For years and years, you and your spouse have worked to provide for your children. Year after year – while you kept them clothed and fed, doled out advice and enforced rules – you were also providing for your kids by maintaining your life insurance policy or policies. When you die, the death benefits from those policies are one final way to provide for your children. The death benefit from your life insurance could also be the one asset that triggers the estate tax and swallows up a chunk of your earnings before they reach your kids. The purpose of Irrevocable Life Insurance Trusts (“ILIT”) is to protect the death benefit of a life insurance policy from being counted toward your estate’s net worth when you pass away. Ladimer Law recommends these trusts to clients who have over $1,000,000 in death benefits of term life insurance policies.
The ILIT is a vehicle for passing on liquid assets to your beneficiary without incurring additional estate or gift taxes. Plus, the ILIT provides the usual trust benefits, such as creditor protection for the beneficiaries and professional management. However, this trust is irrevocable, meaning that once you have established the trust, you cannot change the determinative provisions.
ILITs and the Estate Tax
In Massachusetts, where the estate tax threshold is just $1 million per individual, many married couples end up being subject to estate taxes. Their children don’t inherit as much money as they could. Using an ILIT is one way that couples can minimize their estate tax liability. Keeping the proceeds of a life insurance policy out of an estate may be the difference between incurring the estate tax and avoiding it altogether.
Requirements of an ILIT
In order to keep the policy’s benefits out of their estate, the insured individual may not hold any beneficial interest or control over the policy, such as:
The trust must also have a trustee who is someone other than the insured. It’s advisable to name an independent person as trustee, such as an accountant, a financial planner, an attorney, or a trusted friend. The independent trustee will have the authority to amend the trust for administrative and tax purposes. By giving an independent trustee this authority, it removes the elements of ownership from related persons of the insured. The independent trustee will also be given various administrative powers over the policies within the trust.
The Three-Year Rule
The Internal Revenue Code treats the transfer of a life insurance policy to an ILIT as a gift. To discourage people from avoiding estate taxes by giving their assets away just before they die, the IRC states that gifts made within three years of a decedent’s death may be counted toward their estate. Therefore, a life insurance policy transferred to an ILIT within three years of the insured’s death will be included in the insured’s estate.
As an example, say that Joe transfers $1,000,000 to his brother in 2019. Joe also transfers a $1,000,000 life insurance policy to an ILIT in 2019. Joe then dies in 2020. Joe now has reduced his estate by $1,000,000, because the transfer of cash to his brother is not included in his estate. But because Joe did not live three years past the transfer of the life insurance policy to his ILIT, the life insurance proceeds will still be included in his estate.
Now, take the same example, except suppose that Joe dies in 2025. In this case, Joe has reduced his estate by $2,000,000. Joe transferred $1,000,000 to his brother before he passed away and he transferred his life insurance policy to an ILIT more than three years before his passing.
Under these rules, the younger the person, the less risky it is to transfer a life insurance policy to an ILIT.
ILITs and the Gift Tax
Although there is no gift tax in Massachusetts, there remains a federal gift tax. Both the original transfer of the policy and the payments of any additional premiums are considered gifts for tax purposes.
Since premium payments must come from the owner of the policy, the insured will have to write a check in the amount of the premium, payable to the named trustee of the ILIT. The trustee will then deposit the check into the trust’s bank account and will write a check in the amount of the premium to the insurance company from the trust’s account. In order to avoid a gift tax consequence on the premium paid to the trust, a few things must happen.
First, the trust must contain provisions allowing the beneficiaries (no matter what age) to withdraw additions made to the trust. With this provision, both the original policy transfer and the premium payments will qualify as annual exclusions from the gift tax. Currently, the annual exclusion from the gift tax is approximately $15,000 per donee, with an unlimited exclusion between spouses.
Second, the trustee will have to give notice to non-spousal beneficiaries every time a payment is made to the trust. A letter from the trustee to the beneficiaries will put them on notice that a payment has been made to the trust, and they have a right to withdraw their share of that payment. (If the beneficiary is a minor or incompetent, the trustee must give notice to their legal guardian or conservator, or the parent as the “natural guardian” of the child.) The letter will indicate a time frame for withdrawal, typically between 30 and 60 days. The idea is that the beneficiaries do not exercise their right of withdrawal, but there can be no formal agreement regarding such. To simplify this process for you, Ladimer Law will provide trustee instructions, and a template for the letter.
Third, the amount subject to the right of withdrawal must be ascertainable. This means that the right of withdrawal must be a specified amount. And the trust must have the capability to satisfy the right of withdrawal. Therefore, it is wise to fund the trust with an amount of cash equal to one annual premium payment.
Lastly, if a beneficiary of the ILIT is given a right of withdrawal, and they do not exercise that right, the amount of the withdrawal is considered a gift from the beneficiary to the trust. This gift tax consequence can be minimized by including a “5 and 5” provision in the trust. A “5 and 5” provision provides that there is a taxable gift only to the extent that the amount of the right of withdrawal exceeds $5,000, or 5% of the aggregate value of the property from which the exercise of the power could have been satisfied. This “5 and 5” provision applies to each donee.
Ladimer Law recommends ILITs because when you pass away, the death benefit of any life insurance policy is counted when determining whether your estate owes a tax or not at your passing. Sometimes the death benefit of a life insurance policy is the only asset that causes an estate tax liability. When this is the case, an ILIT can completely eliminate the estate tax.
Ladimer Law can walk you through the entire process of establishing an ILIT to preserve assets for your children. Remember, because of the three-year rule, there’s a real risk in waiting too long to set up your ILIT. Reach out to Ladimer Law today.
Copyright © 2023 Ladimer Law Office PC
209 West Central Street
Natick, MA 01760
Ladimer Law specializes in estate planning. We protect our clients, their heirs, and their assets by listening closely, knowing the law, and executing estate plans that fit and evolve.