Modern Uses for Life Insurance Trusts

Posted by Robert L. Arone

Since the enactment of the Tax Cut and Jobs Act of 2017, the utility of the irrevocable life insurance trust (ILIT) has been in question. The substantial increase in the federal estate tax exemption–$11.4 million for an individual and $22.8 million for a married couple in 2019—greatly reduced the need for estate planning aimed at lessening federal estate tax liability or offsetting estate taxes for many clients. As a result, your clients may be wondering if an ILIT is necessary.

An ILIT Can Still Be a Helpful Planning Tool

Depending upon the particular goals and circumstances of your clients, an ILIT can still be a useful planning tool. As a financial advisor, you can enhance your relationships with your clients by helping them to reassess their goals for both the present and the future, providing valuable guidance about how the ILIT may be able to meet their estate and financial planning needs. There are several factors that you should discuss with your clients:

  1. Rapidly appreciating assets. Particularly for clients with a higher net worth whose current estates are valued below the federal estate tax exemption, it is important to examine the current composition of their estate to determine if it includes assets that are likely to appreciate rapidly, potentially pushing the value of the estate over the federal estate tax exemption. Even if there is currently no estate tax liability, an ILIT may be needed if the estate includes an interest in a successful and growing business, real estate in a location with increasing property values, or other rapidly appreciating assets that may soon be at risk of generating an estate tax liability.
  2. State estate taxes. In 2019, 12 states and the District of Columbia have their own estate taxes (with maximum rates varying from 12 to 20 percent) with exclusion amounts ranging from $1 million in Massachusetts to $5.7 million in Maine. As of 2019, New York has increased its exclusion amount to match the federal exemption of $11.4 million. Although New Jersey repealed its estate tax in 2018, political prognosticators are predicting that it will be reinstated in the future. Obviously, for clients living in those areas, an ILIT may still be a useful tool for mitigating or eliminating state estate tax liability.
  3. Sunset of the current estate tax exemption. It is important to remind your clients that the current federal estate tax exemption is not permanent. It may revert to the 2017 level of $5 million (adjusted for inflation) in 2026, only seven years from now. Many clients who needed an ILIT prior to tax reform are likely to need it again if Congress does not act to extend the current exemption amounts or make them permanent. Discuss these possibilities with your clients and help them assess the exemption level they would feel comfortable planning for in their estate plan.
  4. Protection against your client’s creditors. All 50 states and the District of Columbia have statutes that protect the death benefit or cash value of life insurance, and sometimes both, from creditors’ claims. In some states, however, the exemptions are limited to a specific dollar amount or to the amount reasonably necessary to support the beneficiary. In addition, although typically, the proceeds of the life insurance policy are never available to your client’s creditors because they pass to their beneficiaries without ever becoming part of their estate, some states have laws that limit the exemption only to certain beneficiaries, such as a spouse, children, or other dependents. Designating an ILIT as the direct beneficiary of their policy can be a strategy to protect proceeds that are outside the scope of the statutory exemption.
  5. Protection against creditors of your client’s loved ones. Although state law provides that the proceeds of life insurance policies are exempt (at least partially) from your client’s creditors, once those proceeds are in the hands of your client’s direct beneficiaries, they typically are within the reach of their creditors. Even if their children or other loved ones do not currently have any creditors, they may eventually face lawsuits, bankruptcy, or divorce. If they are direct beneficiaries of your client’s life insurance policy, the death benefit your client intended for them to receive may be exposed to claims from those creditors. As a result, designating an ILIT, rather than an individual, as the beneficiary of your client’s life insurance policy may be a good option. If the trust is the owner of the proceeds, the creditors of the beneficiaries will not be able to reach the death benefit to satisfy their debts. An ILIT can also protect the death benefit through the inclusion of a “spendthrift trust” provision that prohibits trust beneficiaries from pledging the life insurance proceeds, which are an asset of the trust, as collateral. Their creditors are then only able to reach any distributions made to them from the trust.
  6. Liquidity. If your client has assets that are difficult to divide, for example, a business interest or the family home, a life insurance policy can provide liquidity that can be used to equalize an inheritance by providing cash to one or more children. Consequently, children who are not interested in the business will still receive an inheritance, and the family home will not need to be sold so the proceeds from the sale can be divided among the children. An ILIT is a good option under these circumstances because the insurance policy is beyond the reach of creditors.

What If the ILIT Is No Longer Needed?

If your client currently has an ILIT that was created primarily as a means of avoiding estate tax liability, and none of the factors mentioned above are major concerns, there are several strategies your client, as the grantor of an ILIT, could use to extricate life insurance from an ILIT now viewed as unnecessary. For example, your client could substitute cash of equivalent value for the life insurance policy in the ILIT or buy the policy back. Alternatively, the life insurance policy could simply be allowed to lapse by no longer providing funds for the premium payments, leaving the ILIT without any assets to manage. Policies that have cash value could be surrendered or sold in a life settlement transaction, and if the trustee has the discretion to do so, the cash could be distributed to the beneficiaries of the ILIT. It is also possible that the ILIT could be terminated pursuant to its own terms, with the consent of both the grantor and the beneficiaries, or through a court order requested by the beneficiaries.

We Are Here to Help

The best estate plans are the product of a team effort. We can help you and your clients consider all the relevant factors to determine whether an ILIT will be beneficial for them and their loved ones. We look forward to collaborating with you to design the optimal estate plan for your client’s individual circumstances. Please give us a call today to learn more about how we can help.

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