Estate taxes pose a dilemma for asset-rich but cash-poor Americans. To pay Uncle Sam, their heirs may be forced to liquidate their real estate empires or privately held businesses.
But there is an alternative to a fire sale: They can use life insurance to foot the bill with a neat trick. Instead of owning a life insurance policy directly, they take out a policy and put it inside a trust. The irrevocable life insurance trust (ILIT) collects the death benefit, pays the tax bill, and distributes whatever is left according to the insured individual’s wishes.
Any payout is also protected from estate taxes, even if the insured’s estate and death benefit exceed the exemption. (Currently, a 40% federal estate tax applies to estates exceeding $13.61 million). For an ultra-rich taxpayer with a $10 million life insurance policy, using an ILIT could save $4 million in taxes.
“It’s low-hanging fruit. It succeeds in removing the insurance from the estate. It does not deprive anybody of access to anything,” said Robert Strauss, partner at the law firm Weinstock Manion.
The insured can select virtually anyone as the beneficiary such as business partners or friends. While it is less common now, ILITs have been — and can be — used to provide for unmarried partners or extramarital ones.
“Historically, if an individual had a special friend that they wanted to benefit, life insurance inside the trust was one of the ways you could ‘take care of’ that obligation,” said Dan Griffith, the director of wealth strategy at Huntington Bank.
There are other perks. As with other types of trusts, the insured can pick a trustee that manages how the funds are distributed to the beneficiaries. For instance, a grandchild can receive a distribution to pay for college tuition but not a sports car. The ILIT can also limit the future beneficiaries, excluding future partners of a surviving spouse.
If the insured wants to make sure that their heirs are protected from creditors or divorcing spouses, they can use ILITs to be doubly safe, Griffith added. Though law varies by state, trusts and life insurance both have strong legal protections.
“Even if, for whatever reason, the creditor were able to get into the assets of the trust, the insurance policy could be protected by state law on its own,” Griffith said.
Here’s how ILITs work
ILITs have to be properly structured to pass muster with the IRS.
The ILIT must be named as the beneficiary of the life insurance policy. It must also own the policy. While you can transfer the policy to the ILIT as a gift, Strauss does not recommend this as the transfer is void if the insured dies within three years. Instead, he advises the grantor — the person who creates the trust — to provide cash or a loan to the ILIT so the trust can buy the policy.
When cash goes into the trust, there is a waiting period of typically 30 to 60 days during which beneficiaries can take money out. After the beneficiaries have been notified and the period elapses, the trust can use the cash to pay the premiums.
With these cash contributions, the grantor reduces the size of their taxable estate. They also do not incur gift tax if the grantor gifts $18,000 or less a year.
After the insured’s death, the trust receives the death benefit. Whether to pay the estate tax should be left to the trustee’s discretion, according to Griffith. If the trustee is obligated to pay the tax bill, the death benefit would be included in the taxable estate.
After the tax bill is paid, the remainder can be distributed in various ways. For instance, the ILIT can name the surviving spouse as the primary beneficiary and the children as secondary beneficiaries. The surviving spouse receives the assets, which pass on to the children free of estate tax after their passing, Strauss said.
There are a few caveats
Trustees can get in trouble with the IRS by forgetting to notify beneficiaries.
The devil is in the details. It is crucial to notify beneficiaries of their right to withdraw cash from the ILIT within a specified time period with what are known as Crummey notices — named after the taxpayer who coined the technique.
Despite the practice dating back to the 1960s, it’s surprisingly common for trustees to forget to notify beneficiaries. Strauss recalled one of his partner’s clients trying to backdate his Crummey notices, printing them on a laser jet printer. The IRS detected that the notices had been generated after the fact as they predated the existence of laser jet printers. The ILIT was nullified, and the assets were included in the taxable estate.
Make sure you’re getting a life insurance policy that makes financial sense.
Strauss advises clients to be cautious when dealing with commission-hungry life insurance payments and consider their future plans. For instance, a client with $100 million doesn’t need $40 million of insurance to cover estate taxes if they plan to give away $60 million, he said.
ILITs also work best with permanent life insurance policies, which are much more expensive than term policies. Multimillion-dollar permanent policies carry hefty premiums, which can be a drain.
Some clients who set up ILITs when they are young come to regret the decision, according to Kate Maier, vice president of investment advisory Wealth Enhancement Group. Tax policy changes over time, possibly negating the advantages of the ILIT.
“Or in some cases, they need the money,” she said. “When they set it up, the future looked a lot brighter than it is now. It’s difficult to get the money back out.”
