Prior to 2013, most individuals placed life insurance into an irrevocable life insurance trust (ILIT). With the permanent increase in the federal estate tax exemption to $5.25 million, it raises the question of whether many families still need ILITs for estate tax planning. Despite this change, trust-owned life insurance (TOLI) still offers numerous benefits. This article will review those benefits, discuss the various methods that are available to fund a TOLI policy and make general recommendations that may apply to your situation.
Benefits of TOLI
There are many reasons to consider a TOLI, but some of the main benefits are listed below:
- Creditor protection for beneficiaries
- Provides centralized wealth management
- Limits exposure to state estate taxes in states with separate estate tax systems or no state income taxes
In addition to the advantages listed above, you must factor in the issues associated with funding premiums into the trust. We’ll discuss several funding options below.
Gift of Federal Gift Tax Exemption
- Summary: Because an individual can give away up to $5.25 million free of federal gift and GST taxes, it is possible to transfer a lump sum to the ILIT, apply the exemption and then be done with the funding process.
- Advantages: This is the simplest of the techniques and can also be the most tax efficient.
- Drawbacks: This method offers the least flexibility and ties up a significant lump sum into an irrevocable trust. It also requires initial reporting in the form of a federal gift tax return for the year of the gift.
- Best Use: This method is best for those individuals that have the liquidity required to make a sizeable lump sum gift. In addition, this method allows the individual to use leveraged funding techniques, such as the split dollar arrangement described in this article.
Annual Exclusion Gifts
- Summary: Gifts to ILITs can qualify for an individual’s annual exclusion gift (excluded from federal gift tax up to $14,000) if the trust gives beneficiaries withdrawal power over the gift.
- Advantages: In addition to not incurring the federal gift tax, annual exclusion gifts can allow aggregation of gifts (if the ILIT provides a greater number of beneficiaries with withdrawal powers), the ability for married couples to do split gifts and they prevent the “waste” of the annual exclusion gift each year.
- Drawbacks: This method does have some drawbacks, most notably that the total annual exclusion gifts allowed to an ILIT may not completely cover the premiums on larger policies. This method also requires proper administration to ensure that gifts to the ILIT qualify for the annual exclusion.
- Best Use: This method is best used when the total annual exclusion amount is enough to satisfy the premiums for the TOLI policy.
Split Dollar Arrangements (SDA): Private SDAs
- Summary: The grantor funds all policy premiums in exchange for an interest in the policy equal to the greater of its cash value or the total premiums paid.
- Advantages: To maximize the benefit of an SDA, it can be combined with a lump-sum gift as mentioned above. In addition, the private SDA is flexible, and there is a very low economic benefit cost in the initial years of the policy.
- Drawbacks: Because a private SDA faces increasing annual costs as the insured’s age, an exit strategy is required.
- Best Use: Private SDAs make the most sense when the initial term cost of the insurance is low. This can be the case in which the policy is insuring younger individuals or for survivorship policies.
Split Dollar Arrangements: Split Dollar Loans
- Summary: In this arrangement, the grantor makes interest-bearing loans to the ILIT to pay the policy premiums and the ILIT has an obligation to repay the loans at the specified maturity date(s).
- Advantages: Because the applicable federal rate (AFR) is currently very low, these loans can be made to ILITs at minimal interest cost. As with a private SDA, these can also be combined with a lump-sum gift of the federal gift tax exemption to the ILIT.
- Drawbacks: Much like the private SDA, split dollar loans also require an exit strategy as these must eventually be repaid.
- Best Use: Split-dollar loans may be a good alternative when the term insurance rates provided under the economic benefit regime are too high or the grantor wants the ILIT to have tax-free access to the policy’s cash value.
Installment Sales to ILIT
- Summary: A grantor can sell assets to an ILIT in exchange for an interest-only installment note and providing for a balloon payment of principal at the end of the note term. The ILIT then uses income produced by the trust assets to pay the annual interest obligations on the note. Any excess income is used to pay premiums on the life insurance policy held by the ILIT. If combined with an SDA, the ILIT could apply the excess income to pay the economic benefit under a private SDA or the interest due on a split-dollar loan.
- Advantages: When this method is properly executed, the sale of the asset is disregarded for federal income tax purposes. In addition, the assets sold provide for a built-in exit strategy.
- Drawbacks: Because the ILIT should have sufficient initial funds to reasonably demonstrate that it can meet its financial obligations under the sale note, it may require the grantor to fund the ILIT initially with “seed” funds.
- Best Use: This method can be used for individuals with assets subject to valuation discounts or with significant appreciation potential. Also, very large estates that cannot resolve their estate tax exposure with even significant gifting programs may want to consider this method.
For individuals with estates closer to the $5 million federal estate tax exemption, annual exclusion or lump sum gifts may be the best method for funding a TOLI. Larger estates can benefit from combining these gifts with more advanced funding methods, such as loans or installment sales described above, particularly given the current, low interest environment.
To learn more about whether TOLI might be the right fit for you, we encourage you to contact Charles J. Farro. Chuck is the president and co-founder of Marsh & McLennan Agency formerly Benefits Resource Group. You can contact Chuck by phone at 216-393-1818 or by email at firstname.lastname@example.org