Journal of Financial Planning: January 2025
David Haughton, J.D., CPWA, is senior corporate counsel at wealth.com, a next-gen estate planning platform.
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Taking drastic action to plan for an unknowable future may not always be ideal. In fact, overengineering estate tax strategies could result in a loss of control of a client’s assets. Consider the recent election as one example. The prevailing advice for the last few years has been to prepare for the sunset of the Tax Cuts and Jobs Act. But there’s a real possibility it could be extended after all. This doesn’t mean advisers and clients should completely disregard estate tax planning. It simply means caution and flexibility in planning are warranted.
For many advisers, gifting is often what’s top of mind when it comes to planning for estate taxes. That’s because it’s the most direct way to remove assets from a client’s estate and have the assets grow outside of it. Many tools exist to leverage the estate tax exemption to limit the tax impact of this approach, such as grantor retained annuity trusts (GRAT), charitable lead trusts (CLT), and qualified personal residence trusts (QPRT), to name a few. But any trust designed to remove assets from the estate will result in some form of substantial loss of control by the donor and could also result in the loss of a step-up in basis at their death on appreciated assets that would benefit their beneficiaries.
Now, with the potential political calculus suggesting the estate tax exemption could remain historically high (at least for a few more years), these tools seem less attractive. So, how does an adviser help a client who is concerned about the future possibility of an estate tax liability but does not currently have an estate valued at a level that warrants gifting strategies?
Putting Life Insurance in a Trust to Cover Estate Tax Liability
Life insurance is a tremendous tool to provide liquidity to a client’s estate to be able to pay any potential future estate tax liability. However, life insurance alone does not fully address the estate tax issue. Why? Because while life insurance proceeds are typically income tax-free to a beneficiary who receives them, the value of the death benefit is includable in the decedent’s estate along with any other assets they owned at death.
Enter life insurance coupled with an irrevocable life insurance trust (ILIT). Life insurance placed into an ILIT can create flexibility while solving two major issues:
- It does not lead to a loss of control over the client’s current assets (because they’re not being removed from the taxable estate).
- The life insurance proceeds can help cover potential estate taxes at the client’s death.
Of course, life insurance also comes at a cost in the form of ongoing premium payments—but the ultimate value of the death benefit to the estate and beneficiaries could be well worth it.
How an ILIT Is Created, Funded, and Distributed
An ILIT is an irrevocable trust created by an individual, or a couple, to place one or more life insurance policies inside the trust. That trust will now be the owner of any life insurance policies put into it. Any life insurance policies need to insure the life of the grantors (those who set up the trust). The grantors of the ILIT also name beneficiaries of the trust (such as their children) as well as a trustee. The grantors cannot name themselves as a beneficiary or trustee of the ILIT.
Once the ILIT is formed, the trustee would purchase a life insurance policy with the ILIT named as the beneficiary of the policy. This is where the tax strategy comes into play. By naming the ILIT as the beneficiary of the policy, any benefit paid out by the policy following the death of the grantor is removed from their taxable estate.
This is a powerful way to have potentially hundreds of thousands (if not millions) of dollars available to pay for any estate tax liability that may result from the grantor’s death. Here is the kicker: if there is no estate tax liability, the existence of the ILIT and life insurance policy will just result in more tax-free funds reaching the beneficiaries (like their children) at the time of the grantor’s death.
It is important to note that an ILIT does not only apply to new policies. The grantor could transfer an existing policy they own to the trust. However, that approach comes with a couple of downsides:
- Moving an existing policy is a gift. Transferring an existing policy to an ILIT would be considered a completed gift at its current fair market value. The value depends on the interpolated terminal reserve value of the policy (a figure the insurance company can provide). Many complicated factors play into whether this value is a lot or a little, such as the type of policy and the age of the grantor.
- An existing policy remains in the taxable state for three years. The life insurance policy that is gifted is not removed from the grantor’s estate, unless they survive for three years after the transfer, per IRS Code Section 2035(d). Purchasing a new policy, on the other hand, has no waiting period.
Administrative Nuances to Watch Out For
As with any estate planning strategy, the devil is often in the details. To ensure this strategy is effective, the client needs to carefully administer the trust appropriately, in accordance with the law.
First, while an ILIT is a great tool to provide liquidity to the estate to pay future estate tax liabilities, it is not typically advised that the ILIT itself actually pay the estate tax liability of the decedent directly. An ILIT is designed to be a separate and distinct entity from the grantor and outside of the taxable estate of the grantor.
If the ILIT includes a provision authorizing it to pay the grantor’s estate tax liability, the IRS may determine the ILIT is includable in the grantor’s taxable estate. That’s because it could be viewed as the grantor’s own funds being used to pay their estate taxes—which is precisely the opposite of the intent of the trust’s existence.
Instead, the ILIT could provide liquidity to the estate by purchasing assets from the grantor’s estate (like a business interest or parcel of real estate) with the cash received from the life insurance proceeds. Then, the executor or fiduciary of the grantor’s estate would, in turn, pay the estate tax liability with the cash. This process could also be accomplished through a properly structured loan from the ILIT to the estate.
Why Crummey Powers Help Avoid Gift Tax for Policy Premiums
Don’t forget that any life insurance policy is going to require premium payments (at least initially) made by the owner of the policy. As the ILIT is the owner of the policy, the grantor of the trust, individually, should not be paying the premiums directly. Rather, the trustee of the ILIT should be paying the premiums from the assets of the ILIT. This means the grantor would need to routinely deposit funds into an ILIT account to accommodate the trustee’s ability to pay the premiums (because the ILIT likely does not have cash readily available to pay the premiums).
However, as mentioned, depositing cash to an ILIT represents a completed gift. That may not seem like an issue because there is an annual gift tax exclusion (which will be $19,000 as of 2025). However, the IRS would not qualify those deposits for the annual exclusion because beneficiaries of an irrevocable trust do not have immediate access to the funds. Only “present interest” gifts qualify for the annual exclusion, meaning gifts that are received immediately, whereas an ILIT beneficiary would receive them in the future after the grantor’s death.
However, there is a way for gifts to the trust to be considered as present interest by giving the ILIT Crummey right-of-withdrawal provisions. This permits the beneficiaries to have a short window—often 30 to 60 days—where they can withdraw any contributions to the trust. While allowing a withdrawal window could be concerning—what if they take the cash right back out again?—in reality, beneficiaries rarely take advantage of it. The right is typically inserted in the trust purely for tax purposes. A beneficiary who goes rogue and exercises the right would likely prompt the grantor to limit their future distributions from the trust or other parts of the estate.
Provide Clients Future Flexibility while Minimizing Estate Tax Liability
In a society where the estate tax can be seen as a political football that could go any which way, it’s important to stay flexible and provide clients with tools to limit the potential impact of taxes on their estate—without giving up unnecessary control. Life insurance coupled with an ILIT represents a valuable tool for an estate to have the necessary resources to pay estate taxes without impacting the value of the assets of the estate reaching the beneficiaries.