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.

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.

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.

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.

Will a Trust Really Fail for Lack of Funding?*

In some jurisdictions, lack of any trust corpus (even just a couple of dollars, or some personal property) will cause the trust to be treated as if it were never created to begin with, and attempts to place assets into such a trust in the future cannot salvage or resurrect the defunct trust.  Most trusts that are created have some modicum of a trust corpus to prevent such a disaster.  Therefore, having anything in the trust will prevent it from failing, right???  That depends on your definition of "fail."  In order to answer the question, we must first talk about how funding works in relationship to a trust.

How does a trust work?  Think of a trust as a bucket, or a treasure chest.  One writes instructions on the outside of the bucket about what one wants done with the things that are in the bucket.  The trustmaker then takes the "bucket" and puts it into the hands of someone the trustmaker can rely on--that's the trustee.  The trustee's job is to follow the trustmaker's instructions with regard to the things that are in the bucket.

What will happen if the bucket is empty when the trustee attempts to follow the trustmaker's instructions after the trustmaker has died?  The trustee only has authority over what is in the trust, so if there is nothing in the trust, then there is nothing for the trustee to do.  (And as mentioned previously, if there is really nothing in the trust, then it may be void, depending on the controlling state law.)

Anything left outside the trust is outside of the trustee's control.  That means that the trustmaker's directions will not be followed with regard to those assets that are out of the trust.  Some assets may find their way back into the trust through a pour-over will, but typically this requires the expense, delay and publicity of probate to do so.

The process we call "funding" is the process of titling assets so that they are in the trust "bucket"--controlled by the trustee.  These assets will be controlled by the trustmaker's directions without the need for probate.

So, back to our question:  having anything in the trust will prevent it from failing, right?  If the measure of success is mere legal sufficiency, then that is correct.  However, the true measure of a trust's success is not whether it is "legally sufficient," but whether the trust meets the client's goals.

One common motivation many have for seeking out an attorney to create a trust is so that their family will be able to avoid the cost, delay, and publicity of probate on their death.  Failure to fully and properly fund a trust means that the client's directions will not be followed with regard to those assets not in the trust, or at least that probate will not be avoided.

If a trust fails to do what the client wanted (transfer assets by specific instructions contained in the trust, or avoid probate, for example), then it has failed whether the trust is legally sufficient or not.

Hopefully, when you buys a gallon of milk at the grocery store, it comes in a container.  But what if you pay for a gallon of milk and only get an empty or half-full container?  You would be upset, and rightly so.  However, people buy empty (or, at least, not full) trust buckets frequently, and do not realize the reduced value they are receiving.

Make sure you are getting full value for your estate plan by working with an attorney who will ensure that the trust bucket is full when created, and has a formal process in place to make sure that it stays that way.

*Adapted from the Planning Partners Press.

Forgotten Estate Planning: Disability*

An often-overlooked part of estate planning is planning for mental disability.  Many of us have been in the uncomfortable position of having to take care of a relative or friend who can't handle his or her financial affairs anymore.  It could happen to you one day.

Our clients tell us that, "I want to control my property while I'm alive and well, and plan for me and my loved ones if I become disabled."

There are four basic disability planning choices:  1) No planning; 2) a Power of Attorney; 3) a Standard trust; 4) a Counseling-oriented trust.

The most common planning issues are: a) Who decides when I lose control?  b) Who takes control?  c) Who gives instructions to the person who takes control?

In most states, if you haven't planned for when you are disabled, your loved ones will have to hire an attorney and go to court.  The judge will decide whether you are disabled, who will be your guardian, and what that guardian can do.  Every state's system is a bit different, but they all have one thing in common:  the Judge is in control.

People often use a General Durable Power of Attorney to prevent guardianship proceedings.  A GDPOA appoints someone as your Attorney in Fact, or agent.  GDPOA's are usually effective immediately, have no reporting requirements, no personal instructions, and have extremely broad powers.  If you look up "lack of control" in the dictionary, GDPOA should be the first definition.  The advantage of this approach is that you get to name the person who is in control.

Standard Living Trusts are often little more than word-processing.  There is no attempt to prepare a personalized plan, so they often use a standard definition of disability, usually based on the option of any doctor with no guidance on which doctor to use.  Doctors are often unwilling to declare someone disabled unless that diagnosis is absolutely certain.  As a result, many families with these trusts may have to resort to the Probate Court to determine whether the planner is disabled.  Additionally, these trusts typically have few personal instructions, but they may provide for a private transfer of control to personally selected trustees.

Most Counseling-orients Trusts provide a personalized definition of disability through a disability panel.  When your loved ones start to think that it's time for you to turn control over to somebody else, they can call the disability panel together to decide whether you are disabled.  Who's on it?  How does it operate? You decide.

Then who takes care of you?  The Successor Trustee you chose when you were well.

How do they care for you?  They follow the instructions you've left behind.  I often ask my clients, "When you need someone to take care of you, would you rather be cared for in your own home, in someone else's home, or in a nursing home?  Everyone has an opinion, but most estate plans doesn't address it!  When you family knows your wishes, they are more likely to be followed.

Many Americans will go through a period of disability.  Planning for your own care has become critically important, as families have become more mobile and fragmented.  With proper planning, you can be well cared for in the way that you want, by the people you have chosen, for the rest of your life.

*Adapted from Planning Partners Press.

Back At It!

I'm back in the office after spending a week in Orlando at the National Network of Estate Planning Attorneys fall conference.  I always look forward to these conferences for a number of reasons--catching up with friends and colleagues from around the country, re-engergizing myself for all that comes with being a small firm practitioner, and LEARNING!  Lots and lots of learning!

I'm always amazed at how much there is to know about estate planning--and the field is constantly changing.  One of the things that I love about NNEPA is the collective philosophy regarding the importance of educating clients on the ins and outs of estate planning and the importance of personalized counseling for every client family to make sure that together we design a plan that will truly work for their unique family.

As part of this philosophy, I believe there is much more to estate planning than a client's financial net worth.  Each of us has a legacy that we can pass on to those we love.  We have stories to share that explain how we became who we are; we have our own thoughts and ideas and opinions about money, charity, legacy, family, faith; we have hopes and dreams for those we love.  As an estate planner, I believe it is important to help my clients capture these non-tangible assets because it is all a part of their true wealth.

For clients enrolled in the Empowered Legacy Planning program, as a result of the SunBridge Legacy Builder Retreat I attended while in Orlando, I will soon be offering Priceless Conversations as part of your membership.  To learn more about Priceless Conversations and the SunBridge Legacy Builder Network, please visit www.SunBridgeLegacy.com.

If you are interested in learning more about membership in our Empowered Legacy Planning program, please give us a call at 480.855.8383.