The new year brings good news in that the federal gift and estate tax exemption is at an all-time high in 2021: $11.7 million for individuals and $23.4 million for married couples. The potential bad news is that President-Biden’s campaign platform included a proposed decrease of this exemption to $3.5 million for individual and $7 million for married couples and if no action is taken at all, the federal gift and estate tax exemption will revert back to the pre-TCJA amounts ($5 million for individuals and $10 million for married couples) indexed for inflation.
In my practice, I work with closely-held and family owned business owners and real estate investors who have special planning needs due to the illiquid nature of their wealth, the desire to move the business or investment to a chosen successor, and the need to factor in asset protection considerations with their estate planning objectives. Obviously, a lower federal gift and estate tax exemption will have the effect of bringing a far greater number of the estates of these owners and investors within the reach of the federal gift and estate tax than there are currently. In the most basic sense, there are two types of planning strategies to deal with potential estate tax liability. First, an owner or investor may employ a technique designed to reduce their taxable estate. Second, an owner or investor may secure a means for providing the necessary liquidity for paying estate tax.
While no one relishes the thought of paying taxes (of any kind), an irrevocable life insurance trust (or “ILIT”) has great appeal due primarily to its relative simplicity (as compared to many estate tax reduction techniques). ILITs have been reliably used by owners and investors for years, but in recent years ILITs have not received much attention because of the higher federal gift and estate tax exemption. However, now is a good time for owners and investors to refamiliarize themselves with this trusty estate planning tool.
Simply stated, an ILIT is a type of irrevocable trust. A trust may be established by one or more persons (each, a “settlor” or “trustmaker”) as a revocable trust or an irrevocable trust. All trusts are established so that one or more persons (each, a “trustee”) hold an asset or several assets for the benefit of one or more persons (each, a “beneficiary”). In the case of an ILIT, the asset is one or more life insurance policies. The terms and conditions of the ILIT are set forth in a trust agreement which should be prepared by an experienced tax or estate planning attorney. Once the ILIT is established, the ILIT acquires one or more life insurance policies. A trustmaker may assign an existing life insurance policy to an ILIT but in the case of such an assignment, the insurance proceeds from the assigned policies will be included in the trustmaker’s estate if the trustmaker dies within 3 years from the date of the assignment to the ILIT. On the other hand, if the ILIT acquires the insurance policy or policies, then this hazard is avoided.
Naturally, a substantial amount of thought and consideration must be given to the type of insurance policy or polices to be acquired by the ILIT. Each insurance policy will identify an “owner” of the policy (in our case, the ILIT), a beneficiary (the ILIT), and the “insured” (which may be a trustmaker, a trustmaker and their spouse, or a third person with whom an “insurable interest” exists at the time the policy is acquired). If a trustmaker owns an office building, which would be included in their estate upon their passing, then the insured would likely be such trustmaker. If the trustmaker is married, the “insured” might be the trustmaker and their spouse, and the insurance policy might be structured as a “second to die” policy. If the “insured” is a third person, then an insurable interest would exist if the trustmaker and such person jointly owned the office building, and the trustmaker had entered into a buy-sell agreement whereby the trustmaker agreed to purchase the third person’s interest upon the death of the third person. As you can see, there are many options and alternatives. A seasoned insurance professional should be a key part of these decisions. Such an insurance professional may advise the acquisition of a term life insurance, a permanent cash value life insurance, or any number of other types of policies. The determinations made by the insurance professional will take into account the goals of the trustmaker and the purposes for which the ILIT is being created.
Once an ILIT has been established and owns one or more life insurance policies, the ILIT will need a sufficient amount of cash to pay the policy premiums as they come due. Sometimes the ILIT owns an asset (in addition to the policy or policies) which produces cash – for instance, income producing real estate or an ownership interest in an LLC which regularly makes distributions to its owners. However, it is much more common for an ILIT not to own any assets which produce cash. In such case, the trustmakers may make gifts of cash to the ILIT sufficient to cover premiums when due. These gifts of cash from the trustmakers to the ILIT are usually made so that the federal annual gift exclusion can be utilized. The tax law provides that each year a person may gift to another person (other than such person’s spouse) cash in an amount or property having a value not in excess of the current federal annual gift exclusion amount. For 2021, the federal annual gift exclusion amount is $15,000.00. A married person and their spouse may “split” a gift, thereby doubling the amount of the annual exclusion from $15,000.00 to $30,000.00.
In the case of an ILIT (which, of course, is not an individual person receiving a gift), the number of the ILIT’s beneficiaries is taken into account for purposes of calculating the federal annual gift exclusion. Therefore, if an ILIT has 4 beneficiaries, then a trustmaker could make a gift of $60,000 to the ILIT per year ($15,000 x 4 beneficiaries). If the trustmaker is married, then the trustmaker and their spouse could make a gift of $120,000 to the ILIT per year (($15,000 x 2) x 4 beneficiaries).
If an amount to be gifted to an ILIT in a given year is in excess of the amounts provided by the federal annual gift exclusion for such year, then such excess amount may still be given without federal gift tax liability by utilizing the trustmaker’s lifetime federal gift tax exemption in which case, a federal gift tax return (IRS Form 709) should be filed.
However, there is a strange requirement that must be observed when relying upon the federal annual gift exclusion to make gifts to an ILIT. The requirement is the result of an IRS rule which provides that a beneficiary must have a current right to the cash or property gifted by the trustmaker(s) to the ILIT in order for such cash or property to constitute a gift. To satisfy this requirement and to evidence that this rule was observed, the trustee sends a “Crummy” letter to each beneficiary of the ILIT. Crummy is the name of a legal case wherein the use of such a letter was upheld by the court. A typical Crummy letter is not lengthy or complicated and basically advises a beneficiary that they have the immediate right for a period of 30 days, 60 days, or other period of time stated in the letter to the cash or property gifted by the trustmaker(s) to the ILIT. The use of a Crummy letter presupposes that no beneficiary will demand the cash or property gifted during the stated period because each beneficiary understands that doing so would affect the ILIT’s ability to timely pay the required premium.
Upon the death of the insured, the death benefit for each policy held and maintained by the ILIT is paid and the beneficiaries may use such proceeds for the payment of any estate tax liability. The current estate tax rates begin at 18% of the amount in excess of the federal gift and estate tax exemption and quickly increases to 40%. If any estate tax is owed, the amount must be paid within 9 months of the death date.
For more information, contact Frank L. Leffingwell to schedule a time to discuss ILITs, business succession, or your estate plan.
Frank L. Leffingwell is a tax attorney in the firm’s Tax Planning & Controversy, Estate Planning, Probate & Trusts, and Real Estate sections.