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Irrevocable Life Insurance Trusts


INTRODUCTION
Life insurance is a common purchase for many individuals.  However, few people realize that the pay-out value of a policy insuring their life can be included in their gross estate, even though the proceeds are paid to someone else. Life insurance policies are often a key factor in determining whether your estate will owe federal taxes after your death, particularly if those policies are large. Estates that might otherwise be free from federal estate taxes can incur taxes because of the life insurance policy. Given that the highest federal estate tax rate is currently 35%, this can be a hefty bill to pay.  An Irrevocable Life Insurance Trust (ILIT) can be used to remove a life insurance policy from an estate while still providing the benefits of life insurance to loved ones.

When Will Life Insurance Proceeds be Included in My Estate?
Life insurance proceeds will be included in your estate for federal estate tax purposes when you own a policy on your own life. It does not matter who the beneficiary of the policy is; if you own a life insurance policy on yourself, then it is included. However, life insurance proceeds can be passed to a surviving spouse tax-free by use of the marital deduction under certain circumstances.

How Can Life Insurance Affect Federal Estate Taxes?
In order to adequately explain how life insurance policies can affect federal estate taxes, it is necessary to first explain what is called the “Unified Credit.” In 2001, the federal government passed legislation exempting a certain amount of each person’s estate from federal estate taxes. This exemption is called the Unified Credit. The amount of the Unified Credit changes every year according to the following schedule:

 2008:     $2,000,000
 2009:     $3,500,000
 2010:     estate tax is repealed

In December 2010, the Legislature passed the Tax Relief Act of 2010 which reinstates the estate tax for a period of two years. For 2011 and 2012, the estate tax is a flat tax at the rate of 35% with a Unified Credit of $5,000,000 per person. However, this Act is set to expire in 2013 unless Congress passes new estate tax legislation in the interim. Special rules may apply to estates of decedents who died in 2010, which exceed the scope of this article. If you would like more information about this topic, please contact our office.

Therefore, if an individual dies in 2011 and he or she has less than $5,000,000 in assets, there will be no federal estate taxes due. If that person has more than $5,000,000 in assets, then estate tax is only due on the amount in excess of that $5,000,000. 

How Does an ILIT Work? 
In order to remove the life insurance policies from an estate, the ILIT must be the owner and beneficiary of the policy. There are two ways to set up an Irrevocable Life Insurance Trust: (1) transfer ownership and beneficiary designation(s) of existing policy or policies to the ILIT; or (2) have the ILIT purchase the policy or policies directly. Option 1 is the best choice for existing life insurance policies.  However, it can be subject to what’s called the “three year look-back rule,” which will be discussed below. Option 2 would best serve individuals who have not yet purchased a large life insurance policy but intend to do so.  Whichever option is used, the ILIT must be both the owner and the beneficiary of the policy in order for the strategy to be effective.
 
The three year look-back rule was enacted by the IRS to prevent transfers of assets in contemplation of death. This means that any asset (life insurance policy or other) that is transferred to another person within three years of death will automatically be included in the decedent’s estate for tax purposes. Therefore, if a policy is transferred to an ILIT and the transferor dies within three years of the transfer, the insurance policy will still be included in the estate upon death. This rule does not apply when the ILIT purchases the policies under Option 2 because the ILIT was the original owner and no transfer has taken place.
 
CONCLUSION
If drafted properly, an ILIT can be a very effective estate planning tool to minimize estate taxes.  Whether or not an ILIT is needed will depend on your unique circumstances. Individuals or couples with large estates that include large insurance policies might consider this trust as an additional estate planning strategy.  Please contact our office if you would like to discuss this matter further or if you would like to obtain additional information regarding this kind of trust.

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