Estate Taxes and Life Insurance

It’s a question I am obliged to ask my clients at the outset of the initial consultation about estate planning. I will gravely ask if they think there will be a concern with federal estate taxation. A concerned look will cross their faces – “Should we be concerned?” I will reply that if their gross estate is worth more than $11.7 million for individuals, or $23.4 million for couples, they need to be concerned. Invariably, my clients will smile and assure me they are not worth nearly that much. I will smile, and dryly say, “Just once, I’d like a client to answer that question with a ‘yes.’ ” We’ll share a laugh and move on with the discussion. My estate tax question has become an ice breaker for the conversation about their assets and property.

This was not always so. Back when I was just starting out as an attorney (shortly after the earth cooled and dinosaurs were the dominant species), the estate tax threshold for individuals was $600,000.00. In the late 1980s and early 1990s, that was a sizable estate. However, it wasn’t that hard for an average middle class American to cross over that threshold.

The reason for this was the estate tax was based on a person’s gross estate – unlike a person’s probate estate, which includes only those assets owned in a person’s own name individually on their date of death. The taxable estate covers any assets under the decedent’s control before they died.

One area that people don’t often consider is life insurance. Life insurance passes as a matter of contract to the beneficiary on the policy. Life insurance proceeds are not subject to income tax. But, because life insurance is generally included in the taxable estate, it was easy to cross over into taxable territory when the threshold was $600,000 and the decedent owned a $500,000 life insurance policy.

Beginning in 2004, Congress started pushing the lower limits of estate taxes, with the individual rate jumping to $1.5 million. By 2016, this amount was $5.49 million. Then, in 2017, the threshold more than doubled to $11.18 million, and, indexed for inflation, the 2021 starting point for estate taxation is $11.7 million.

Another consideration, however, are local estate taxes. Illinois has its own estate tax. The threshold here is $4 million for individuals. (Fortunately, Indiana did away with its inheritance tax several years ago). Therefore, my estate planning clients also have little concern about the Illinois estate tax.

But with the lower $4 million dollar state-level threshold, and the potential that some of our more progressive congressional representatives may seek to lower the federal estate tax threshold, some of my entrepreneurial clients (those who have built profitable businesses or invested well) might inadvertently fall into an estate tax problem. And the culprit will no doubt be life insurance proceeds. As with my earlier example, the heirs of a business owner who has created personal wealth of around $3 million may not realize the actual calculation is closer to $4 million. A $1 million doller life insurance policy pushes it over the edge. The Illinois estate tax on a $5 million dollar estate will be anywhere from $320,000 to $400,000.

How can this life insurance trap be avoided?

Life insurance proceeds are considered part of the taxable estate if the decedent owned the policy at the time of death. If I want my life insurance proceeds to avoid estate taxation, I need to transfer the ownership to somebody else.

How would you accomplish this?

You would need to designate a competent adult or corporate entity to be the new owner. It can even be be the policy beneficiary! You would need to consult your insurance company to obtain the correct assignment forms to accomplish this.

After assignment of the ownership, the new owner must pay the premiums. If the new owner finds this difficult, you are allowed to give up to $15,000 per person per year and not face a tax consequence. This would allow the new owner to use the gift to pay the premiums.

Of course, by giving up ownership, you also give up the ability to control the policy or to amend it in the future. However, if your strategy is to benefit family or friends with the policy proceeds, if you name a family member or friend as the new owner, its likely they will be willing to change things upon your request.

To qualify as a true transfer of ownership, the change must be irrevocable. You would need to be aware of potential future situations when choosing the new owner (e.g. You choose to name your spouse, and later you divorce).

You would, of course, make sure to receive  written confirmation from your life insurance company as to proof of the ownership change.

A second way to remove life insurance proceeds from your taxable estate is to create an irrevocable life insurance trust (“ILIT”). For an ILIT to work, you cannot be the trustee of the trust and you may not retain the right to revoke the trust.  The ILIT holds the policy in trust,  meaning you are not considered the owner; the proceeds are therefore not included as part of your estate.

What is the benefit to creating a trust instead of transferring ownership to another person? An ILIT allows you to maintain some legal control over the policy. In the case of that person we described earlier who might be unable to pay the premiums, the trust can be set up so that premiums are paid promptly. If the beneficiaries of the proceeds are minor children, an ILIT will  allow you to name a dependable person as trustee to oversee the money on behalf of those children, controlled by the terms of the trust document.

In addition, there are IRS regulations that govern the determination of who owns an insurance policy at the time a person dies. There is a “three year rule,” which states that any gifts of life insurance policies made within three years of death are still subject to federal estate tax. Whether it’s a transfer to another person or the creation of an ILIT, the life insurance proceeds will be included in your taxable estate if you die within three years of the transfer. The IRS also looks to make sure the transfer of ownership is truly a transfer; the original owner must not retain any power to change beneficiaries, borrow against the policy, surrender or cancel, or select beneficiary payment options. Most important, the original owner cannot be paying the premiums. It the original owner holds on to any of these rights, any advantage gained by the transfer will be negated. Another issue is the value of the policy at the time of transfer. If current cash value exceeds $15,000.00, a gift tax will be assessed, and potentially payable at the time of the original owner’s death.

So while it is true that most if not all of my clients are not concerned about estate taxes, it is true that most if not all of my clients don’t think about their life insurance benefits when computing their net worth. When the value of a home, retirement accounts, savings, investments, business holdings, and other property are added together, the actual size of your estate may surprise you. Add in future years of growth along with a (theoretical) $2 million dollar life insurance policy, and maybe your taxable estate actually WILL cross the $4 million dollar Illinois line. The solution is to preserve the value of the life insurance for your family, maximize your giving potential, and transfer the life insurance policy while avoiding gift tax costs. As long as you live another three years after the transfer, your estate could avoid or minimize the tax.

It happens to be national life insurance month, so in order to figure all this life insurance stuff out, you need an expert. I can claim expertise in legal matters, but not life insurance, so make sure you discuss this matter with your trusted life insurance professional, who has the background, training and experience to meet your life insurance needs.