Using Life Insurance and Irrevocable Trusts to Provide Liquidity for The Payment of Estate Taxes
Daniel B. Harris March 6, 2014
One of the most frequent problems faced by families subject to the Estate Tax (a married couple having made no prior gifts must have a net-worth of over $10,680,000 in 2014 to be subject to the Estate Tax) is how to actually pay the taxes. Very often a family owned business makes up the bulk value of the estate. This business is typically not publicly traded, and is not an easy asset to sell quickly for a good price (that is if the family even wants to sell the business, which is often not the case). If the family does not own other liquid assets sufficient to pay taxes, then they are placed in a very tough situation. For instance, let’s assume that Bob and Susan own a business that provides a service, such as pest control.
With proper estate planning, upon the first spouse’s death no Estate Taxes will be owed, due to the “Unlimited Estate Tax Marital Deduction.” However, when the second spouse passes away, there may be taxes owed depending on the values of all of the assets. If Bob and Susan own a house valued at $1,000,000, vehicles and boats valued at $300,000, checking and savings accounts in the amount of $100,000, brokerage accounts in the amount of $700,000, retirement accounts in the amount of $200,000, and the value of the business for Estate Tax purposes is $15,000,000, then the approximate Estate Tax liability under current law would be $2,648,000. However, they only have true liquidity in the amount of $800,000.
This presents a real problem for their children. If Bob and Susan decided to be proactive and insure against this risk, then they may choose to take out a “second to die” life insurance policy with face value of $3,000,000. Bob and Susan probably feel pretty good about this decision and think that their children will be able to continue the business and pay any required taxes. However, because they were owners of the life insurance policy, the face value is also included in the calculation of their assets for Estate Tax purposes. Now the approximate Estate Tax liability would be $3,848,000. This situation is much better for their kids, but is still troublesome. The better solution for Bob and Susan would be if they created an Irrevocable Trust (often referred to as an Irrevocable Life Insurance Trust, or ILIT). They would appoint a third party, such as a trusted friend, relative, or advisor, as Trustee of the ILIT. The Trustee would purchase the same exact life insurance policy, and would be the legal owner of the policy. Therefore, the face value of the policy is not included in Bob and Susan’s Estate Tax calculation and the approximate tax liability would be $2,648,000. The policy would be paid for by gifts to the ILIT made by Bob and Susan. The ILIT will ultimately benefit their children in the same way that their Revocable Trusts do; however, the Trustee of the ILIT will also be given the power to deal with and do business with the Trustee of the Revocable Trusts, and the Personal Representatives of their Estates. When the second to die of Bob and Susan passes away, the ILIT will receive a check for $3,000,000. The Trustee of the ILIT can use that liquidity to purchase unmarketable assets, namely as a portion of the family business, from the Revocable Trusts and/or Estate of the survivor. Thus, the liquid assets end up in the hands of the person who must pay the taxes, and the children inherit a larger amount than would otherwise be the case.
It is important however, that the ILIT does not require the Trustee to pay the policy proceeds to the Revocable Trust or the Estate of Bob or Susan; otherwise the face value will be included in the Estate Tax calculation. At the end of the day, $2,648,000 worth of the family business was purchased by the ILIT and is held for the benefit of the children. The Trustee under the Revocable Trusts used that cash to pay off the Estate Taxes. The children did not have to dip into their personal assets to pay the taxes, nor did they have to use up all of their parents’ liquid assets, nor did they have to sell the family business for peanuts in a “fire sale.” This type of planning is a very good solution for many families and is a very flexible estate planning tool.