Irrevocable Life Insurance Trusts

You know those heartwarming commercials where a new parent lovingly buys an insurance policy on his life the day his baby is born; just to be sure his family is provided for if something were ever to happen to him?  Of course you do, and you went out and bought that insurance.  Or perhaps you are thinking about purchasing a policy given the other benefits of the proceeds upon your death—providing liquidity to pay for estate taxes, to fund a buy-sell agreement, etc.  

 What you may not anticipate is that, even though the death benefit proceeds of a life insurance policy to do even come into existence until your death, the IRS nonetheless considers those proceeds part of your taxable gross estate!  This means that the proceeds are subject to estate tax at your death (depending on the value of all your other assets).

For example, suppose the total value of your assets is $4,000,000.  Given the current $5,120,000 exemption from federal estate tax, you think you are flying under the estate tax radar.  But, suppose you also own a $2,000,000 term life insurance policy at the time of your death.  Now your taxable estate is at $6,000,000 and subject to federal estate tax.  The result is even worse if your state imposes its own estate tax.  Illinois, for example, imposes its own, separate estate tax on assets in excess of $3,500,000.

Luckily, there is a very simple way to have the entire value of proceeds from life insurance removed from your estate:  transfer the policy to an irrevocable life insurance trust or “ILIT” for short.  Simply put, where a life insurance policy is owned by an ILIT rather than by the individual insured, the all of the proceeds will  pass to beneficiaries both estate tax and income tax free.

HOW AN ILIT WORKS

An ILIT is an irrevocable trust specifically designed to be the owner and beneficiary of a life insurance policy.  Once the ILIT is prepared by your attorney, you transfer ownership of an existing policy to, or purchase a new policy in, the name of your ILIT.  The trustee is then responsible for managing the policy and making premium payments.  Because you no longer own the policy and do not have any control over it, you do not have what the IRS calls “incidents of ownership” with respect to the policy, and therefore the proceeds are not included in your gross estate when you die.

While you cannot be the trustee (otherwise you would have incidents of ownership), your spouse and/or children can be.  Each year you would make gifts of cash to the trust so that the trustee has money to pay for the proceeds.  Typically these gifts are not subject to gift tax because they fall within your “annual gift tax exclusion” (currently $13,000 per beneficiary per year).

Upon your death, the proceeds would be paid directly to the ILIT free of estate tax and income tax liability.  The trustee would then manage or distribute the funds for the benefit of your loved ones pursuant to the terms/strategies you specified in the ILIT.

MAKE SURE IT’S DONE RIGHT

In concept, an ILIT is relatively simple.  But, it is important to make sure your ILIT is properly drafted to include language necessary for your gifts to qualify for the annual gift tax exclusion (referred to as Crummey Powers, named after a famous court case).  Also, transfers of policies are subject to a “three year look back rule,” meaning, if you were to die within three years of transferring your policy to an ILIT, the proceeds would nonetheless be pulled back into your taxable estate.  Therefore, it is important to transfer existing policies sooner rather than later.  In certain cases, a sale of the policy could be structured.  Better yet, you should purchase any new policy in the name of your ILIT from the start and avoid all transfer issues.

Changes in Illinois Estate Tax Laws

On December 16, 2011, Governor Patrick Quinn signed into law Public Act 97-0636 (the “Act”).  The Act received much press at the time as it was primarily meant to address tax incentives for Sears Holdings Corp. (“Sears”) and the CME Group, Inc. (“CME”) which operates the Chicago Mercantile Exchange (in response to Sears’ and CME’s threat to leave Illinois and take their jobs with them).  However, contained in the very last two pages of the lengthy Act are new rules regarding Illinois’ state estate tax exemption.  

Illinois imposes its own state-level estate tax on decedent’s estates (in addition to the Federally-imposed estate tax).  Illinois also provides an exemption to the state estate tax such that estates valued below a certain threshold are not subject to the state estate tax at all.  Traditionally, Illinois’ state estate tax exemption was tied to, or “coupled” with the Federal estate tax exemption.  For example, in 2008 both exemptions were $2,000,000.  In 2009, however, the Federal exemption increased to $3,500,000 where Illinois’ stayed at $2,000,000.  This divergence is referred to as “decoupling”, and can result in unintended estate tax liability unless proper language is included in estate planning documents.  

In traditional estate plans for married couples, upon the death of the first-to-die spouse, his assets are split into two trusts, the marital trust and the family trust.  The family trust is funded with the applicable Federal estate tax exemption amount, and any excess is used to fund the marital trust.  Because the marital trust qualifies for the marital deduction from estate tax, no estate tax would be due upon the death of the first spouse.  However, in this scenario, although no Federal estate tax would be due, Illinois would nonetheless impose its own, separate estate tax on the funds in the family trust that exceed Illinois’ exemption level.  For example, for 2009 decedents, this would mean a potential Illinois estate tax liability of over $200,000.

With passage of the Act, Illinois eased the decoupling-burden slightly—over the next several years, the Illinois exemption will increase to a maximum of $4,000,000.  In particular, the Act provides exemption levels of:

• $2,000,000 for persons dying prior to January 1, 2012;
• $3,500,000 for persons dying on or after January 2, 2012 and prior to January 1, 2013; and
• $4,000,000 for persons dying on or after January 1, 2013.

However, Illinois’ exemption will still not equal the Federal exemption of $5,000,000.  Therefore, decoupling remains an issue.  To deal with the potential state-level tax, we have crafted language that allows the Executor of the estate to make a marital deduction with respect to a portion of the family trust for Illinois purposes only.  In practical terms, upon the death of the first-to-die spouse, the family trust would be fully funded with up to $5,000,000 and qualify for the Federal estate tax exemption amount. The Executor would then make an election as to the assets in excess of the Illinois estate tax exemption amount (currently, as described above, $3,500,000) in the family trust to qualify for the marital deduction for Illinois purposes only. This allows maximization of both the Federal and Illinois exemptions without subjecting assets to either Federal or Illinois estate tax.

 

If you have a taxable estate above $3,500,000, and thereby are above the Illinois estate tax exemption, you should consider other “estate tax minimization” strategies to minimize your estate tax liability.  We can assist you with such strategies as gifting, charitable planning, sales to defective grantor trusts, and other advanced techniques to minimize estate tax exposure.

If you want to implement any of these “estate tax minimization” strategies or modify your estate planning documents to take into account of the above-described changes in Illinois law, contact me at eosborne@stahlcowen.com or 312-377-7761!

NEW Illinois Tenancy by the Entirety Law

The simplest asset protection measure a couple can take is to own their home as tenants by the entirety (“TBE”).  In Illinois, the only asset you can own as TBE is your principal residence.  Under TBE ownership, your home is deemed to be owned by both parties as a fused marital unit (or a fused civil union unit).  Therefore, an individual creditor of either person would be unable to reach the primary residence in satisfaction of a debt.  

Traditionally, spouses/partners would have to choose between asset protection concerns (TBE ownership) and estate planning concerns (ownership in a living trust)—the two concepts were mutually exclusive.  However, effective January 1, 2011, spouses and civil union partners in Illinois can hold title to their primary residence in their living trusts, as TBE.  In other words, they can now have the best of both worlds.

Note that this protection is not automatic—the deed conveying title must specifically reference not only the applicable living trust(s), but also TBE language.