So you bought a life insurance policy to protect your family and your assets? They may end up paying for this piece of seemingly good planning, however.
While life insurance proceeds are exempt from income tax, they are not necessarily exempt from estate tax. If your estate receives the proceeds of your life insurance policy, the value of your estate may be increased so that it exceeds the current $2 million threshold, and that excess will be subject to federal estate tax at a marginal rate of 45 percent. This threshold is not hard to cross these days given the value of real estate.
With careful structuring, however, you may be able to avoid this pitfall and use life insurance as a key planning tool so that the proceeds get to the people you intend to protect.
If a life insurance policy is owned by an irrevocable life insurance trust (ILIT), the proceeds may avoid the estate tax. In addition, the proceeds may bypass probate, allowing the cash to get to your heirs much more quickly.
Here’s how it works: An ILIT is typically created by having an attorney draft an irrevocable trust document. The ILIT purchases a life insurance policy on your life. The insured periodically makes deposits into the trust account, thus providing the funds to pay the policy’s premium and any other trust expenses.
If structured properly, any deposits into the ILIT will be considered a gift to the trust’s beneficiaries and qualify for the $12,000 annual gift exclusion. If the amount deposited exceeds the annual exclusion of $12,000 per trust beneficiary, then you have a taxable gift.
If the premium payments create a taxable gift, there are steps you can take to avoid it. For example, you could “gift split” with your spouse, which would allow your gift to be deemed as half made by you and half made by your spouse, thus utilizing both of your $12,000 annual gift exclusions.
Even if you end up with some portion of taxable gift, don’t let this dissuade you. Just because you’ve made a taxable gift doesn’t mean you will actually pay a gift tax. You may have part of your unified credit available to offset the current tax due.
Upon your death, the trust receives the policy’s death benefit. Thereafter, the trust can in turn make a distribution to its beneficiaries. The proceeds are now in the hands of the beneficiaries to use as they wish. They can even opt to use these funds to buy business interest or other property owned by your estate at the estate value. As the basis of estate property is stepped up to market value, the estate should not realize any gain on the sale to you that would subject it to income tax.
ILITs may be one of the easiest and least expensive ways for your family to avoid significant estate tax. It could also help provide them the liquidity they will need to protect their interests in your property.
When you transfer an existing policy to the trust, the transfer must take place more than three years prior to your death for the proceeds to avoid estate taxation. Additionally, consider borrowing the cash surrender value before the transfer, otherwise the cash surrender value will be considered a gift to the trust’s beneficiaries. To avoid these negative effects, it is always better for the trust to be the owner of the policy at the time of issuance.
Remember, ILITs are irrevocable and cannot be amended. If, for example, you later decide to change beneficiaries, your only choice may be to stop funding the premiums and risk loss of coverage. Additionally, you cannot borrow from the policy, nor can you retain any power to give instructions to the trustee, as the IRS may consider the integrity of the trust to be breached and can require the insurance proceeds to be included in your taxable estate. Therefore, it is crucial that the trust be properly crafted, all the rules carefully followed, and you consult your tax advisor prior to engaging in the transaction.
BARBARA LANE, CPA, is a partner in the White Plains office of Citrin Cooperman & Company, LLP (www.citrincooperman.com), one of the largest accounting, tax and business consulting firms in the New York metropolitan area, with offices in New York City, White Plains and Springfield, N.J.