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In the course of clients planning for the transfer of their wealth and the attainment of goals related to the estate, the irrevocable life insurance trust (ILIT) is one of the most popular and oft-used techniques available to them. Clients who already have an ILIT in place or who are considering implementing this technique need to understand how the ILIT works, both generally and in the context of the client's own financial strategies. The need for this understanding is underscored by the failure of many recommendations to integrate the ILIT into the analysis, to the detriment of the client. This article will address the most important aspects of modeling the ILIT as a part of a client's goal package and assumes some familiarity with the basic requirements of this technique.1
Briefly, an ILIT owns life insurance on a client and/or the client's spouse and at the death of the insured, the policy proceeds will flow into the trust for the benefit of heirs - beneficiaries - named therein. Because the ILIT owns the life insurance, the proceeds are not included in the taxable estate of the insured, thus avoiding transfer taxation. The premiums on the insurance typically are considered a gift to the trust beneficiaries and a properly created and operated ILIT will permit the use of the annual gift tax exclusion to make these gifts transfer tax free. Once the proceeds are paid into the trust and invested, subsequent distributions for the beneficiaries will be made in accord with the requirements laid out by the client when the trust was established.
During Client's Lifetime
Modeling the ILIT in the context of the client's goal package and your recommendation to the client involves a number of considerations. First, during the lifetime of the insured client, a number of cash flows may be required to be shown in the client's overall analysis. A cash flow withdrawal representing the payment of premiums on the insurance owned by the ILIT may occur from the time the trust is established and the insurance purchased until the insured's death. This death will be at the end of the planning period for a second-to-die insurance policy or for the spouse with the longer life expectancy, although it may be sooner for a client with a life expectancy shorter than the planning period. The premium cash flow normally will not inflate over time, meaning that it will take less purchasing power to maintain this flow over the planning period. This withdrawal should be tied to the insured or, when modeling a second-to-die policy, should be tied to the spouse with the longer life expectancy. In years prior to retirement, where the premium payments are funded from income, it is not necessary to model the premium payment as a withdrawal.
In the usual case, the premiums will be paid in such a way as to qualify for the gift tax annual exclusion so there should be no transfer tax consequence of the cash flow.2 With regard to the gifting of the premiums, though, be aware that the utilization of the annual gift tax exclusion for an ILIT will mean that this exclusion is NOT available for other planned transfers such as a gifting program. It is important for the advisor, client and estate planning professional to ensure that the analysis does not assume multiple gifts above the annual gift tax exclusion amount and then ignores the transfer tax impact. Thus, if there are gifts above the annual exclusion, then the client will be deemed to exhaust the lifetime gift exclusion (currently $1,000,000 per person) and thereafter will be required to pay gift tax on the excess amounts. These items would be included in our model as additional withdrawals where applicable.
The discussion of premiums may not apply where the ILIT is funded by a gift from the insured client to the trust and those funds later are used to cover any premium expense. In this case, the model generally will reflect a withdrawal of the assets used to fund the trust initially. If there are income tax or gift tax consequences associated with the funding of the ILIT, those would be entered in this situation as current withdrawals. This may be an added cost of using the technique.
The ILIT may be created as a grantor trust, meaning the income tax consequences attributable to the trust flow through to the insured grantor. In such case, there may be a need to reflect a withdrawal to meet client income tax liability based on activities of the trust. This will not occur when the only ILIT asset is life insurance since, during the grantor's life, there will be no liquid assets and therefore no current income to the trust. It will only be following the insured's death and receipt by the ILIT of the insurance proceeds that the trust may have taxable income. In such case, the trust or beneficiaries receiving distributions will be responsible for the income taxes as discussed below.
The model will not show any inflows during the insured client's lifetime as the trust will not be making distributions to the client. There ordinarily are no income tax benefits attributable to the ILIT during the client's lifetime. Finally, the ILIT is not shown as an investment asset of the client since, as an irrevocable trust, it is not the client's property and normally has no immediate value.
At the Client's Death
The operation of the ILIT upon the death of the insured client may impact the client's personal goal package and the recommendation in several ways. It is important to understand that a properly implemented ILIT will not create a cash flow into the insured client's estate on the client's death and the trust's receipt of the insurance proceeds. The ILIT proceeds will normally count towards the client's estate or legacy goal and will usually be modeled as a cash flow into the recommendation at the client's death for exactly that purpose. Normally, this cash flow will not inflate and will represent a fixed death benefit provided by the insurance. However, the proceeds will not come into the analysis for purposes of the estate tax calculation and that cash flow should not be modeled so as to overstate the client's estate for transfer tax purposes. It is important here for client and advisor to understand the dichotomy between the tax model and the cash flow analysis or recommendation.
Most often, the client will have a goal of leaving a specified legacy amount to heirs, including potentially a surviving spouse but also children, grandchildren and others. The ILIT is a useful means of fulfilling an estate or legacy goal as it allows the client to minimize transfer taxes while maximizing control over the distribution of funds from the trust. The ILIT, through its acquisition of life insurance, is also a means to wealth creation. Although the insurance proceeds typically are not included in the taxable estate, the proceeds may well be applied to help defray any estate taxes so that other client assets may be passed intact to heirs. This works particularly well where the client owns real estate or other illiquid assets and the ILIT may either loan the estate the money to pay the transfer taxes or will purchase the assets, thus bringing cash into the estate while moving the assets to the heirs named as beneficiaries of the ILIT.
In some cases, where the insured client is the first to die and leaves a surviving spouse, the ILIT may provide for the payment of income to the surviving spouse during his or her remaining lifetime. The survivorship period is coextensive with the planning period for the basic goal package, ending with the second death, that of the spouse. This income should be modeled as a cash inflow for the years following the client's death through the end of the planning period. The income may or may not be a fixed amount or subject to grow at a specified inflation rate - this will depend in part on the terms of the ILIT and in part on market performance of the invested insurance proceeds during the relevant period. For example, the actual cash flow may be determined from a separate model of the ILIT itself, where the analysis includes a percentage withdrawal for the surviving spouse for the remaining life expectancy. Normally, the cash flow will be taxable to the recipient and so the flow should be entered as a gross amount. This analysis will not apply where the ILIT owns only second to die insurance or only holds insurance on the life of the longer lived spouse.
The client may have more than one ILIT, in fact in some cases there may be several ILITs holding different insurance policies and intended to fulfill different aspects of a client's estate plan. The key is to keep track of each of these trusts in terms of any relevant cash flows during the course of the planning period as well as any survivor cash flow that may play into the basic analysis. The advisor also will need to understand when and how the proceeds will apply in the context of client goals.
The ILIT Model
Quite apart from modeling the impact of the ILIT on a client's goal package, primarily in terms of cash flows, an advisor may wish to create a separate client to model the ILIT itself. This approach may be desirable where the advisor would like to illustrate the impact of investing the insurance proceeds received by the trust as well as the anticipated future distributions to be made from the trust. The model will mirror cash flows in the client's goal package to the extent they affect the ILIT. This could include, for example, the receipt of premiums paid by the client and disbursement of same to the insurance company or distributions to a surviving spouse in a first to die case.
The model should use the date of trust creation as the date of birth or start date for the trust analysis. The planning period would be for the duration of the trust as established in the trust document. The receipt of the initial funding or recurring gifts of premiums would be modeled as inflows and the payment of premiums to the insurance company as outflows. In the case where an initial gift funds the trust, without the annual Crummey gifting approach, there may be income to the trust. The trust itself may be responsible for the income taxes although in the more common case the ILIT will be a grantor trust and the client will be responsible for payment of the income taxes out of client assets. This would mean no tax burden on the ILIT prior to the receipt of the insurance proceeds.
At the death of the insured, as determined by the life expectancy used in the client's goal package analysis, the receipt of the insurance proceeds would be modeled as a net contribution to a taxable account. The proceeds are invested in accordance with the allocation selected for the ILIT. The advisor may model the payment of distributions to a surviving spouse either as a dollar amount or a percentage of the proceeds and may use the results to feed the cash flows in the client's recommended goal package.
Taking the analysis one step further, the advisor could then model future distributions from the ILIT to heirs - other than the surviving spouse - to show the impact on subsequent generations. This could be used simply to provide the insured client with an idea of what the ILIT might generate in terms of cumulative wealth transfer over time. In addition, the advisor could tie this information into separate client recommendations for individual heirs.
Summary
Bringing the ILIT into a client's overall goal package requires that we accurately reflect how the client may be affected by both the trust related cash flows and the use of the technique as it relates to the client's valued goals. This applies both in the years prior to the insured client's death and thereafter, with consideration for surviving spouses as well as heirs in the analysis. In keeping with the Wealthcare process, we want the model to provide a useful means of helping the client make an informed decision on how the ILIT will be used and how it may help the client make the most of the one life he or she has.
Working the ILIT into a comprehensive analysis...This is the future of financial advising.
1 See "A Primer on the Irrevocable Life Insurance Trust" February 18, 2004, full text at
http://www.financeware.com/homepage.asp?showsnippet=02.18.04.wem
2 This approach to premiums is based on the Crummey tax case and allows the client's gift of the premium amount to qualify for the gift tax annual exclusion where the beneficiaries are notified of each premium payment and offered an opportunity to take their pro rata share of the premium payments currently or leave it in the trust.
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