By: Isaac Yedid, Esq. and Raymond Zeitoune, Esq.

Many individuals are unaware of the benefits in forming an irrevocable life insurance trust (“ILIT”). Although the proceeds of your life insurance policy are not subject to income taxation, they are generally included in your taxable estate. However, with an irrevocable life insurance trust, the trust is the owner of the insurance policy, which keeps the proceeds of the life insurance out of your taxable estate. After your death, the trust’s assets (i.e. the life insurance proceeds) are available to your beneficiaries free of income taxes, as well as free of estate taxes.

In addition, an irrevocable life insurance trust can also be an important source of cash to help pay your estate taxes. The beneficiaries of the irrevocable life insurance trust can use the proceeds from the life insurance policy to offset some of the taxes that may be owed on your estate. This can help keep the assets that are part of your taxable estate intact for your beneficiaries. This strategy can be especially useful if a large portion of your estate consists of illiquid assets (such as real estate or a closely held business) and you want to be sure that your family will not be forced to sell those assets in order to pay estate taxes.

Some of the more frequently asked questions on this topic are:

1. What does a life insurance trust do? 

An irrevocable life insurance trust gives you more control over your insurance policies and the money that is paid from them. It also lets you reduce or even eliminate estate taxes, so more of your estate can go to your loved ones.

2. What are estate taxes and who has to pay them?

Estate taxes are taxes owed by your estate based on the value of assets you owned at your death. Federal estate taxes are expensive and must be paid in cash, usually within nine months after you die. The burden of paying estate taxes falls on the people who inherit your assets when you die.

Because few estates have the cash, it has often been necessary to liquidate assets to pay these taxes. But if you plan ahead, estate taxes can be reduced or even eliminated. The new tax law imposes federal estate taxes on individuals who die with a net worth greater than the “basic exclusion amount,” which is adjusted for inflation every year. The basic exclusion amount for individuals dying in 2015 is $5.43 million. Any dollar amount above the basic exclusion amount may potentially be taxed as high as 40%.

Note: Although an individual that dies in 2015 with a net worth of less than $5.43 million will not be required to pay any federal estate taxes, the estate may still be subject to state estate taxes. In New York, the current exclusion amount is only $3,125,000 per person. Estate amounts over $3,125,000 and under $3,281,250 may potentially be taxed as high as 16% on the dollar amount between $3,125,000 and $3,281,250. Estate amounts over $3,281,250 may potentially be taxed 16% on the entire estate value and not just on the amount over $3,125,000.

3. When are insurance policies included in my taxable estate?

Insurance policies in which you have any “incidents of ownership” are included in your taxable estate. This includes policies you can borrow against, assign or cancel, or for which you can revoke an assignment, or can name or change the beneficiary. You can see how life insurance can increase the size of your estate and the amount of estate taxes that must be paid.

4. How does an ILIT reduce estate taxes?

The ILIT owns your insurance policies and prohibits you from having any “incidents of ownership.” Since you don’t personally own the insurance policy or have any “incidents of ownership,” the life insurance proceeds will not be included in your taxable estate. Let’s say you have a net estate value of $4 million, $1 million of which is life insurance, and you die when the New York State estate tax exemption is $3,125,000 and the top tax rate is 16%. If you did not have an ILIT, your estate would have to pay $640,000 in New York State estate taxes on the entire $4 million. With an ILIT, the $1 million in insurance would not be taxable to your estate. Since the remaining estate assets are under $3,125,000, your New York State estate tax consequence would be $0.00. The ILIT would have provided your estate with an approximate savings of $640,000 in New York State estate taxes.

5. How does an ILIT work?

An ILIT has three components: (i) the grantor is the person creating the trust — that’s you; (ii) the trustee you select manages the trust; and (iii) the trust beneficiaries you name will receive the trust assets after you die.

The trustee purchases an insurance policy, with you as the insured and the trust as owner and beneficiary. When the insurance benefit is paid after your death, the trustee will collect the funds and distribute them to the trust beneficiaries as you have instructed (who happen to be the same beneficiaries of your estate). The beneficiaries of your estate (i.e. your children) can use the life insurance proceeds to pay estate taxes.

6. Can I be my own trustee?

Not if you want the tax advantages we’ve explained. Some people name their adult children or close friends or relatives as trustees.

7. Why not just name someone else as owner of my insurance policy?

If someone else owns the policy, you lose complete control. This person could change the beneficiary, take the cash value, or even cancel the policy, leaving you with no insurance. You may trust this person now, but you could have problems later on. The policy could even be garnished to help satisfy the other person’s creditors. An ILIT is safer – it lets you reduce estate taxes and keep control. With an ILIT, your trust owns the policy. The trustee you select must follow the instructions you put in your trust.

8. Who can be beneficiaries of the trust?

You can name any person or organization you wish. Most people name their spouse, children and/or grandchildren.

9. Where does the trustee get the money to purchase a new insurance policy?

From you, but in a special way. If you transfer money directly to the trustee, it will be a taxable gift. However, you can make annual tax-free gifts, which in the 2015 calendar year is at $14,000 ($28,000 if your spouse joins you) to each beneficiary of your trust. If you give more than this, the excess is applied to your federal gift/estate tax exemption.

Instead of making a gift directly to a beneficiary, you give it to the trustee for the benefit of each beneficiary. The trustee notifies each beneficiary that a gift has been received on his/her behalf, and unless the beneficiary elects to receive the gift now, the trustee will invest the funds — by paying the premium on the insurance policy. Each beneficiary must understand the consequences of taking the gift now; for example, it may reduce the trustee’s ability to pay premiums.

10. Are there any restrictions on transferring my existing policies to an insurance trust?

Yes. If you die within three years of the date of the transfer, it will be considered invalid by the IRS and the insurance will be included in your taxable estate. There may also be a gift tax. Be sure to discuss this with your financial advisor.

11. Can I make any changes to the trust?

An insurance trust is irrevocable, which generally means you cannot make changes to it. However, under the Uniform Trust Code and decanting provisions in some states, you may be able to make some changes. Still, you should read the trust document carefully before you sign it.

12. When should I set up an insurance trust?

You can set up one at any time. Many people like to form the trust before they purchase a life insurance policy so as to avoid the three year look back period (see Question #9). Given the fact that the trust is irrevocable and cannot be changed, there are those that wait until they are in their 50s or 60s before they set them up. By then, family relationships have usually settled, and the grantor assumes that he or she would have fewer worries with the need to change certain selected individuals in the ILIT. Just don’t wait too long and remember that if you transfer existing policies to the trust, you must live three years after the transfer for it to be valid.

13. Should I seek professional assistance?

Yes. If you think an irrevocable insurance trust would be of value to you and your family, talk with an insurance professional, estate planning attorney and a CPA who has experience with these trusts. May we all merit living long, healthy and happy lives – amen.

The attorneys in the Trust & Estates Practice Group at Yedid & Zeitoune have a combined 20 years of legal experience and are ready to assist you with all your estate planning needs.

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Isaac Yedid, Esq. & Raymond Zeitoune, Esq.

Yedid & Zeitoune, PLLC

1172 Coney Island Avenue Brooklyn, New York 11230

Phone: (347) 461-9800 Fax: (718) 421-1695 Email: [email protected]

NYC Office – By Appointment Only:

152 Madison Avenue, Suite 1105 New York, New York 10016

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