Life Insurance & Life Insurance Trusts

Life insurance is often an important element of an estate plan. It can provide liquidity to the estate to pay estate taxes and other expenses in the even of your death, and it can also supplement or create an estate for the support of your family.

Life insurance that you own is part of your estate. Consider that even with a modest estate, if you own a substantial life insurance policy, the assets you transfer to your beneficiaries could be greatly reduced by transfer taxes.

An insurance policy owned by you on your life at the time of death will be included in your taxable estate and subject to federal estate tax if your estate is the beneficiary or you possess certain ownership rights ("incidents of ownership"). Life insurance owned by you that you have transferred within three (3) years of death will also be included in your estate.

It is easy enough to change your estate from being the beneficiary of your policy, but eliminating the incidents of ownership can present some difficulty. You are deemed to have incidents of ownership if you possess certain rights. These rights, if held by you, will cause the proceeds to be taxed in your estate. Some of these rights include (1) the right to change beneficiaries (2) the right to assign the policy (or to revoke an assignment) (3) the right to pledge the policy as security for a loan (4) the right to borrow against the policy's cash surrender value, and (5) the right to surrender or cancel the policy. Even if you never exercise the right, just having any of the rights will cause the proceeds to be taxed in your estate.

A commonly used technique to avoid inclusion in your estate as the insured, is to create an irrevocable life insurance trust (ILIT) to own the policy and receive the policy proceeds on your death. A properly drafted and administered life insurance trust removes the life insurance proceeds from the gross estate of the insured, while also making those proceeds available as a source of liquid funds for the payment of estate taxes and other obligations.

The following example illustrates the tax benefit of a properly designed and administered ILIT as part of an estate plan. This example is simplified and will assume that no other credits or deductions are available, nor more advance planning done other than that stated in the example.

EXAMPLES: (also see Tax, Portability and Exclusion Planning for 2014 plus Pros and Cons of Portability)

Fact Pattern:
Let's say it is 2014 and John and Mary, both US citizens are married with one child, Bobby, and live in California. Let's also assume that their combined estate, consisting 100% of community property is valued at $25 million on February 22, 2014, the date of John's death. John and Mary had always talked about seeing an estate planning attorney but never got around to it. By the laws of intestacy of California, Mary, as John's spouse, inherits John's ½ share of the community property ($12.5 million). All $25 million of the estate value is now owned solely by Mary.

Scenario One:
It is 2014 and the unified credit amount is $5,340,000. John's interest in the community estate is $12.5 million. Even though John had a taxable estate, by virtue of the marital deduction, all of John's property will pass to Mary and completely escape estate taxation at John's death. However, Mary's estate is now worth $25 million which is $19,660,000 more than the exemption exclusion amount for 2014. Let's say Mary dies later in the year from a broken heart. Mary's estate uses her $5,340,000 applicable exclusion for 2014. That leaves $19,660,000, million subject to the 40% estate tax to be paid before the property passes to Bobby.  Instead of Bobby receiving $25 million inheritance from his parents, he will receive $17,136,000 after payment of the estate tax liability of $7,864,000 . This is a large estate tax bill that could have been reduce and possibly eliminated with advance planning.

Adding insult to injury, if Mary neglected to do her own estate planning for her property, Bobby would be forced to have the property transferred to him through a time consuming, public probate proceeding incurring even more costs.

Scenario Two:
Here we will assume that at the beginning of 2014, John and Mary draft an estate plan. The plan provides that the unified credit exemption equivalent available in the estate of the first spouse to die would be transferred to a Bypass/Credit Shelter Trust for the benefit of the surviving spouse with Bobby as the remainder beneficiary. With our facts, when John died, a marital deduction was claimed and his estate escaped estate taxation. John's exclusion exemption, $5,340,000  for 2014, was placed in a Bypass/Credit Shelter Trust for the benefit of Mary. When Mary passes away later in the year, her estate will use her $5,340,000 exclusion for her estate, and because the $5,340,000 in the Bypass/Credit Shelter Trust will not be included in Mary's estate, the plan has reduced the estate tax liability considerably. In this scenario, the tax liability will be $5,728,000 and Bobby will receive $19,272,000 of inheritance. Considerably less than the tax liability in Scenario One (over $2 million less), but more could be done to reduce the tax exposure.

Scenario Three:
Let's assume the same facts as scenario two, except John and Mary's estate planning professional identifies that $2 million of the estates assets consist of life insurance policies. The attorney prepares an Irrevocable Life Insurance Trust (ILIT) effectively taking the value of the life insurance out of the estate for estate tax purposes. Here, at the time Mary dies (John is already dead) John's $5,340,000 unified credit has been preserved by transfer to the Bypass Trust, Mary's $5,340,000 exclusion is utilized at her death and the $2 million from the life insurance has been removed from the estate for valuation purposes by the ILIT.   Mary's taxable estate is $2 million less due to the ILIT planning and Bobby's inheritance is $2 million more for the same reason.

If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.

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