One of the toughest problems we face in designing trusts for our clients is an estate that can’t be easily liquidated without incurring sizable losses. One excellent solution is what’s called an irrevocable life insurance trust. It’s an important way that we help deal with estates made up largely or entirely of illiquid assets.
By that, of course, I mean anything that can’t readily be converted to cash, as stocks, bonds or mutual funds can. Common examples of illiquid assets are real estate and privately-held businesses, including S corporations and LLCs. I include real estate in this category because unfortunately, market cycles can make some parcels or buildings difficult - if not impossible - to sell when cash is most needed.
Or, if they can be sold, they may not command what they would be worth in a better market, or when conditions are right to develop the property. There are also times, especially here in our great state, when there are parcels of land that are held for many years by one generation as farmland that may be difficult to market as something else.
Life insurance policies are a good way to ensure heirs can get cash, but they have their drawbacks. A lump-sum insurance settlement may not be appropriate for certain beneficiaries. A life insurance trust is a means to avoid these drawbacks.
These are important considerations for some clients. I once had to work with an estate whose assets were mostly illiquid, without benefit of a life insurance trust, and it turned into an eight-year-old nightmare.
If you’re considering setting up a life insurance trust, you should be aware of a couple of very important details. One is that this is something to plan well in advance. Under federal law, until an insurance policy has been in the trust for three years, its proceeds are taxable just as if there were no trust. That is due to gift tax laws.
So, this may not be worthwhile for someone in poor health who doesn’t expect to survive three years. The other consideration is this kind of trust is irrevocable. Not only can’t it be reversed, it also can’t be amended once it’s set up. It’s important to think through very carefully how you want the insurance proceeds to be used.
Here, in simplified terms, is how a life insurance trust works.
The trust becomes both the owner and the beneficiary of one or more life insurance policies. You, as “grantor,” transfer ownership of your policies to the trust. Because you don’t own them anymore, they won’t be considered part of your estate after your death.
The trust itself is set up to benefit the grantor’s heirs, such as spouse, children or grandchildren. When the grantor dies, the insurance proceeds go into the trust. The trust then can invest that money and administer it for the benefit of the survivors, or distribute it according to pre-specified instructions.
And, again, because the trust owns the policies, the proceeds aren’t subject to estate tax. That’s true even if the estate’s other assets might put it over the taxation threshold.
Setting up the trust can get complicated. One tricky issue is to decide whether the trust is “funded” or “unfunded.” A funded trust has other assets, besides the insurance policies. Income from those assets pays the policy premiums. An unfunded trust requires its grantor to make regular contributions so premiums get paid. This has its own complex tax implications. Of course, the funding issue is moot if the insurance consists entirely of paid-up whole life policies. All these questions get deep into the weeds of tax law, which is why setting up such a trust is a job for experts.
I sometimes get asked: I already have good life insurance and my estate isn’t likely to be taxable, so why bother setting up one of these trusts? One very good reason is to shield your beneficiaries from the temptations that can come with getting a big chunk of cash all at once, as insurance policies typically pay out. The person getting the money might be a child or otherwise unsophisticated in money management, and unlikely to invest it well — or at all. You may well believe your beneficiaries’ interests are best served by having someone else, such as a trust, handling their funds.
A life insurance trust is also a better idea than just putting your life insurance policies in somebody else’s name. Yes, that might avoid estate taxes… unless the policies’ owner dies first! Then the value of the policy is part of that other person’s estate, and maybe taxable after all.
The other problem is a loss of control. Remember, the trust is irrevocable! Not so with an insurance policy that somebody else owns. They could easily change the beneficiary, or cancel the policy, or if it’s whole life, cash it in for themselves. That can’t happen with a trust.
So, for anyone whose assets are mostly tied up in real estate or in a business, a life insurance trust is a safe and reliable way to get liquid assets to your heirs without a big tax bite.
Old North State Trust, LLC (ONST) periodically produces publications as a service to clients and friends. The information contained in these publications is intended to provide general information about issues related to trust, investment and estate related topics. Readers should be aware that the facts may vary depending upon individual circumstances. The information contained in these publications is intended solely for informational purposes, is proprietary to ONST and is not guaranteed to be accurate, complete or timely.
Susan Willett is the director of trust services and oversees all aspects of trust administration for Old North State Trust, LLC. Old North State Trust, a North Carolina chartered trust company, provides: asset management services; income, estate and trust tax consulting; retirement planning and administration; and trustee and estate services to both individuals and businesses. Old North State Trust professionals have many years of experience and for over a decade have assisted clients in identifying and reaching their financial goals. For more information, visit www.oldnorthstatetrust.com or call 910-399-5470.
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