Using Life Insurance to Pass Assets Free of Estate Tax
 
July 15, 2003
 
Joshua Husbands - Portland
J. Alan "Alan" Jensen- Portland

Two ways you can use life insurance to pass assets free of estate tax and create leverage are through an irrevocable life insurane trust (ILIT) or split dollar life insurance.

Irrevocable Life Insurance Trusts

An irrevocable life insurance trust (ILIT) is a trust designed to own and maintain one or more life insurance policies, typically on the life of the grantor (the person who establishes and funds the trust) of the trust. The main benefits of forming and using an ILIT, if properly structured, are that the proceeds of the life insurance policies owned by the ILIT will not be included in the grantor’s taxable estate, and the policy proceeds may provide liquidity to the grantor’s estate in order to fund the payment of any estate tax due.

Avoiding the Estate Tax. Though the proceeds of a life insurance policy are paid to the designated beneficiaries free of income tax, the proceeds will be included in the taxable estate of the decedent if he or she was both the owner of the policy and the insured party. Alternatively, if an ILIT is established during the grantor’s lifetime and the trustees buy and own one or more life insurance policies on the grantor’s life, the ILIT is the owner of the policy and the beneficiary is entitled to receive the proceeds on the death of the insured. Thus, the proceeds will not be included in the estate of the deceased grantor and will not be subject to the estate tax. To ensure that the proceeds are not included in the grantor’s estate, the grantor cannot be the trustee of the ILIT.

The manner in which the ILIT acquires the life insurance policy is very important. If the grantor is already the owner of an existing life insurance policy on his or her life, it is permissible for the grantor to assign the existing policy to the ILIT, but that transfer will be a taxable gift. Moreover, if the grantor dies within three years of the transfer of the policy to the ILIT, the policy proceeds will be included in the grantor’s taxable estate. This risk may be avoided by establishing the ILIT ahead of time and having the policy issued directly to the ILIT as the original owner.

Providing Liquidity to the Estate. The terms of the ILIT agreement should authorize the trustee both to purchase and maintain life insurance on the life of the grantor, and to deal with the grantor’s estate after his or her death. Typical terms of the ILIT will allow the trustee to purchase assets from the estate or make loans to the estate in order to provide the liquidity needed to pay estate taxes. Since any asset purchased from the estate will pass under the distribution provisions of the ILIT, the property will typically pass to the same beneficiaries as it would have under the grantor’s will or revocable lifetime trust. The grantor’s entire estate plan should be coordinated to ensure the desired property and cash distribution scheme.

Gift Tax Considerations. There are a number of gift tax issues that must be considered when planning for the use of an ILIT. First, if an existing life insurance policy is transferred to the trust by the grantor, the value of the policy will be considered a gift from the grantor to the trust. If the trust terms do not include certain provisions to ensure the availability of the gift tax annual exclusion for the gift of the policy, or if the value of the policy is too great to be covered by the available annual exclusion, a gift tax may be imposed in the year the policy is transferred to the ILIT. This is another reason, in addition to the three-year estate inclusion concern discussed above, that the superior method for getting the policy into the ILIT is to have it issued directly to the ILIT from the insurance company.

The main gift tax implications of using an ILIT arise each year when the amount of cash necessary to pay policy premiums is transferred to the ILIT. Absent an arrangement to the contrary (See summary on Split-Dollar Life Insurance below), each transfer of money to the ILIT for the payment of premiums will be a gift. This result may not be avoided if the grantor pays the premiums directly to the insurance company on behalf of the ILIT, as a gift of the premium amount will be deemed to be made by the grantor to the ILIT in that case. The gift tax implications of present and future premium payments should be considered and planned for when forming an ILIT as part of an estate plan. Typically, ILITs include a provision referred to as a “Crummey Power,” which gives one or more beneficiaries the right to withdraw the premiums within a period of time after they are contributed to the trust. This provision enables the contribution to qualify for the annual gift tax exclusion.

Split Dollar Life Insurance

In its simplest form, split dollar life insurance financing is a method for the payment of life insurance premiums under which one party, typically an employer, pays the policy premiums on behalf of another party, typically an employee or a trust established by the employee. Split dollar agreements are useful for a number of reasons. The life insurance policy most often insures the life of the employee, but it may insure someone else at the employee’s direction. The premiums paid by the employer are to be reimbursed from the policy’s death benefit proceeds when the employee (or other insured) dies, or from the cash surrender value in the policy if the agreement is terminated prior to the death of the insured.

This method of paying life insurance premiums often will allow the employee to secure a larger amount of insurance than he or she would otherwise be able to afford, while doing so in a tax efficient manner. Any type of life insurance policy that accumulates cash value, such as whole, variable or universal policies, can be used in a split dollar arrangement. Term life insurance policies are not appropriate in these arrangements because they have no cash value.

The taxation of these arrangements depends on a number of variables, most importantly which party owns the policy. In some instances the employer owns the policy before it is transferred to the employee upon termination of the agreement. In other cases the employee owns the policy and the employer’s right to repayment of the premiums advanced is secured by the cash value in the policy. The taxation of these two arrangements will be different and should be considered when determining whether one of the two methods of life insurance financing is appropriate for the situation in question. The law governing split dollar financing is in a state of flux, but proposed regulations provide a good idea of how the Internal Revenue Service intends to tax these arrangements.

Employer Owns the Policy. When the employer owns the insurance policy (the economic benefit method), the split dollar agreement typically specifies that the employer will be repaid the amount it has advanced in premiums from the cash value in the policy if the agreement is terminated prior to the death of the insured or from the policy proceeds if the insured dies while the agreement is still in effect. The employee’s rights in the policy are ensured by a policy endorsement executed by the employer in his or her favor as part of the split dollar agreement. If the death of the insured triggers the repayment of the premiums, the policy’s death benefit proceeds in excess of the amount owed to the employer for the repayment of the premiums advanced will be paid to the beneficiary named in the policy (designated by the employee). If the split dollar agreement is terminated prior to the death of the insured, the employer will be repaid the advanced premiums it is owed from the cash value in the policy, after which the policy will then be transferred to the employee for continuance or surrender.

Under the economic benefit method, the annual tax implications for the employee will depend on whether, upon termination of the agreement, the employer is entitled to receive back only the premiums it has advanced or the entire cash value in the policy. If the employer is entitled to the entire policy cash value when the agreement is terminated then the employee will recognize income each year equal to the one year term cost for the life insurance coverage provided under the agreement. This one-year term cost is typically determined from Table 2001, published by the U.S. Treasury, which provides the term cost per $1,000 of insurance coverage depending on the age of the insured. In certain instances it may be possible to value the economic benefit provided to the employee each year based on the insurer’s published term costs, but the requirements are very strict and too detailed to discuss here.

If the employer is entitled, upon termination of the agreement, only to receive back the premiums it has advanced, the employee receives the benefit of the equity spread between the amount owed back to the employer and the policy cash value. In this “equity” situation the employee will be taxed each year on the incremental growth in that equity spread in addition to the annual term cost described in the preceding paragraph.

Cash value in the policy exceeds the amount of premiums repaid to the employer when the split dollar agreement is terminated while the insured is still alive. The excess cash value will be taxed to the employee as income when the policy is transferred. If the agreement is terminated due to the death of the insured, the proceeds will be paid out free of income tax.

Employee Owns the Policy. When the employee owns the policy (the loan method), the split dollar is technically a below-interest loan agreement. For purposes of this discussion, we will assume the loan is an interest- free loan. Under these circumstances, the employer loans the amount of the policy premium to the employee each year and will be repaid the total amount loaned upon the termination of the agreement. The cash value in the policy serves as security for the employer’s loan and a collateral assignment agreement is executed in the employer’s favor to memorialize that fact. The loan from the employer is to be repaid from the cash value in the policy if the split dollar agreement is terminated during the lifetime of the ensured and from the policy death benefit proceeds if the insured dies while the agreement is still in effect.

Under this type of arrangement, the term cost of the insurance coverage provided to the employee is irrelevant because he or she owns the policy outright. However, the employee will be taxed each year on the amount of foregone interest deemed as transferred from the employer for the payment of the interest that was not charged. The interest rate to be charged is determined based on a complex set of variables, depending on how the split dollar/interest-free loan agreement is structured, but in most cases the interest rate used to determine the amount of foregone interest to be taxed to the employee will be a blended annual rate published by the Treasury each year.

Other Options. As mentioned above, it is also possible for a trust to stand in place of the employee as the owner and/or beneficiary of the policy, which, if structured correctly, may avoid inclusion of the death benefit proceeds in the employee’s taxable estate. It is also possible to structure a split dollar agreement between two private parties, such as an individual and an irrevocable life insurance trust, without the involvement of an employer. This is typically referred to as a “private” split dollar arrangement. In any case, when a trust is involved or any non-employment arrangement is contemplated, there are gift tax issues that must be considered before going forward with the arrangement.

Conclusion

When structured properly and used in conjunction with an integrated estate plan, an ILIT is a very effective tool for providing liquidity to an individual’s estate while avoiding the imposition of estate tax on the funds that provide the liquidity. Even in estate plans that do not require additional liquidity, an ILIT should be considered as a vehicle for passing assets to the objects of the grantor’s bounty free of estate taxes.

When carefully considered and appropriately structured, split dollar life insurance funding agreements can be a valuable economic leverage and tax saving tool for use in a business or estate plan. To effectively evaluate the use of a split dollar plan, a tax advisor and insurance agent should be consulted and work together as a team to determine the costs and benefits of such a plan and which type of plan will be most valuable to the client.

For more information, contact Joshua E. Husbands or J. Alan Jensen via e-mail at joshua.husbands@hklaw.com and alan.jensen@hklaw.com, respectively, or call toll free 1-888-688-8500.