Business owners are particularly sensitive to cash flow and liquidity needs. This can be especially true of the business owner’s estate after death. The estate needs cash to continue business operations and to pay potential estate taxes. Life insurance can be an effective planning strategy for business owners if properly structured. In some circumstances, life insurance is used to ensure funds for a successful business succession plan. In this case, however, the insurance is structured with the additional benefit of reducing or eliminating the threat of the estate tax. As a reminder, both the state of Washington and the federal government impose an estate tax for estates larger than specified thresholds. Accordingly, when conducting a cost/benefit analysis of whether the strategy works for the business owner, the tax impacts must be considered. If the insurance proceeds are taxed in the owner’s estate, then the net to the estate could be roughly half of the face value of the policy. A planning strategy that is commonly used to deal with the estate tax threat is the irrevocable life insurance trust (ILIT). This article addresses how the ILIT functions.
The key to the strategy is the ownership on the life insurance policy. As a general rule, everything you own at death is part of your gross estate and potentially subject to tax. The ILIT addresses this issue by placing the ownership of the asset (the insurance) in a trust rather than in the business owner’s name. By doing so, it is possible to completely exclude the asset from the business owner’s estate. This means that it can be structured so that the full amount of the insurance will never be subject to estate or income tax.
A person could use a similar strategy without the use of insurance. Indeed, some people may prefer to invest in marketable securities instead of life insurance. The problem is that trusts pay some of the highest levels of income tax. Thus, if the asset in the trust has income, then the value of the asset could be substantially reduced over time. The benefit of life insurance is that it has no income and thus is not subject to the high income taxes associated with trusts. And, this is why this estate planning strategy is specifically named The Irrevocable Life Insurance Trust.
Mechanically, the process works by the business owner setting up an irrevocable trust. The fact that the trust is irrevocable means that it cannot be changed. Once the trust is set up, then the business owner transfers into the trust either: (1) cash for the trust to purchase life insurance on the business owner’s life; or (2) a pre-existing life insurance policy. Typically, the business owner would appoint an independent trustee (professional) to administer the trust. The beneficiary of the trust would be whomever the business owner would like the estate to be distributed (usually his or her children). The business owner has thus created a mechanism that protects the assets from estate tax exposure with the same result that the kids get the life insurance at the business owner’s death. Then, when the children are confronted with costs or taxes for the rest of the business or estate, they have the liquidity to continue operations as before.
When the business owner transfers the life insurance or cash into the trust, it is treated as a gift. And, depending on the value of the transfer, the business owner may need to file a gift tax return. However, if the gift is under the applicable annual exclusion amount (currently $14,000 per year), then the gift need not be reported so long as it qualifies as a “present-interest gift.
Now, in order to make it qualify as a present-interest gift, the trustee must send the beneficiaries Crummey letters which authorize the Crummey power (named after the court case of Crummey v. Commissioner from the 9th Circuit Court of Appeals). A Crummey power is a provision in the trust that will give each beneficiary, for a limited period of time, the right to withdraw a portion of any contributions made to the trust. The mere existence of this right, even if not exercised, will convert the gift into a present-interest gift. So, the business owner transfers money to the trust, the Trustee sends out Crummey letters, and the trust uses the money to pay the premiums on the life insurance.
Of course, this is a simplistic overview (written in 750 words or less) of a sophisticated estate planning strategy. Be sure to consult your estate planning professional for more details.
- Licensed, not practicing.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.