“Do I always need a trust? It seems so complicated.” While we at Howard Kaye almost always recommend the use of a trust, we admit that the creation of these trusts can be pretty complex. So when we get that question on trusts from clients, we like to look at their own individual needs to see if what they want can be accomplished another way. There are a few alternatives to the irrevocable life insurance trust (ILIT) that can be used, but it’s important to remember that these have their limitations as well.
Why Our Clients Use Trusts
Most of our clients have a large amount of assets that will probably exceed the current individual estate tax exemption of $11,200,000. An ILIT is created as part of their estate plan to ensure that some of their assets can bypass probate, while at the same time, bypassing estate taxes.
This is done so they can pass on funds to their heirs and cover estate taxes without having to liquidate any assets. These trusts are also often arranged for charitable purposes to allow the client to create a legacy. Finally, this also creates a pool of assets to be held outside of the client’s estate to preserve family wealth.
Such trusts require regular management. Creating them involves funding a trust using annual gift tax exclusions to buy policies, managing Crummey notifications, and paying policy premiums. All of this is managed to ensure that the trust grantor never has any incidents of ownership, which could invalidate an existing trust and cause these funds to be included in the grantor’s estate anyway. Often, a trust is managed through a professional company to ensure that this doesn’t happen.
If your estate isn’t that extensive, or you just want to streamline the process, there are a couple of ways to get certain items out of your estate while still passing on funds, assets, and business interests to heirs.
Having an Entity Policy Owner
With our business-owning clients, we sometimes recommend having the business be the owner of the life insurance policy, and that the business purchase that policy on the insured’s life. Provided the business is not the kind that will be considered part of your estate (like a sole proprietorship), this can be a good way of passing on business interests to heirs.
This tactic is used as part of a business continuation plan, and can be almost as complex as buying policies through a trust. This involves creating a buy/sell agreement and is only appropriate in managing future business interests.
Another option for entity-owned life insurance involves the creation of a limited liability company, which is a common tactic used in keeping a family business in the family. Again, creating an entity for the purpose of estate management is just as complex as creating a trust. If you’re looking to decrease the complications, another alternative could be to gift the policy outright.
Gifting a Life Insurance Policy
You can gift a policy to get it out of your estate, but there are some limitations. First, the value of the policy must be under the annual gift tax exclusion of $15,000. Anything above and beyond that amount will be added to your lifetime gifts and gift tax will be applicable. Also, gifting the policy to your spouse or making them a beneficiary could cause some estate issues, so this is only a wise tactic with children, friends, and entities.
Finally, there is a major risk you could run into when gifting a policy, regardless of who you give it to. The issue is something called the three-year rule. Under the three-year rule, anything you gift within three years of your death will be considered part of your estate. So if you gift a policy to your children, and pass away a year later, that policy is going to be considered part of your estate. For some, this is an unacceptable gamble. Another alternative is to have your child own the policy from the very beginning.
Making a Child the Policy Owner
An alternative to having a trust is instead to use your annual gift tax exclusion to give your child up to $14,000 per year, and your child can use that money to purchase a life insurance policy on your life. Each spouse can gift each child $15,000 each year, so it is fairly simple to create a sizeable enough annual premium to purchase a very significant policy through gifting. In this case, your child or children would be the owner(s) from the very beginning. This eliminates the risk of the three-year rule. Because your child or children would be the owner of the policy from the very beginning, it won’t be considered part of your estate.
Keep in mind this requires the child or children to be the policy owner(s) and the premium payer, so they would be responsible for keeping the policy in force. There are a few limitations on this. First, the children can’t be minors because a minor doesn’t have the legal right to enter into a contract. Second, the children you’re doing this with will need to be responsible enough to manage such an arrangement, especially if ongoing premiums must be paid.
Usually, a trust is the best method for keeping life insurance policies out of your estate, but there are a few other methods that might work in specific scenarios. To discuss life insurance trusts and their alternatives, contact a Howard Kaye advisor at 800-DIE-RICH today.
