"I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money." - Entertainer Arthur Godfrey
Several temporary tax provisions that were part of the 2017 Tax Cuts and Jobs Act are set to expire at the end of 2025, including the lifetime estate and gift tax rules.
The exemption amount for 2023 is $12.92 million per person or $25.84 million for couples. This means for those below these exemption amounts there is currently no estate tax due upon death. If Congress fails to act and the scheduled sunset takes place in 2026, the estate and gift tax exemption will revert back to an estimated $7 million per person or $14 million for couples, depending on the inflation rate over the next few years.
For those above these exemption amounts, a federal estate tax is levied at a 40% rate on all assets above the exemption. (The rate is 18-39% up to $1,000,000 and then 40% on anything above that. We’ll use 40% for simplicity.)
17 states and the District of Columbia levy estate or inheritance tax. California is not one of them.
With this pending change on the horizon, you might consider revisiting your estate strategy, especially if you are uncertain whether the sunset will influence your approach.
The irrevocable life insurance trust (ILIT) can be an important estate strategy tool that may accomplish a number of estate objectives (although it may not be appropriate for every individual).
What Is an ILIT?
An ILIT is a trust created by an individual (the grantor) during his or her lifetime.
The ILIT owns a life insurance policy on the grantor’s life via the transfer of ownership of an existing policy or through the grantor’s annual contribution of cash to pay the premiums on a new policy purchased by the trust.
The grantor designates beneficiaries, usually family members, who will typically receive the trust proceeds upon the death of the grantor.
The trust is irrevocable, meaning that the grantor forfeits all rights to the property contained in the trust. Its irrevocable nature is integral to accomplishing the ILIT’s objectives.
What Can an ILIT Accomplish?
The ILIT may be able to accomplish several estate objectives, including:
Meeting liquidity needs.
Managing estate taxation on the policy proceeds.
Providing income to survivors.
How Does an ILIT Work?
At death, the trust is designed to receive to the proceeds of the life insurance policy.
But since the trust’s ownership of the policy is irrevocable, the proceeds are not considered your property. Consequently, they do not fall into your estate, thus potentially avoiding estate taxation. Remember too, generally no income tax is due on such life insurance proceeds.
The trust provisions should be set up to provide direction about how and to whom payments may be made. You may direct that the trust pays out cash to cover certain expenses, e.g., funeral costs, probate, taxes, final medical expenses, and debts.
Having a life insurance policy which creates instant liquidity in the trust may obviate the need to sell illiquid assets at an inopportune time to cover such costs, most commonly estate taxes.
The trust’s beneficiaries may receive the proceeds (after any payments are made to satisfy liquidity needs), creating an inheritance free of estate taxes. Finally, creditors should not be able to attack these assets since they belong to the trust, not you.
An Example
Tom and Pam are a 55-year-old married couple with two adult children. They have accumulated a net worth of $40,000,000. Most of their net worth is in illiquid assets such as their family business and real estate.
They understand that spouses can pass an unlimited amount of wealth between each other, and that the estate tax would not be levied until the death of the last living spouse. When that ultimately happens, they would like to pass their entire net worth to the children including their business and real estate.
Under current estate law, Tom and Pam can each pass $12,920,000 of assets to their children tax free, or $24,840,000 in total. The remaining $15,160,000 of their net worth will be taxed at a 40% rate or $6,064,000 of tax. This tax is generally due within nine months of death. As you can imagine, the IRS only accepts cash!
As I alluded to in the introduction, it’s important to note that unless Congress passes legislation before the end of 2025, the exemption amounts are projected to drop to $7,000,000 per person or $14,000,000 per couple. In Tom and Pam’s case, after that date, the 40% estate tax would be due on the remaining $26,000,000, or $10,400,000 of tax.
Tom and Pam do not want their children to have to sell their illiquid assets, especially under the potential duress of a tight timeline just to raise enough cash to pay the estate taxes.
So, after consulting with their estate attorney and financial advisor, they decide to create an ILIT. Their children will be the beneficiary of the trust and Pam’s brother, Michael, agrees to be the trustee.
Tom and Pam then purchase a $10,000,000 second-to-die life insurance policy which the trust will own and be named the beneficiary. This type of policy insures two people but only pays out upon the death of the last person (also known as a last-to-die policy).
To pay the annual premiums due on the policy, they will each use their annual gift exemption which currently allows each of them to give $17,000 per child per year. These annual gifts, which total $68,000 ($17,000 each x two children), are deposited into the trust. The trustee, Michael, then forwards this on to the insurance company.
Upon the second death, the trust will have $10,000,000 of liquidity at the exact time the estate tax is due.
Tom and Pam see this as an excellent way to preserve their estate and hard-earned assets, while also maximizing gifts to their children and removing an additional $68,000 per year from their estate along the way.
Important Considerations
1. An ILIT is not appropriate for everyone. And frankly, some people have told us that their kids will get enough and it’s not their problem what happens after they’re gone. Fair enough. But for those that want to create a plan to manage the estate tax, an ILIT is a popular option.
2. Creating an ILIT should be done only with the assistance of a qualified estate planning attorney. It is a complicated exercise in which mistakes may result in losing the benefits ILITs offer.
3. Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.
4. Several factors will affect the cost and availability of life insurance, including age, health, and the type and amount of insurance purchased. Life insurance policies have expenses, including mortality and other charges. If a policy is surrendered prematurely, the policyholder also may pay surrender charges and have income tax implications.
So, you should consider determining whether you are insurable before implementing a strategy involving life insurance. Any guarantees associated with a policy are dependent on the ability of the issuing insurance company to continue making claim payments.
5. The above example is hypothetical and used for illustrative purposes only. It is not representative of any specific estate or estate strategy. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.
Please reach out if you’d like to discuss this or anything related to your plan.
Happy planning,
Brian