Life insurance often plays a key role in estate planning. It is frequently useful in providing liquidity and flexibility, as well as to achieve overall estate planning goals.

WHAT IS LIFE INSURANCE?

Life insurance is a contractual agreement between the owner of a policy and the insurance company. The insurance company agrees to pay a certain dollar amount upon the death of the insured in exchange for the payment of premiums. There are primarily three types of life insurance, “term life,” “whole life,” and “universal life” although there are an infinite number of variations on these three types.

Term life insurance is an insurance policy covering a person’s life for a specified number of years. It is often offered with a guaranteed premium for a particular number of years. Term life does not have accumulated cash value. Accumulated cash value generally is the distinction between term life insurance and whole life or universal life insurance. Cash value policies are initially much more expensive than term life insurance policies for the same amount of coverage.

Whole life insurance provides coverage for an individual’s whole life, rather than a specified term. A savings component called cash value or loan value, builds over time and can be used for wealth accumulation. Whole life is the most basic form of cash value life insurance. The insurance company essentially makes all of the decisions regarding the policy. Regular premiums both pay insurance costs and cause equity to accrue in a savings account. A fixed death benefit is paid to the beneficiary along with the balance of the savings account. Premiums are fixed through the life of the policy even though the breakdown between insurance and saving swings toward the insurance over time. Management fees also eat up a portion of the premiums. The insurance company will invest money primarily in fixed-income securities, meaning that the savings investment will be subject to interest rate and inflation risk.

A common variation on these themes is “universal life insurance,” which is a flexible premium life insurance policy that acts as a hybrid between a term life and whole life policy. This type of policy permits variations in the payment of premiums, and typically the insured (rather than the insurance company) controls the investment of policy funds.

IRREVOCABLE LIFE INSURANCE TRUSTS (ILIT)

An irrevocable life insurance trust (ILIT) is a trust designed to cause life insurance proceeds to be excluded from the grantor’s estate for estate tax purposes. This type of trust is often useful to provide liquidity, so that cash may be used to pay estate taxes attributable to assets that remain in the taxable estate. For example, suppose that an estate with no liquid assets owes $500,000 in estate taxes. This may require that the estate sell property in order to pay the government. An ILIT can help to avoid this result. The ILIT can receive $500,000 in life insurance payable on the death of the settler, which can then be used to purchase property from the settlor’s estate. The estate then uses cash to pay estate taxes, and the beneficiaries of the ILIT receive the assets that were purchased from the estate.

There are certain specific requirements that must be met in order for the insurance to be excluded from the settlor’s estate. In summary the settlor must give up control over the trust and the life insurance policy following its formation. An ILIT is irrevocable. While the settlor can decide upon the terms of the trust initially, it generally cannot be changed after its formation. In addition, the settlor cannot retain “incidents of ownership” over the life insurance policy. This requires the appointment of a neutral third party to act as trustee, who may then control the life insurance policy.

In order for premium payments to be eligible for the $13,000 annual gift tax exclusion, notice must be given to the beneficiaries of their right to withdraw the contribution to the trust. This withdrawal right is called a “Crummey power” (which is named after a case in which the taxpayer was named Crummey). Essentially, the settlor is giving the beneficiaries money which is then used to purchase life insurance on the life of the settlor. As a practical matter, this withdrawal right is almost never exercised because the beneficiaries stand to gain more in the long run by waiting until the life insurance is paid upon the death of the settlor.

LIFE INSURANCE FOR BUSINESS

Life insurance is often useful in designing a buy-sell agreement triggered by the death of an owner of a business entity. The type of insurance policies required will depend upon the structure of the buy-sell agreement. It may be necessary for each of the owners to obtain a policy on the life of other owners if the agreement is between the owners directly, although one survivor joint-life policy may sometimes be used to accomplish the same purpose. By contrast, a redemption agreement causes a buyout at the entity level, rather than by the individual owners. This type of agreement typically requires the entity to purchase a joint life policy or separate policies on the life of each member.

The specific type of buy-sell agreement that is appropriate under a given set of circumstances requires careful planning and analysis. In many cases, life insurance may provide the liquidity necessary to make a buy-sell agreement practicable. This is but one example of the fact that estate planning and business planning needs frequently coincide.

ESTATE PLANNING IN BLENDED FAMILIES

Many estate plans provide that assets are to be held in trust for the benefit of a surviving spouse, and then distributed to the settlor’s children when the surviving spouse dies. This does not always reflect the best plan of distribution.

Suppose that a fifty-five year old settlor is married to a forty year old, and has a thirty year old child by a prior relationship. In other words, the settlor’s new spouse is only ten years older than the child. The child will be waiting a long time to receive their inheritance if assets will be held in trust for the lifetime of the surviving spouse. Life insurance may be used to provide the child an immediate inheritance upon the death of the settlor, and the surviving spouse may receive the other assets outright.

LIFE INSURANCE IN NON-TAXABLE ESTATES

Even where it is not anticipated that the estate will be subject to estate taxes, life insurance is often an important estate planning tool. (Currently estate taxes are only imposed on estates exceeding $3.5 million.)

Life insurance is often useful to buy out the share of a beneficiary. For example, suppose that a settlor with three children owns a property with a value of $200,000, and that only two of the children are interested in inheriting the property. The settlor may leave the property to two of the children, and purchase a $100,000 life insurance policy payable to the third child, so that each child receives $100,000 in value.

For a younger person with a modest estate, life insurance is often an affordable method to protect loved ones against the possibility of an untimely death. This is particularly appropriate where the person has young children, who will have a need for funds for many years until they reach adulthood.

CONCLUSION

Life insurance is often a useful tool to achieve estate planning goals. The particular type and amount of insurance can vary greatly from case to case. Please consult with your attorney to learn more about the use of life insurance in your estate plan.