If you are contemplating buying life insurance to pay estimated future estate taxes, you will probably want to use an Irrevocable Life Insurance Trust. Here’s why… Irrevocable Life Insurance Trusts (ILITs) are planning tools used to keep life insurance proceeds outside of the taxable estate.
For example, if a married couple has an estate of 5 million, they can pass 4 million to the next generation with no tax if they set up the proper trust arrangement to take advantage of the maximum lifetime unified credits. That leaves 1 million still subject to tax under the current law.
The logical thing to do is to purchase a survivorship life insurance policy for the projected tax. However, a policy purchased in the manner most people are familiar with, the problem is not solved; it is compounded.
If the couple retain any "incidences of ownership" in the policy, it will be included in the estate. The purchase of a one million dollar policy increases the estate to 6 million. Four million passes tax-free, but now the taxable estate is 2 million. This increases the tax by roughly $225,000.
Solution: the Irrevocable Life Insurance Trust. The Irrevocable Life Insurance Trusts will apply for its own Federal Tax ID number. The trust will then apply for the survivorship life insurance policy. It will be the applicant, owner and beneficiary of the policy. Typical wording is "The Smith Family Irrevocable Life Insurance Trust dated April 1, 2008,Hank Friendly, trustee." In this example, since the Smiths have no "incidence of ownership" in the policy; hence, it will not be part of their taxable estate.
The Owner and Beneficiary Alternative As opposed to using an ILIT, I have worked with a few cases where the only child or children are the owner and beneficiary. This may work. However, each year the parents gift the money to pay the premium, there is no assurance that the money will be used to pay the premium. Furthermore, the children, as owners, have access to the cash values. An ILIT has much more assurance.
The trustee can be a child, the couple's attorney, accountant or a long-time family friend. All of these will work, but an un-biased third party, such as a bank of trust company, may be the better choice. If an individual is the trustee, you can name a bank as the successor trustee. The advantage being, well, Banks don't die.
The Crummey Letter Typically, the life insurance premiums are paid by the parents in the form of annual gifts to the Irrevocable Life Insurance Trust. Currently (2008) a person can give up to $12,000 each year to as many people as they want without paying gift tax or having the amount subtracted from their lifetime exclusion. However, these gifts must be "present interest" gifts, which mean the recipient must have immediate rights to the gift.
Here’s where it gets a little complex: Gifts to an ILIT, for paying premiums on a life insurance policy owned by the ILIT, are not "present interest" gifts. A "Crummey" letter qualifies the gift as a "present interest" gift. The letter is not crummy or poorly written; the letter takes its name from a court case initiated in 1968 by Clifford Crummey, who was trying to do this very same thing: make annual gifts present interest gifts. Ultimately, the outcome of the case required the use of a letter, now known as the "Crummey" letter.
A letter is sent every year to each of the beneficiaries of the ILIT. It simply states that a gift has been made to the ILIT and they can withdraw it if they want within a certain timeframe, usually 30 or 60 days. If they don't exercise this right, the gift becomes a present interest gift.
There is probably an undocumented "understanding" between the parents and children to ignore these letters, as it is a part of the overall estate plan. NOTE: it is very important to arrange for the annual drafting of these Crummey letters. If you have an estate that will be subject to estate taxes and your advisor suggests a life insurance policy to pay the tax at a discount, make sure you evaluate the use of an Irrevocable Life Insurance Trust.
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