life insurance
Life Insurance plays several important roles in estate planning. It can provide liquidity to pay estate taxes which will avoid the need to sell or encumber family assets. Other common uses for life insurance include funding buy-sell agreements and providing liquidity to non income producing surviving family members.

Insurance products are basically divided into two basic categories, term and whole life. However, there are multiple variations for each type. Term insurance is temporary insurance that provides insurance coverage for a period of time. It provides pure insurance coverage without any investment build up. Term insurance is the least expensive type of insurance for that reason. However, because it is age based, each year term insurance becomes more expensive. Whole life insurance is made up of risk protection and an investment account. The risk portion represents term insurance and the investment portion acts as a savings account in the policy, also referred to as cash value. The cash value is available to the policy owner through borrowing or distribution. Under Florida law, the cash value is not subject to claims of creditors and therefore is a good asset protection vehicle. The cash value is income tax deferred. There are multiple types of whole life insurance which are beyond the scope of this discussion, which include but are not limited to: limited pay whole life, current assumption whole life, blended whole life term, universal life, variable life and variable universal life.

Life insurance proceeds are includible in the insured’s estate for estate tax purposes if the insured possessed any “incidents of ownership” over the policy or the proceeds were payable to or for the benefit of the insured’s estate. “Incidents of ownership” include any rights to economic benefits from the policy, including the power to change beneficiaries, borrow against the policy, surrender or cancel the policy, or assign or cancel the assignment of the policy. In addition, policy proceeds are includible in the insured’s estate if within 3 years prior to death, any incident of ownership is actually transferred by the decedent without consideration. For example, a gift of an existing life insurance policy to an irrevocable life insurance trust will trigger the estate tax if the transferor dies within three years of funding the trust.

Life Insurance And The Irrevocable Life Insurance Trust (“ILIT”)

The transfer of all ownership rights in a life insurance policy is a taxable gift measured by the fair market value of the policy. If the policy is term insurance, the value is measured by the unused portion of the premium. If the policy is whole life, the value of the gift is the interpolated terminal reserve at the time of the gift, plus the unused portion of the last premium and dividend accumulations, less outstanding policy loans.

The Irrevocable Life Insurance Trust (“ILIT”)

The easiest way to avoid estate tax on the insured’s death is to have someone, other than the insured, own the life insurance policy. However, the insurance proceeds would be paid outright to the beneficiaries which is problematic since the beneficiary will have unlimited discretion with the proceeds and such proceeds would be subject to creditors. In addition, the proceeds would be subject to estate tax in the beneficiary’s estate.

To avoid these issues and avoid estate tax inclusion, an ILIT is the best structure to own the policy. The ILIT would be the owner and beneficiary of the policy. Since the insured cannot serve as trustee of the ILIT without possessing incidents of ownership, a third party, such as a spouse must serve as trustee.

The settlor of the trust will transfer funds to the trust so that the trust can pay the premiums on the life insurance policy. Such transfers will constitute a taxable gift to the beneficiaries. Since the transfers are actually future interests they will not qualify for the $14,000 annual exclusion. In order to recharacterize the future interest transfer as a present interest, the ILIT must grant the beneficiaries a lapsing limited power to withdraw annual contributions (premium payments) to the Trust. Since the power to withdraw constitutes an unrestricted right to immediate use or possession of the property subject to the power, the donor is entitled to utilize the $14,000 per donee annual gift tax exclusion. These powers are often referred to as “Crummey” withdrawal powers.

On the death of the insured, the proceeds would be payable to the trust and held for the benefit of the beneficiaries and distributed according to the terms of the ILIT.

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