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Life Insurance as part of your Estate Plan

By M. Todd Smith

A crucially important aspect of estate planning, for most people, is life insurance. There are various purposes for obtaining a life insurance policy. Whatever the circumstances, the purpose will drive the strategic design of an appropriate estate plan for the insured. It is wise to seek professional guidance when planning in order to avoid mistakes due to a simple misunderstanding of property law, tax law, or insurance law. For example, a common misunderstanding of life insurance is the myth that all life insurance proceeds are inherited by the beneficiary “tax-free.” While that may be true with respect to the income tax, many people are surprised to learn that without proper planning, such proceeds will be included in a decedent’s estate when calculating the estate tax. This article will briefly discuss the mechanics and benefits of using an irrevocable trust, sometimes called an irrevocable life insurance trust or ILIT, to own and control a life insurance policy.

Mechanics

The grantor, the person who creates the ILIT, designates an independent trustee to manage the trust assets; in this case, independent means any person or entity other than the grantor, including the grantor’s wife and/or children. Once the ILIT is established, it will obtain ownership of a policy insuring the life of the grantor, the person who created the trust. Depending on compliance with certain timing rules in the tax code, the proceeds of the life insurance policy held in the ILIT are not subject to inclusion in the decedent’s estate. The key to securing the exclusion of the policy for estate tax purposes is that the grantor has given up all “incidents of ownership” in the policy. That means that the grantor does not have the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to pledge the policy as collateral for a loan, or to obtain directly from the insurer a loan against the cash value of the policy.

Benefits

In many cases, the primary motivation for holding life insurance in an ILIT is to create liquidity for the estate. For example, many large estates carry substantially all of their value in illiquid assets like a farm or family business. When the owner of the farm or business dies, there can be a very significant estate tax due, but no funds to pay it! Without proper planning, this can ultimately lead to a “fire-sale” of the business, meaning that the heirs will be forced to accept a sale price that is perhaps significantly less than the business is worth.

Life insurance is an easy solution, but it can come with a price. If the proceeds of the insurance policy are included in the decedent’s estate, it will result in significantly more tax due! However, by holding the policy in an ILIT, the amount of the proceeds will not increase the amount of estate tax due because the total estate value for estate tax purposes will not include the proceeds.

Similarly, the liquidity created in an estate by life insurance can be an effective way to equalize inheritances among children. For instance, again using the example of an illiquid asset like a family business, if one or more children are not actively involved in the business, maybe those children that are actively involved will inherit the business, in order to maintain consistency in the ownership transition, while the other children inherit proceeds from the life insurance policy.

It is also important to keep in mind that at the end of the day, an ILIT is simply an irrevocable trust that holds life insurance. That means that all of the other reasons for establishing an irrevocable trust can be satisfied in many cases with the same irrevocable trust used to hold life insurance. Other uses for irrevocable trusts include asset protection, IRA planning, and lifetime gifting.

Conclusion

The ILIT is a cost-effective estate planning strategy, especially for individuals with large estates that are facing substantial estate tax problems. Professional guidance should be sought when designing an estate plan that utilizes a significant life insurance policy.