Federal Estate Tax 2011: Part 3

In this final part of the Federal Estate Tax 2011 series, I hope to simplify some additional opportunities for minimizing or even eliminating the Federal Estate Tax that appears likely to return on January 1, 2011 to pre-2001 rates. In Part 2, the charitable deduction, marital deduction, and usage of both spouses' unified credits were explained as techniques that can be used to minimize or eliminate the Federal Estate Tax. In this Part 3, I will explain how life insurance policies can avoid the Federal Estate Tax if proper planning is used. In addition, gifting strategies during an individual's lifetime can be used to obtain additional Federal Estate Tax savings.

I. The irrevocable life insurance trust ("ILIT").

Part 1 explained that the death benefits of a life insurance policy are subject to the Federal Estate Tax. For individuals that own, or plan to own, a large life insurance policy, the death benefit payout can lead to a large estate tax bill. Fortunately, with proper planning, and the use of an ILIT, the entire life insurance policy can avoid estate taxation.

This process requires that an irrevocable trust be created. As the name implies, the trust cannot later be changed or revoked. Once established, it is permanent, so care must be taken when establishing the trust.

Once the trust is created, the owner of the life insurance policy must transfer the policy to the trustee of the trust. The trustee (someone other than the original life insurance policy owner, who is the insured life) takes over the ownership of the policy and pays the premiums. The trustee is also named as the recipient of the death benefits upon the original policy owner's death.

The trust identifies the beneficiaries to whom the trustee will eventually pay the death benefits after the trustee receives them from the life insurance company. The original owner's surviving spouse should not typically be the sole beneficiary of the trust because the goal is to pass these assets to future generations in a way that will avoid the Federal Estate Tax. Distributing them to the surviving spouse simply creates a larger taxable estate upon the surviving spouse's subsequent death.

Obviously, the payment of premiums during the insured's life requires a source of cash. This requires the original owner to make periodic gifts of cash to the trustee in order to fund those premium payments. The trust agreement must include certain provisions that allow the original owner to make these cash transfers in a way that takes advantage of the annual gift exclusion and provides the ultimate beneficiaries with a withdrawal right so that the trust can qualify for the exemption from estate taxation.

Term life insurance policies are the easiest to transition to an ILIT. This is because they normally have no investment value to them. Instead, relatively small amounts of premiums are paid over a term period in exchange for the obligation of the life insurer to pay a defined death benefit to a beneficiary upon the insured's death during that term.

Life insurance policies that contain some type of investment value (universal, whole life, etc.) may be more difficult to transfer to an ILIT if they are transferred after they have already been purchased and have built up a substantial cash surrender / investment value. However, they can be transferred to the ILIT as long as there is appropriate planning. If the owner has not yet purchased the policy, then the ILIT can be created prior to the purchase of the policy in order to maximize the use of the ILIT, maximize tax savings, and reduce transfer complications.

Properly established and administered, use of an ILIT can completely eliminate a very large life insurance policy from estate taxation and create a significant source of tax-free cash for use by the beneficiaries upon the death of the original life insurance owner.

II. Gifting strategies using the annual gift exclusion

As discussed in the prior installment, individuals can make annual gifts to other persons up to the amount of $13,000 per year, per person. With a large family, and by using both spouses' annual exclusion to split gifts, this annual exclusion can allow for large transfers of assets in a relatively short period of time.

Here's an example: Fred and Donna have 4 children and 8 grandchildren. They have a combined estate of $1,800,000 which includes a large amount of cash in certificates of deposit and savings accounts. If they chose to make annual gifts to their 4 children, they could each make a gift of $13,000 to each child ($26,000 per child by split gifting) and transfer $104,000 in one year, reducing their combined estate to $1,696,000. If they chose to also include each of their grandchildren, then $312,000 could be gifted in one year simply by maximizing the annual gift exclusion.

Individuals that wish to make gifts to minor children can use certain types of trusts to receive such gifts in order to protect the cash from being used too early by the child. Gifts of marketable securities, interests in real estate, and other types of assets are all eligible to be transfered in this manner.

Individuals must be very careful to consider all of the potential issues that come with making unrestricted gifts. Recipients of such gifts may use the gift foolishly, and recipients that are eligible for certain types of governmental assistance may lose their eligibility upon receiving gifts that have any significant financial value.

III. Conclusion

When considering your potential liability for estate tax, and evaluating various ways to minimize that liability, it is crucial that you discuss these issues with an attorney that is experienced with estate tax, trusts, and probate planning.

Implementing many of the techniques discussed in this series requires the use of particular legal documents. A "Do-It-Yourself" approach is never recommended and can lead to disastrous legal or tax consequences. Family disputes may arise and litigation may occur even though you thought you created a simple and easy-to-follow plan. Talk to your estate planning professionals. Proper planning can save significant amounts in taxes, avoid family disputes, and provide for a smooth transition during a very difficult time for your family.