A client, whom we’ll call Lou, is meeting with his life insurance agent, estate-planning attorney and tax advisor. They’re talking about the 2025 tax law sunset, how it could impact Lou’s tax position and liquidity needs and what planning he might consider doing now in anticipation of the impending change.
After listening closely to his advisors, Lou cuts to the chase. “Unlike you guys, I’m not a student of the tax law. But I am a student of politics. And my studies indicate that there’ll be no sunset. So, I don’t see that there’s anything to plan for. That said, I could be wrong. So, I’m willing to hedge my bet, but not with any strategy involving my parting with total control over assets. I’ll consider life insurance because I know I can control it.
“I know you guys are thinking that we’ve visited the topic of life insurance and control before and that you covered the pros and cons of my owning the policy outright versus having it owned by an irrevocable life insurance trust (ILIT). Yes, I know you were more pro the ILIT and I was more con, but I think it’d be a good idea for you to dust off the presentation you gave me on that topic so I can make some decisions and get the insurance just in case my health sunsets.“
The advisors respond almost in unison, “You know, we just happen to have the slides right here. Let’s get started, but unlike last time, we’ll skip the schematic of your current plan and the A/B trust because we know you understand how all that works. That leaves just four slides.”
You Own Policy
You own the policy and name your A/B trust as beneficiary. This is pretty straightforward. You own the policy, period. You can change the beneficiary, access the cash value or surrender it. There are no income tax implications to your owning the policy unless and until you take money from the policy in an incorrect manner, which you won’t. There are no gift tax implications to paying the premiums because you own the policy. When you pass away, the proceeds will be included in your gross estate, but there’ll be no tax as long as your wife Sue survives you. Whatever remains in Sue’s estate will be subject to estate tax when she passes away. If Sue predeceases you, however, the proceeds, along with the rest of your estate, will be taxable to the extent they exceed the exemption amount at that time.
An ILIT From the Outset
Once the trust is up and running, the trustee, and not you, applies for the policy and designates the ILIT as the beneficiary. If done in this fashion and assuming the ILIT is properly drafted, the insurance proceeds will be excluded from your estate from Day 1. They’ll also be excluded from Sue’s estate, so that whatever remains in the ILIT on her death will be distributed to the children estate tax-free. The ILIT can make funds available to either your or Sue’s estate through asset purchases or loans.
You’ll pay the premiums through annual gifts to the ILIT. A special provision in the ILIT provides a mechanism by which those gifts can qualify for the gift tax annual exclusion, $18,000 a year per beneficiary in 2024, thereby not consuming any of your lifetime gift tax exemption. There are other ways to finance the premiums, but they can be complicated, cumbersome and probably contra-indicated for someone like you who has deep reservations about using an ILIT in the first place.
The ILIT would be designed as a so-called “grantor trust,” meaning that while the policy and any other assets the ILIT owns are outside your estate, you’ll be taxed on any income or capital gains that the ILIT generates from its holdings. For now, there would be no such income, as the ILIT would own only the policy and any cash value in the policy wouldn’t be taxed as it grows. However, that grantor trust status can be helpful down the road. For example, if you decide to transfer income-producing assets to the ILIT to generate cash flow to contribute to premiums and, therefore, reduce your gifts, the ILIT will keep (and apply) the cash, but you’ll pay the tax on that income. Because under current law, your tax payment isn’t a gift, this is a nice way to make tax-efficient transfers to the ILIT. Grantor trust status will also be beneficial if you want to do certain transactions with the ILIT without triggering income tax. More on that in a moment, but in anticipation of your questions, here are some of the downsides of the ILIT.
You don’t own the policy. Full stop. You can’t change the benefits, access the cash value or do anything else with it. The ILIT is just what it says it is: irrevocable, which means you can’t change it. That said, and though we know you’ll cringe when we say this, we can draft the ILIT with certain provisions that add some measure of flexibility for you and, as with your current trusts, some solid protection for the beneficiaries. So, though irrevocable, it isn’t quite “set it and forget it.”
Of course, we’d be remiss not to point out that the mechanism that qualifies the annual gifts for the exclusion requires annual notification to the beneficiaries. We can help you set up a system for that.
You Move Your Policy to an ILIT
The logistics of this one are simple. We draft the ILIT, and when it’s ready, you assign the policy to the ILIT, which becomes the new beneficiary. You would fund the premium using the same mechanism we discussed earlier. That’s the easy part because now, the plot thickens.
There are two ways to move the policy into the ILIT. You can give it to the ILIT, or you can sell it. Each route has its own set of tolls. As with any gift, you’ll need to assign a value to the policy for gift tax purposes. Gift tax valuation of a life insurance policy is beyond the scope of this discussion, but for now, let’s say that we’ll help you with that when the time comes. The more serious downside of a gift of a policy is the “3-year rule.”
If you die within three years of the transfer to the ILIT, the policy will be in your estate as though you never transferred it. The proceeds are still payable to the ILIT, but again, they’ll be included in your estate.
Because of the 3-year rule, an ILIT created by one spouse primarily for the other typically provides that if the proceeds are caught by that rule and, here, if Sue survived you, the trust could function as a type of marital deduction trust that would protect the proceeds from estate tax until Sue passes away. The ILIT wouldn’t exclude the proceeds from both of your estates, but just as your “A” trust does, it would defer the estate tax to the surviving spouse’s death, in this case, Sue.
If such a contingent marital provision doesn’t sit well with you, we can explore another option. Under the age-old life insurance principle that there’s no problem you can’t solve with more premium, if the new ILIT can buy a term policy and keep it in force for three years, it would have the cash to cover the tax if the
3-year rule snares the proceeds. That way, it presumably doesn’t need to use the contingent marital deduction and can preserve estate exclusion for both spouses.
As we mentioned, the alternative to giving the policy to the ILIT is to sell it. A bona fide sale, which means one that passes the IRS’ “Whom do you think you’re kidding” test, would avoid the 3-year rule. The policy will have to be appraised by a professional to withstand any challenge by the IRS that you sold it for less than full value. Any difference between the full value and the sale price would be a gift, bringing back the 3-year rule.
The other aspect of the sale that doesn’t apply to a gift is that the buyer, here, the ILIT, has to pay for the policy. You could finance the purchase by lending the funds to the ILIT under an interest-bearing note. That story only gets more complicated as it unfolds, both administratively and tax-wise.
The good news about the sale is that because the ILIT is a grantor trust, there would be no income tax implications for the sale or the financing arrangement. And grantor trust status would ensure that the insurance proceeds are income tax-free when received by the ILIT.
An ILIT Owns the Policy, but You Want it Back
You wouldn’t be the first person to experience a case of ILIT remorse. We’ll dispense with a list of the symptoms of that malady and talk about the potential cures.
Remember, you can’t just ask the ILIT trustee to give you the policy back. You’ll have to buy it, which presents a couple of issues. First, the trustee won’t be obligated to sell it to you. The trustee could have some serious fiduciary issues with any beneficiaries who assert that, for whatever reasons, the sale wasn’t warranted or justified. Of course, the trustee will have to get full value for the policy, as determined by appraisal. The good news is that, once again, because the ILIT is a grantor trust, the sale will have no income tax implications.
Another way to “buy” the policy back is for the ILIT to have a so-called “substitution” or “swap” power, which would allow you to, basically, swap cash or property of equal value for the policy. Revenue Ruling 2011-28 says that you can have this right without jeopardizing the estate exclusion of the policy. You must observe some rules, but one advantage of a swap power over the pure sale is that it doesn’t involve the trustee’s discretion. The trustee has to be sure to receive full value for the policy. There’s more that we can cover, but we should leave it here.
Lou says, “Okay, I’ll talk it over with Sue. Meanwhile, let’s get going on the insurance.”