I was talking to a gentleman I've been working with for a few years. He has built a successful business in Baton Rouge and a New Orleans financial advisor is suggesting that he purchase a life insurance policy inside of an irrevocable life insurance trust (ILIT) to pay the taxes when he dies. Here's how that scenario typically works:
Example. Leon built a successful construction company. He has four children. Leon's estate is valued at $14 million. Since his estate is valued at more than $5.45 million, Leon's estate faces a significant estate tax bill when he dies. A quick calculation shows that the estate tax at this death would be about $3.5 million - more if his estate continues to appreciate before he dies. The financial advisor is suggesting that form an ILIT and have the ILIT purchase a $3.5 million life insurance policy on his life. He explains to Leon, "The policy will avoid tax because the life insurance is tax free and your children will inherit your estate." The financial advisor tells Leon that the policy will cost $56,000 per year. Leon is not sure what to do. Leon is the kind of guy that generally "doesn't like" insurance and he reluctantly asks his financial advisor for all of the reasons why he should NOT create the ILIT and purchase the insurance.
Here are a few issues that Leon and his estate will face:
- Gifting. If Leon goes through with the plan, he will use the present interest gift tax annual exclusion to shield the $56,000 from having gift tax consequences. The ILIT will be a "Crummey" trust, which means that Leon must give his children an opportunity to take the $14,000 now, as opposed to have it used to purchase life insurance. In order to avoid gift tax consequences, the gift must be a gift of apresent interest instead of a gift of a future interest. While the "tax-free" gifting sounds like a good idea, Leon will have to make this gift/insurance payment every year, so Leon may never be able to give his children money again without gift tax consequences. Some parents like give money to their kids during the parent's lifetime, so the parent can see the children enjoy the gift.
- Life Insurance Policy. In years past, many life insurance policies have "expired" because the insured lived too long, and the policy ran out of cash value to pay for the insurance. In the early years, Leon will be making $56,000 annual premium payments but the insurance cost will not be that much. As Leon ages, the annual insurance cost (if he lives long enough) will be more than $56,000 so there is a risk that Leon will have to pay more than $56,000 annually to maintain the policy, even if he has no more gifting limits to make those payments.
- Tax Not Reduced. Some people who create ILITs do so because they want to avoid tax. But creating an ILIT does not reduce your estate tax. The tax will still exist but if the insurance pays out at your death, there will be funds in the trust that can be used to pay the tax and your children will inherit your estate.
- Is $2.6 million for each child enough? If Leon dies with a $14 million estate, and his estate owes $3.5 million in estate tax, then there will be $10.5 million in assets remaining, and his children will each inherit about $2.6 million. Perhaps Leon feels that $2.6 million for each child is enough - heck, Leon never received an inheritance so why should he spend $56k per year so that his children might inherit more than $2.6 million each.
So, Leon's got some decisions to make. Hopefully Leon will have the kind of advisors who are able to show him all the reasons for and against certain actions so that when Leon decides to move forward with the planning, he does so fully informed and feeling confident that he did what was best for his family.