Life Insurance Trusts in Florida [as an Estate Planning Strategy]

There are plenty of good reasons to buy life insurance, not the least of which is ensuring your loved ones have a means of support after you’re gone. And, along with this important function, life insurance is also a valuable estate-planning tool.  By providing a reliable source of cash to pay taxes, funeral costs, and administrative fees, life insurance proceeds protect other assets from liquidation.  If an executor can pay estate taxes from policy proceeds, for example, he or she won’t need to sell the family business to pay Uncle Sam.  The common use of life insurance as an estate planning strategy raises the question of how to hold life insurance and begs the question whether a life insurance trust in Florida (also known as an Irrevocable Life Insurance Trust (“ILIT”) can offer additional advantages.

Life insurance for estate planning reveals a potential snag in many cases because; though it may seem counterintuitive at first, the proceeds of a decedent’s life insurance policy are included within that decedent’s taxable estate.  It doesn’t matter that the recently departed never had access to the money during life – the death benefits are part of the estate.  As a result, if the policy’s pay-out, when added to other assets, increases the total estate value over the federal estate tax exemption amount ($11.4 million for 2019), estate taxes kick in.  If the decedent’s assets already exceed the exemption, life insurance policy proceeds will be taxed at a rate of up to forty percent.

Here’s the thing, though.  If a policy is not owned by the person whose life is insured, the proceeds are not part of his or her estate.  And, with that in mind, clever estate-planning attorneys created a specialized type of trust called an irrevocable life insurance trust (ILIT) designed to hold a life insurance policy and keep the eventual proceeds out of the insured’s taxable estate.  The trust can hold other assets, too, but its central function is to own one or more life insurance policies.

How Do ILITs Work?

Like other trusts, an ILIT has three necessary parties:  a grantor (the insured person forming the trust), a trustee (a third party who manages the trust and makes distributions), and one or more beneficiaries (the individual(s) who receive the benefits of the policy proceeds once paid to the trust).  The trust itself is the named beneficiary of the insurance policy so that, upon death, the benefits are paid into the trust and managed by the trustee according to instructions set out by the grantor.

The instructions can be simple, like directing the trustee to pay each beneficiary an equal share of proceeds upon receipt.   Or they can be more complex.  A trustee might be directed to only make distributions on a defined schedule (e.g., once per year for life), at certain milestones (e.g., upon college graduation), and/or for certain purposes (e.g., taxes and educational expenses). In short, ILITs allow you to get creative and make sure policy proceeds are used in the manner you think best.

While flexibility and control are big advantages of using an ILIT, it is vital to remember that the trust must be “irrevocable” to be outside of the grantor’s estate. That means that, once the trust is in place, a grantor cannot have any “incidents of ownership” in the policy.  So, you can’t revoke the trust, amend the trustee’s instructions, or change beneficiaries.  And the trustee has to be a third-party, which makes sense because the grantor won’t be around to make distributions anyway.  Frequently, the trustee is a family member or close friend of the grantor who is willing and capable of managing the trust, but attorneys and banks also often act as trustees for a fee.

How do You Establish an ILIT?

It sounds obvious, but to do its job, an ILIT has to actually own a life insurance policy.  Having insurance and declaring an ILIT alone is insufficient – the policy has to be formally held by the trust.  There are basically two ways of accomplishing this: transferring an existing policy or purchasing a new one.  Significantly, the IRS will not consider a transferred policy as separate from your taxable estate unless you live at least three years after the transfer.  So, if you transfer an existing policy and then die a year later, the proceeds will be included within your taxable estate even if paid into the trust.

Transferring an existing policy can potentially trigger gift tax liability if the policy has a cash value over the annual $15,000 exclusion, in which case you can either pay the tax for the year of the transfer or reduce your eventual estate tax exemption accordingly.  Even if gift taxes can’t be avoided, transferring a policy to an ILIT can still be a smart move since the federal gift tax on the cash value will probably be much less than the estate tax on the entire policy proceeds.

When the trust itself purchases the policy, the chief concern is making sure that premiums are paid.  With a “funded” ILIT, the trust receives other assets in addition to the policy, and those assets are used to pay premiums.  As with a policy transfer, the asset transfer can trigger the gift tax or reduce your estate tax exemption, so a funded ILIT should be planned strategically.

An “unfunded” ILIT holds no assets other than the life insurance policy and therefore requires regular transfers to the trust to pay the policy premiums. The grantor gifts to the trust sufficient cash to pay the premiums as they come due, and the trustee uses the cash to pay the insurance company.  If the annual premiums exceed the $15,000 exclusion, the transfer will trigger the gift tax or result in a reduction to the estate tax exemption.  However, gift tax liability can be reduced or avoided if the trust’s beneficiaries technically receive the right to withdraw the cash from the trust before the premiums are paid.  To make it work the trustee sends a “Crummey letter” to each beneficiary.  The letter states that the money has been received and will be used to pay premiums unless the beneficiary elects to make a withdrawal before a certain date.  As long as beneficiaries cooperate, Crummey letters are an effective way to pay premiums without reducing your estate tax exemption.

What Other Advantages are Offered by an ILIT?

As mentioned above, the most obvious benefit of an ILIT is that it keeps life insurance policy proceeds out of your taxable estate.  Depending on the estate’s size, this can reduce the estate’s tax bill or avoid estate taxes altogether.  But even if estate taxes are not a concern, an ILIT gives you control over how insurance proceeds are used.  If you bequeath life insurance funds in a will or name a third-party beneficiary, the payee has complete control over how the money will be used once received.  An ILIT, though, gives you some say over how funds are distributed.  If your intended beneficiary is a minor, is not capable or interested in investing wisely, or is financially irresponsible, an ILIT can protect against imprudent spending.

Holding life insurance proceeds in trust also shields the money from beneficiaries’ creditors.  If your would-be heir has a large outstanding judgment, a lump-sum distribution could easily be attached by the creditor, but periodic distributions from an ILIT are only attachable when the funds are actually paid out.  Similarly, the trust can protect against loss of assets through a divorce.

Along with avoiding creditor claims, an ILIT can also safeguard other important estate assets.  For instance, if your estate will include valuable real estate but not much cash, an ILIT provides tax-free funds to pay estate taxes without having to sell the property.  Or the cash can cover administration fees, final medical bills, and funeral expenses without decreasing your heirs’ inheritance.

Although the theory behind an irrevocable life insurance trust is fairly straightforward, ILITs require careful attention to detail and observation of formalities.  An experienced estate-planning attorney in Florida can help you decide if an ILIT is right for your situation and how best to gain the greatest possible benefit from a life insurance trust.

Steve Gibbs, Esq.