One of the most valuable tools in the estate planning arena is the Irrevocable Life Insurance Trust. Unfortunately, too many estate planners make very limited use of this planning technique. Estate planning attorneys tend to look at this as only a planning technique to avoid estate taxes. This trust, however, can be utilized to provide much more than that. Not only can this trust avoid estate taxes, but because of the tax advantages of life insurance, this trust can have a multiple function.
We will call this trust the "Multifaceted Irrevocable Insurance Trust" ("MIIT"). One of the unique features of life insurance is that it is the only asset that can, through proper planning, avoid income taxes under Section 101 of the Internal Revenue Service (I.R.S.) Tax Code, and avoid estate taxes, if you avoid the inclusion of life insurance under Section 2042 of the I.R.S. Code. Additionally, insurance has an investment element which is known as "cash value". Under the Section 72 of I.R.S. Code, the cash value can be borrowed to the extent of basis in the policy, tax-free, provided you meet the tests set forth under Section 7702 of the I.R.S. Code, to avoid the problems of a modified endowment contract. Because of these very unique income and estate tax advantages, coupled with the use of a properly drafted trust, this planning technique can become a multifaceted tool. The MIIT, the trust can be structured in such a way that:
1. You can avoid estate taxes (avoid inclusion under Section 2042 of the I.R.S. Code); 2. Can provide a supplemental tax-free education funding program for the children (tax-free borrowing) (Section 72 of the I.R.S. Code); 3. Provide a tax-free supplemental retirement planning program for the insured spouse (tax-free borrowing) (Section 72 of the I.R.S. Code); 4. Provide income tax planning after the death of the insured by spreading income to multiple beneficiaries through a spray trust; 5. Provide creditor protection through use of a spendthrift clause which would protect the cash value build-up during the insured’s lifetime, and insurance proceeds after the insured’s death.
How Does the Planning Work?
It is important first of all to set-up the irrevocable insurance trust and make certain that there is at least one independent trustee named under the trust. This independent trustee should have the discretion to borrow on the policy during the insured’s lifetime and also make distributions to the beneficiaries (spouse and descendants, normally) of the trust both before and after the insured’s death. The independent trustee, can under this program (a) borrow on the cash value and make payments (to the extent of the basis of the policy) to the children of the insured for college funding, and (b) borrow on the cash value and make payments to the insured’s spouse tax-free as supplemental retirement income (to the extent that the borrowing is less than the basis on the policy). Bear in mind that any borrowing on the cash value, though, will reduce the reserve value in the policy and this must be monitored to protect the death benefits. Also, since these are unpaid loans, upon the death of the insured these loans must be paid back, and thus reduce the net insurance proceeds.
What Insurance Would Be Best Used With a MIIT?
Obviously the best insurance to be used in these programs would be an insurance product that will allow for maximum cash build up. The insurance product that would most likely provide this would be a "paid up policy at age 65". This is normally an insurance product which is paid up when the insured reaches age 65, thus causing an accelerated cash value build-up, because the premium payments are made in a shorten time frame. Also, because the stock markets have been so successful recently, probably the best long range insurance product to also use, would be a "variable insurance product". Under these products you are able to allocate the reserve investment portion of the insurance payment into multiple funds and provide diversification of the policy’s investment reserve. In the long run there will probably be better returns over a long period of time than with a conventional whole life product.
Suggestions on Insurance Illustrations for MIIT
First: In order to see how well the MIIT may work, have the insurance agent run projections at a rather conservative rate of return (8 - 12%). The agent should show in the projections the cash value available in the policy when the children of the insured reach college age, so that the amount of reserve set-aside for borrowing for college funding can be determined. Also bear in mind that cash values for insurance are not taken into consideration when applying for financial assistance for college. Second: Have illustrations run that will show a tax-free distribution when the insured’s spouse reaches age 65, to determine what type of supplemental retirement income may be available to the insured’s spouse. Third: Make sure that the projections that are presented are through at least age 100 of the client, to make certain that the program in this insurance trust will not expire because of lack of cash reserve in the policy.
Use of the MIIT With Charitable Planning
An MIIT can also be a valuable tool in charitable planning, used in conjunction with a Charitable Remainder Unitrust (CRT) (Section 664 of the I.R.S. Code). Under such a program, a client can transfer property with low basis to a Charitable Remainder Trust and sell the property without any capital gains, because the remainder man is a charity. The client can receive a cash flow (Unitrust payment) from the trust earning each year for his or her life (or the joint life of himself or herself and his or her spouse). This planning works even better if the appreciated asset transferred to the trust is not generating very much income. This could be real estate that is not generating much income, which has appreciated in value, and has been fully depreciated. It may also be some form of appreciated stock that pays very low dividends. Since the remainder interest is going to charity, First the actuarial value of that remainder interest to charity based on life expectancy tables and I.R.S. tables, will provide an immediate charitable income tax deduction for the client. Second, upon the client’s death, the assets in the trust will be distributed to charity and will not be subject to estate taxes.
The obvious downside with this planning is that the assets of this trust will not go to the client’s heirs. In order to provide for the heirs, we create a MIIT with the CRT, which not only can have the advantages that we mentioned before, but would be a means to provide replacement of the assets to the heirs, that are earmarked for charity under the CRT. The tax benefits that the client obtains from the Charitable Remainder Unitrust Trust should provide extra cash flow for the client, to substantiate the payment of insurance premiums. The MIIT, which in turn will pass free of income and estate taxes to the client’s heirs, to replace the interest that the CRT distributes to charity. An MIIT is not only a valuable estate tax planning vehicle, but also a tool to be utilized as a retirement plan, education plan, income tax planning technique, and, lastly, an asset protection technique. A total understanding of the use of the MIIT and the right insurance product may provide a very useful tool for the estate planner for his/her client.
Richard A. Kuenster is a practicing attorney, concentrating for over 20 years in the areas of tax, estate planning, business planning, insurance consulting, investment advice and general financial advising. He also was formerly the director of a large downtown financial and estate planning department of a major accounting firm.