Life Insurance and Irrevocable Life Insurance Trusts

Life insurance can significantly leverage your wealth. It is a cost-effective way to help your loved ones deal with the financial consequences of losing you. In most cases, the build-up of internal cash value in a life insurance policy is not subject to current income taxation. Similarly, the receipt of death benefits by the named beneficiaries is generally not considered income.

Fortunately, North Carolina also provides significant protection of life insurance proceeds from your creditors. By statute, insurance on your life is not available to pay your creditors so long as it is payable to someone other than your estate. If you want to be extra cautious, make sure your insurance policy proceeds are payable to your spouse or children. Article X, Section 5 of the North Carolina Constitution protects all life insurance paid to your spouse or children from your creditors.  

The proceeds of a life insurance policy may provide a means to satisfy mortgages or pay other debts, such as the costs of your last illness or your funeral expenses. Life insurance can also be used to equalize inheritance to your beneficiaries when you leave a business, a farm or other assets to one child. It may also be used to provide funds for a surviving business partner to buy your ownership interest. In some cases, life insurance proceeds are invested to provide a source of support for your heirs. It may also provide liquidity to for the payment of federal estate taxes.

A decade ago, estate tax planning often drove the estate plan. However, in the current era of fairly high estate tax exclusions, estate planning is usually focused on the best way to protect your beneficiaries and enhance their lives. There is a great deal of flexibility in how to handle life insurance in non-taxable estates.

But for estates with assets greater than the applicable exclusion, life insurance may be an essential component of the estate plan. This is particularly true in taxable estates with little liquidity. You can’t pay estate taxes with land or an interest in a closely-held business. But your gross estate for estate tax purposes consists of the value of all property that you owned or in which you had an interest at the time of your death.

If you have any “incidents of ownership” in a life insurance policy at death or have transferred those incidents of ownership during the past three years, your gross estate includes the death benefit proceeds of your life insurance policy. The current maximum estate tax rate is 40%. So if you have a taxable estate, the effective value of a life insurance policy owned in your name is reduced by 40%. That is a good reason to remove your life insurance from your estate. There are several ways to remove the life insurance from your taxable estate.

The simplest – and most dangerous – way to remove life insurance from your estate is to have a third party, such as a child, own the policy. The premiums could be funded with a bonus if that child works in your business. But when a child buys a policy on your life, there are several potential problems. Perhaps the most significant is problem is that you lose control of ownership and beneficiary designations in the case or your child’s death or disability. You want to make certain that the policy ends up in the right hands in those cases. Specifically, you don’t want the policy coming back into your hands. You also want to make sure that someone else, such as your child’s spouse, doesn’t have the ability to change the beneficiary designation. Although the proceeds are protected from your creditors, they are not protected from your beneficiary’s creditors. If that child owes money when you die, his or her creditors will be paid from the proceeds. Leaving the policy to a child will cause estate tax inclusion in his or her estate. Of course, if they have to spend it on estate taxes, that won’t matter. But if your child died in a car wreck six months after you, before the estate tax was paid, that entire amount would be a part of his or her estate. Another consideration is that if the benefits are paid to a child, and that child pays debts that would have been attributable to other children, there could be a gift tax issue. Finally, there is no way to take advantages of Generation Skipping Transfer Tax saving strategies with this kind of ownership. So having a child own an insurance policy is somewhat dangerous. 

Another common alternative is to let your business own the policy. However, there are several concerns with this option as well. Creditors of the business could make claims against the policy value. Also, premiums paid by the company are not deductible. Should the company ever wish to distribute the policy, there could be tax implications. Generally, death benefits payable to the business are not taxed as income. However, there are situations in which they could be. And although the death benefit will generally not be considered a part of your estate, it will increase the value of your business interest, which will be part of your estate. So there are concerns with this method as well.  

The safest alternative if you have a taxable estate is an irrevocable life insurance trust (“ILIT”). An ILIT is a trust that is designed specifically to hold life insurance policies and keep them outside your estate. The trust normally receives cash gifts from you during your lifetime, and the trustee uses those gifts to maintain a life insurance policy on your life. When structured correctly, the value of the property transferred to an ILIT is removed from your gross estate for estate tax purposes. The property is not subject to estate tax or to your beneficiaries’ creditors or predators at your death.

If existing policies are gifted to an ILIT, you must live at least three years from the date of transfer to have the death proceeds excluded from your taxable estate. Therefore, when possible, it is best to replace existing policies with new policies which are owned from the outset by the ILIT trustee. However, there are more advanced strategies to avoid this three-year inclusion issue, such as a sale to the trust.  

Each time a premium payment is made through the trust, the trustee must send certain notification letters to each of the beneficiaries, including any minors. These are referred to as Crummey notices. Crummey was the 1968 decision by the Ninth Circuit Court of Appeals that approved of this procedure. The purpose of these notices is to ensure that the funds paid to the trust are considered completed gifts. The gift tax exclusion applies only if these notification letters are properly sent each time a premium contribution is made to the trust, or a policy is transferred into the trust. Your trustees should keep a file containing all of the notification letters.

If you have or may have a taxable estate, life insurance may be necessary in order to provide liquidity to pay estate taxes. Although ILITs are inflexible and require maintenance, they overcome many of the problems of the other forms of ownership