Friday, February 25, 2011

Shred Mania Month

We noticed on our little wall calendar today that February is "Shred Mania Month!"  It suggests that you go through all of your "important" papers, files, and documents.  Things that you thought were important six months ago, probably aren't anymore.  Once you've made sure that everything is up to date and accurate, "give that shredder a workout," it says.  How perfect!  Need help making sure your affairs are up to date?  That's where we can help you.  For our current clients, you can ensure that your estate plan will be in good working order by reviewing and sending back you Asset Review Reports.  Don't have an estate plan?  Well, now that you've cleaned out your files, bring all your papers in and we'll help you make one.  Happy Shred Mania Month!

Irrevocable Life Insurance Trusts: Annual Gifting & The "5 and 5" Limit*

Contributions to an irrevocable trust are considered gifts to the beneficiaries of the trust, and are therefore taxable.  Ideally, the trustmaker would use the $13,000 annual gift tax exclusion to help offset any gift taxes that may arise.  If there is more than one beneficiary of the trust, the maker could give up to $13,000 per beneficiary.  Under ordinary circumstances, however, the gift is not eligible for the $13,000 annual gift tax exclusion because the beneficiaries do not actually have the free use of the gift presently.  The amount of the gifts would instead reduce the maker's lifetime gift tax exemption amount (currently set at $5,000,000 in 2011), or if that is insufficient, they would then be subject to gift tax.

In order to qualify gifts to an Irrevocable Life Insurance Trust for the annual gift tax exclusion, the beneficiaries must have a "present interest" in the amount given to the trust.  A present interest can be created by giving the beneficiaries the right to withdraw the asset from the trust under a provision known as a withdrawal right, sometimes called a Crummey power.

In a famous court cases in the late 1960s (Crummey v. Commissioner), the courts decided that if an irrevocable trust's beneficiary is given the right to withdraw a gift made to the trust for a reasonable period of time after the gift is made, the gift will qualify for the annual exclusion.  The number of annual exclusions that are allowed for a gift to an ILIT is equal to the number of beneficiaries who have a demand right.  For example, a demand right can be given to children and grandchildren.  If there are two trustmakers, then $26,000 per beneficiary can be given to the ILIT and still qualify for the annual exclusion.

The right to withdraw assets means that the demand right beneficiary has a power of appointment during the time in which he or she can withdraw the assets.  The Internal Revenue Code stipulates that the release or lapse of the power of appointment results in a gift of a "future interest to the other beneficiaries."

This means that if a beneficiary does not exercise his or her right to withdraw, that beneficiary is making gifts to the other beneficiaries of the amount that was given up. If this amount exceeds (the greater of) $5,000 or 5% of the total assets in the trust, then the beneficiary is considered to have made a gift of a future interest to the other beneficiaries.  The is called a gift over amount.

The amount of this gift reduces the beneficiary's own exemption equivalent amount.  As a result, though many clients desire to use the full $13,000 annual gift tax exclusion limit, they find it creates tax problems for their beneficiaries.

One solution is to have each beneficiary allow his or her right to lapse with respect to the "5 and 5" amount, but retain an ongoing power to withdraw the excess amounts which have been contributed to the trust.  These are called "hanging powers."

Another solution is to create a separate share for each beneficiary.  Using this strategy, when the beneficiary allows his demand right to lapse, the lapsed amount is allocated to a separate share which that beneficiary ultimately receives.  no other person benefited and, therefore, there is no gift over problem.

*Adapted from the Planning Partners Press.

Tuesday, February 22, 2011

Irrevocable Life Insurance Trusts: Individual vs. Joint Trusts

An irrevocable life insurance trust with one trustmaker is called and individual trust.  An irrevocable life insurance trust with two or more trustmakers in called a joint trust.

Individual Trusts

Individual trusts are used by unmarried trustmakers who want to avoid federal estate tax on their insurance proceeds.  Because unmarried trustmakers do not have the benefit of the marital deduction, irrevocable life insurance trusts are extremely important if their estate exceeds $5,000,000 in 2011.

Individual irrevocable life insurance trusts are also used by married trustmakers who want to take care of spouses and family members while ensuring that life insurance proceeds escape taxation in their own estates, as well as in their spouse's and family member's estates.

In some cases, two individual irrevocable life insurance trusts are created -- one for the husband and another for the wife.  Each irrevocable life insurance trust owns and is the beneficiary of policies on the life of its trustmaker.  No matter which trustmaker dies first, the proceeds can then be used to care for the surviving spouse, children, and other beneficiaries.  When the second spouse dies, the proceeds will be available to pay federal estate tax and/or meet other planning goals.  Both policies' proceeds will be free from federal estate taxation.

Individual irrevocable life insurance trusts are also used when the trustmaker has existing life insurance policies that he or she would like to transfer to an irrevocable life insurance trust.  Prudent planning often dictates the use of new life policies when an irrevocable life insurance trust is being created.  However, new policies aren't always feasible.  For example, a trustmaker that experiences health problems may find that the premiums required for a new policy are simply too expensive, or even that they are no longer insurable.

Joint Trusts

A joint irrevocable life insurance trust generally owns a second-to-die policy on the lives of both spouses.  This policy pays when the second spouse dies, so it is ideal for when the purpose of the life insurance is primarily to pay estate taxes.

A benefit of this type of policy is that the premium payments are generally lower than they are for two individual policies because premiums are based on the joint actuarial lives of both insured person.  A second benefit is that the proceeds will be available to pay federal estate tax regardless of which spouse dies first.

Individual and family circumstances determine whether an individual irrevocable life insurance trust or a joint irrevocable life insurance trust is better.  A major decision factor will be whether the client wants to use the insurance to benefit a spouse or children, or to pay estate taxes.

*Adapted from the Planning Partners Press.

Friday, February 18, 2011

Irrevocable Life Insurance Trusts: What To Do With Existing Policies*

Previously, we explored the steps that are taken when funding an Irrevocable Life Insurance Trust (ILIT) with a brand new insurance policy.  But what if a client trustmaker is no longer insurable or premiums would simply be too expensive?  Can we use policies that the client already owns?  The answer is "yes," but with caution.

The proceeds from an insurance policy are includable in the estate of a decedent if the decedent possessed "incidents of ownership" either at death or within three years of death.  This means that if a trustmaker transfers a life insurance policy that he or she currently owns by gift to an Irrevocable Life Insurance Trust, and if the maker dies within three years, the life insurance proceeds will be subject to estate tax.  This is the primary reason that new policies should be purchased by the trustee of the ILIT when possible.  It eliminates the three-year look-back for inclusion.

Another potential problem arises when using existing life insurance to fund an irrevocable life insurance trust.  Many times, the life insurance has a substantial cash value.  If it does, then the value of the policy is treated as a gift to the irrevocable life insurance trust.  If the value exceeds $13,000 multiplied by the number of demand right beneficiaries, then the excess will reduce the $5,000,000 (2011) exemption equivalent.  If the exemption equivalent has been used, then a gift tax will be due.

If the existing life insurance policies are sold to the life insurance trust, this three-year rule is avoided.  Of course, for the irrevocable life insurance trust to be able to purchase the policies, enough cash will be need to be given to the irrevocable life insurance trust to pay for the policies.

When life insurance policies are sold, we must consider whether or not the sale will be a "transfer for value" which will result in the death benefit being income taxable.  To avoid this result, the sale must fall into one of the exceptions to the transfer for value rule.  The most frequent solution to this problem is to sell the policy to a partner of the insured.  By giving interests in a family limited partnership, for example, to the irrevocable life insurance trust, the irrevocable life insurance trust becomes a partner of the insured person.

Care must be taken to insure that the policy is being sold for fair market value.  In most cases, the policy value information provided by the insurance company will suffice.  However, if the insured person is in poor health, an outside appraisal of the policy may be needed.

If a trustmaker insists on using an existing policy, and none of these solutions are available, an existing life insurance policy can still be placed into an ILIT.  However, the trustmaker must be aware of the rule and understand that the strategy won't be fully effective until three years have passed.  Or, if insurable, the trustmaker might consider the purchase of a three-year term policy in case of death during the waiting period.

*Adapted from the Planning Partners Press.

Tuesday, February 15, 2011

Irrevocable Life Insurance Trusts: Handle With Care*

Although Irrevocable Life Insurance Trusts (ILITs) are a wonderful planning tool, they must be implemented carefully to avoid serious problems.  Here is a quick summary of the process that should be followed when a client contemplates purchasing a brand new life insurance policy:
  • The need for life insurance is established by analyzing the liquidity and estate planning goals of the family.
  • The family's life insurance expert gathers preliminary medical information and schedules physicals in order to determine insurability.
  • After determining insurability, the irrevocable life insurance trust is prepared. The trustmaker (or trustmakers if a joint irrevocable life insurance trust is to be created by a husband and wife) signs the irrevocable life insurance trust.
  • The trustee applies for a taxpayer identification number for the trust and opens a bank account in the name of the trust.
  • The trustmaker makes a gift to the irrevocable life insurance trust that the trustee deposits in the trust's bank account.
  • The trustee notifies the beneficiaries of their limited right to withdraw their share of the gift from the irrevocable life insurance trust.  (Often referred to as Crummey Notices based on the name of a plaintiff in a court case against the IRS.)
  • The beneficiaries sign an acknowledgment that they have received the notice and return it to the trustee for the trust's records.
  • The beneficiaries allow their withdrawal rights to lapse (as opposed to waiving the rights).
  • The trustee signs applications for the life insurance.
  • The trustee pays the life insurance premium and the policy is issued showing the trust as the owner and the beneficiary.
Irrevocable trust are used extensively in sophisticated estate planning because they remove assets from an individual's estate and allow a certain degree of control by their makers.  When they are properly designed and implemented, they also allow a surprisingly high degree of flexibility.

However, professional advisors must exercise caution to avoid shortcuts that might cause the strategy to fail.  If the withdrawal notices are not issued, for example, the trustmaker has made a gift of a future interest which doesn't qualify for the annual gift tax exclusion.  Or if the insured is listed as the policy owner on the insurance app (instead of the ILIT being listed as owner), the IRS can find "incidents of ownership" that will cause the insurance proceeds to be included in the taxable estate -- in spite of all the precautions taken to prevent that.

Each step of the process is there for a reason, and must be carefully and patiently followed.

*Adapted from the Planning Partners Press.

Friday, February 11, 2011

Irrevocable Life Insurance Trusts: The Benefits*

In our last issue, we mentioned that if life insurance is not owned correctly or if premiums are not paid in the most tax-efficient manner, gift and estate taxes can potentially reduce the benefits of life insurance policies by more than half.

An irrevocable life insurance trust (generally referred to as an "ILIT"), potentially protects the value of life insurance policies in several ways:
  • No Gift Taxes. Allows premium payments to qualify for the $13,000 annual gift tax exclusion.
  • No Estate Taxes. It avoids a federal estate tax of up to 35% (2011) on life insurance proceeds on the death of the insured person(s). (The actual percentage will depend on what year the insured dies.)
  • No Generation-Skipping Transfer Taxes. With proper planning, it can shelter those proceeds from estate taxes for many generations while also avoiding the generation-skipping transfer tax when its assets pass from generation to generation.
  • Continued Control. By including explicit instructions to the trustees regarding future beneficiaries, it permits a trustmaker to make gifts with strings attached.
  • Protection from Creditors and Predators. Assets of the irrevocable life insurance trust will not be subject to the claims of your creditors or your beneficiaries' creditors, as long as the assets remain in the trust.
  • Insure Liquidity to Pay Debts and Estate Taxes. By permitting the trustees of the ILIT to purchase assets from the taxable estate or to loan trust principal to the estate.
  • Minimize Federal Gift & Estate Taxes. The principal of the irrevocable life insurance trust, including insurance proceeds added to it upon death, will be free of federal gift and estate taxes.
  • Minimize Income Taxes. Life insurance proceeds will be paid to the irrevocable life insurance trust free of income taxes.
  • Avoid Generation-Skipping Transfer Taxes. If the client and the representatives of the estate make proper elections on gift and estate tax returns, all assets of the irrevocable life insurance trusts will be able to pass from generation to generation, free of both estate and generation-skipping transfer taxes.  This will enable the client's family to build wealth in the trust, free of all forms of transfer taxes, for generations.
ILITS obviously have many benefits.  However, in our next issue, we'll discuss planning pitfalls to avoid when working with irrevocable life insurance trusts.

*Adapted from the Planning Partners Press.

Tuesday, February 8, 2011

Irrevocable Life Insurance Trusts*

An Introduction

This introduction is the first of a multi-part series on an extremely important planning tool -- the Irrevocable Life Insurance Trust (often referred to as an ILIT).  The ILIT is not as simple as it appears at first glance.  It has the potential to blow up if it isn't 1) based on sound counseling, 2) drafted well, and 3) implemented with precision.

In future issues, we'll discuss the procedures that must be followed every time an ILIT is used, what to do with existing policies, the differences between individual and joint ILITs, how ILITs impact annual gifting programs, the famous "5 and 5" limit, the risks when estate taxes are paid from the proceeds of an ILIT, generation skipping, and choosing proper trustees.

The Big Picture

Life insurance is a critical tool in estate planning.  Life insurance proceeds create liquidity at precisely the time it is needed to pay the expenses of a person's final illness and death -- and to pay estate taxes if necessary.

In addition, life insurance provides cash for beneficiaries of estates that are asset-rich, but cash-poor.  A family business owner may use it for beneficiaries who are not involved in the business.  In a second marriage, one spouse may use it to provide for the other, while preserving the bulk of the estate for children.

Life insurance payable to a designated beneficiary avoids probate (unless the estate of the insured person is erroneously named as the beneficiary). If life insurance is not owned correctly, however, or if premiums are not paid in the most tax-efficient manner, gift and estate taxes can reduce the benefits of life insurance policies by approximately half!

Many people believe that life insurance is exempt from all taxes.  This is not true.  They may remember an advisor telling them that they "won't pay taxes" on the life insurance proceeds.  The advisor, of course, had federal income tax in mind.  Income taxation is separate and distinct from estate taxation.  And if you own life insurance, the death proceeds will be subject to federal estate taxation and perhaps state estate taxation, depending on the state in which you live.

As long as the insured person has any rights or powers over the policy (referred to as "incidents of ownership" in the Internal Revenue Code), the proceeds will be included in his or her estate for estate tax purposes.

To avoid this problem, a life insurance policy can be purchased by, or contributed to, an irrevocable trust.  The insured person cannot be a trustee or beneficiary of that trust because both control by a trustee and enjoyment of benefits as a beneficiary would constitute incidents of ownership.  Instead the irrevocable trust (an ILIT) becomes both the owner and the beneficiary of the policy, and the insured person chooses trustees to manage it.

We often think of life insurance in the context of paying estate taxes.  However, even those estates that will never be large enough to be taxable will probably include insurance policies purchased for other reasons.  By having those policies owned in an ILIT, the estate has more room for growth.

More next issue...

*Adapted from the Planning Partners Press.