a little more in hourly rates, but it will be worth its weight in estate tax saving. Do not try to do this on your own.
Start by asking your attorney if this is an area of the law that he or she has know-how. If so, ask them how many wills, living trusts, and irrevocable life insurance trusts they have created? If they have not done any or only a small amount ask if they have a colleague or a referral who has estate planning expertise before proceeding. If you do not have an attorney you can check with your CPA, CFP, banker, and / or insurance agents for referrals.
COMMON MISTAKES TO AVOID IN ESTATE PLANNING
This information is brought to you by The NAEPC Foundation and Noverus, your financial and estate planning partners. © Copyright NAEPC, The NAEPC Foundation, Noverus and Valentino Sabuco, CFP®, AEP®. Republished for educational purposes on this site only with the permission of Valentino Sabuco.
Last edited Jul 11, 2010