by Layne T. Rushforth
Why Own Life Insurance?
- Estate creation: to create an estate, usually to replace the income that would be lost in the event of the insured's death.
Liquidity: to provide cash that can be used to pay funeral and burial expenses, debts,claims against the estate, and provide immediate cash needs without having to liquidate investments or sell other assets.
Leveraging the applicable exclusion for federal gift and estate taxes: (1) By making gifts of insurance premiums, which are frequently less than the gift tax annual exclusion, the applicable exclusion will be available for other things. The same can be said for the GST exemption, which provides an exemption from the generation-skipping transfer tax (GST tax).
Hedging other planning options: Some other planning options are more effective if combined with life insurance, particularly options that are only effective if the person outlives a particular period. Insurance can provide cash to cover additional taxes if the insured dies prematurely.
Potential problems for life insurance
Probate may be required if the estate is the designated beneficiary, if the designated individual beneficiaries are all deceased, or if a testamentary trust is intended to govern the distribution of the insurance proceeds.
Income tax is normally not payable on the proceeds of a life insurance policy, but if one violates the "transfer-for-value rules", it is a possibility.
Estate tax is due on life insurance if the insured held an "incident of ownership" in the policy at any time within the last 3 years of life.
Business-owned insurance will normally be subject to the estate tax if business entity is controlled by insured, but there are some exceptions. The value of the business entity will always impact the taxable estate's value.
Insurance ownership by the wrong person can create problems:
Ownership by a spouse merely defers the tax.
Ownership by one or more children can expose the insurance to the children's creditors' claims and can even get tied up in divorce proceedings. Also, ownership by a child eliminates the possibility of excluding the insurance proceeds from the child's estate.
Ownership by a qualified plan can expose the proceeds to the income and the estate tax unnecessarily.
Irrevocable life insurance trust (ILIT)To minimize taxes and maximize flexibility:
The ILIT must be irrevocable and "funded" properly.
If a spouse is a beneficiary, community property cannot be used to fund the trust.
The settlor (trust creator) should not be the trustee or a beneficiary.
- The settlor may have the power to remove and replace a trustee but cannot change beneficiaries.
The trustee cannot be authorized to pay the estate tax.
For greatest flexibility, an ILIT should be a "grantor trust" for income tax purposes, and it should contain provisions related to noncash assets (e.g., S corporation stock).
An ILIT can be designed as a generation-skipping trust, including a "dynasty trust".
The Irrevocable life insurance trusts (ILIT) is discussed further in the article on irrevocable trusts.
Split-dollar plans provide an alternative way to pay insurance premiums.
In traditional split-dollar plans, the insured's company pays the insurance premiums on a life insurance policy.
To save estate taxes, the policy owner and beneficiary is usually an irrevocable life insurance trust [ILIT].
The policy owner and company enter into an agreement that provides that the company will be repaid the premiums when the policy is surrendered or when the insured dies and the policy proceeds are paid. Under that agreement, the company receives a security interest in (i.e., a "collateral assignment" of) the policy to make sure it gets reimbursed for the amounts it advances.
A split-dollar arrangement can solve funding problems where annual exclusions gifts are insufficient to pay the premiums.
A split-dollar arrangement can also be done privately, which means that an individual -- perhaps the insured -- takes the place of a company.
The term cost of the insurance policy is treated as taxable income to the insured-employee, and that same amount is deemed a gift from the insured to the ILIT's beneficiaries.
It is important to make sure the ILIT has enough assets to satisfy "Crummey" withdrawal rights so that the gifts to the trust are covered by the annual gift-tax exclusion, and a line of credit may be an alternate method of addressing this issue.
Taxable income can be triggered if the equity in the insurance policy exceeds the collateral amount, but this can be addressed in the collateral assignment agreement.
Recent regulations issued by the IRS make split-dollar arrangements more complicated by treating the arrangement as additional compensation or a below-market loan, but split-dollar arrangements are still viable planning tools.
Charitable split-dollar arrangements are not recommended.
Coordination with Other Estate-planning Techniques
Several other estate planning techniques can benefit from coordination with insurance planning:
- Grantor-retained interests trusts --
A qualified personal residence trust (QPRT) is the gift of the remainder interest in a home after a period of years. Using the IRS valuation tables, the remainder interest will have a gift-tax value that is "discounted" to present value, saving the estate tax on the amount discounted.
A grantor-retained annuity trust (GRAT) is also the gift of a remainder interest, but in income-producing investments.
Both the QPRT and the GRAT are effective at estate reduction, but they require that the grantor outlive a specified term of years. Insurance in an ILIT is a good way to plan on providing liquidity to pay the estate tax that is triggered by an untimely death.
An ILIT can also be an appropriate remainder beneficiary of a QPRT or GRAT in some situations.
The QPRT and the GRAT are discussed further in the article on Estate Freezing.
Insurance in an ILIT can replace wealth being transferred to charity under a charitable remainder trust (CRUT or CRAT). These are discussed further in the article about charitable trusts.
A short-term policy might be sued to cover the exposure under the 3-year-of-death rule.
Large retirement plans can be "de-funded" with reduced tax costs by using life insurance purchased in the plan. The retirement plan purchases insurance that has little build up in the policy's "fair market value" in the first few years.
The retirement plan invests in the insurance, and after two years or so, a plan distribution is made to the employee, reporting the policy's fair market value as taxable compensation. The policy is then placed into an ILIT. Frequently, the face value is reduced to reduce or eliminate the need for additional premiums to be paid.
Additional new insurance is purchased to cover the additional estate tax if death occurs "prematurely", either while the insurance is inside the plan or during the 3-year period afterward.
An IRA that was established with funds rolled over from a qualified plan can be "rolled back" into a qualified plan if untainted by subsequent contributions.
Is Not Life Insurance a Bad Investment?
Except for those for whom insurance is unavailable or unaffordable, every individual's estate planning can benefit from some form of life insurance.
Candidly, you cannot truly compare life insurance with other types of investments. Life insurance, including life insurance with investment components, is different primarily because it includes a death benefit that is immediately available. When cash is needed to pay the estate tax and other expenses associated with a person's death, investments such as securities and real property are not immediately available, and the sale of such assets when the market is down can deplete the estate even more than the amount of the cash needed.
Insurance is now more affordable than ever. Term insurance, variable universal life, and last-to-die policies are among the offerings of most life insurance companies. Of course, it is extremely important to purchase the type of insurance that meets your needs from a company that will be there when the insurance is needed. Your insurance advisor will be an important part of your estate-planning advisory team.
These materials continue in the article entitled "Business Entity Planning".
1. Internal Revenue Code § 2010(c) provides for an "applicable exclusion", which is the cumulative amount that can pass free of gift and/or estate tax. This is sometimes called "the exemption equivalent of the Unified Credit". Some past, present, and future values of the applicable exclusion are: $625,000 in 1998; $650,000 in 1999; $675,000 in 2000 and 2001; $1,000,000 in 2002 and 2003; $1,500,000 in 2004 and 2005; $2,000,000 in 2006, 2007, and 2008; $3,500,000 in 2009; unlimited in $2010; and $1,000,000 in 2011 and beyond. President George W. Bush introduced legislation to make the repeal the of estate tax permanent but in the summer of 2002, the Senate rejected that legislation.