Why would I need life insurance and how should I structure it?
Among the common purposes of life insurance are:
• To provide your loved ones with immediate liquidity to pay estate taxes and funeral expenses until your estate is administered through probate or a trust. This is especially helpful where an estate consists primarily of illiquid assets such as real property.
• To equalize beneficiaries who have received other assets (say, the family business), or to leave disproportionate assets to beneficiaries if that is your intention.
• To buy out a business partner, so that you need not remain in business with your partner’s spouse when your partner dies.
• To pay any outstanding mortgages or maintain properties until other assets can be liquidated.
• To ensure that your beneficiaries have funds available to pay other potential future tax liabilities, such as estate, annual estate income or capital gains taxes.
A common misconception about life insurance is that it is not “tax free.” Income generated by whole-life policies are income tax free but they are not estate-tax free. The proceeds of a policy will be calculated as part of your gross taxable estate for the purpose of calculating the applicable estate tax.
An irrevocable life insurance trust can help exclude life insurance from your gross taxable estate and thereby from estate taxes. It is a form of irrevocable trust that owns (and controls) and is the beneficiary of your life insurance policies. It is irrevocable, which means that it cannot be changed or amended once created (although the grantor can always stop making gifts to the trust to pay the premiums). Existing policies are transferred to the trust, or the trust buys new policies on the grantor’s life. The trust is named beneficiary of the policy, and the terms of the trust dictate who receives the proceeds of the policy and when.
For owners of small businesses, life insurance can be a crucial part of a solid estate plan. For many business owners, their net worth is inextricably intertwined with the business itself, and the business is an illiquid asset that cannot be readily sold. The Internal Revenue Service is not sympathetic. It demands that estate taxes be paid in cash within nine months of death, even if you file for an extension to file the taxes. Although there is a provision in the tax code for applying for an “installment plan,” it is not a request that is readily granted and the government charges interest on the installments. Often the survivors of business owners must use the little cash or liquid investments that were left to them — and on which they expected to depend to satisfy daily needs — to pay the estate taxes and expenses of administrating the estate. Some are forced to sell the business in a fire sale under duress to raise the funds. Life insurance can help cushion the blow of a tax bill arising from a small business ownership interest. An irrevocable life insurance trust can be used as a vehicle to hold insurance policies so that the death proceeds are payable to the trust and pass to the trust beneficiaries free of estate tax.
How does an irrevocable life insurance trust work?
You gift money to the trust. Usually, you transfer enough money to cover the annual premium. In order to avoid paying gift taxes on the gift (or decreasing your available tax exemption at death), the trust usually gives the trust beneficiaries an immediate right to withdraw the gift contribution (usually a short window like 30 days). This is known as a “Crummey power” for the court decision that sanctioned it permissible for rendering the transfer qualified for the annual gift tax exclusion ($14,000 in 2014). Although not expressly stated in the trust itself, the beneficiaries usually understand that they will ultimately receive more by not exercising their withdrawal right and leaving the gift inside the trust to purchase the life insurance.
The trustee of the trust then purchases life insurance on your life (depending upon how the trust is set up, the trust may purchase insurance on the joint lives of you and your spouse). When you die, the trust receives the insurance proceeds from the life insurance company.
The irrevocable life insurance trust has many other benefits depending on the client’s objectives, such as ensuring preservation of principal against creditors, remarriage of your spouse or of children-beneficiaries, or from the beneficiaries themselves in the case of a spendthrift or where substance abuse is an issue. It can help ensure that capital will remain in the trust for future generations if desired. A forced sale of other assets under duress or in bad market conditions can also be avoided or the impact softened. In short, the irrevocable life insurance trust is an excellent vehicle for ensuring your financial legacy, regardless of your net worth or anticipation of estate taxes.
Alison Arden Besunder is the founding attorney of the law firm of Arden Besunder P.C., where she assists new and not-so-new parents with their estate planning needs. Her firm assists clients in Manhattan, Brooklyn, Queens, Nassau, and Suffolk Counties. You can find Alison Besunder on Twitter @estatetrustplan and on her website at www.besunderlaw.com.
