Here in the United States, we have a federal estate tax that can have a huge impact, because it carries a draconian 40% maximum rate. It is only a factor for wealthy people, because there is an $11.58 million exclusion. You can transfer this much tax-free before the estate tax would become applicable.
The federal estate tax can be applied on asset transfers to anyone other than your spouse. Spousal transfers are completely exempt because there is an unlimited marital deduction. One caveat to this statement would be that this deduction is only applicable to transfers to American citizens.
On the subject of spouses and the estate tax exclusion, since 2011, it has been portable. In this context, “portability” refers to the ability of a surviving spouse to use the exclusion that was earmarked for his or her deceased spouse. This means that a surviving spouse would have a total exclusion of $23.16 million in 2020.
You cannot simply give gifts to avoid the estate tax, because there has been a gift tax in place since 1932. The exclusion that we have for an individual encompasses large gifts that you give while you are living along with the value of the estate that will be transferred after your death.
The reason why we used the qualifier “large” gifts is because there is an additional gift tax exclusion. It allows you to give as much as $15,000 to any number of individuals in a year free of taxation before you would have to use a portion of your unified exclusion to give the gifts in a tax-free manner.
To be clear, the total amount can be unlimited, as long as you don’t give more than $15,000 to any one person during a calendar year. This is relevant information to bring with you as you proceed to the following section.
Irrevocable Life Insurance Trust
If you are exposed to the estate tax, you have to take steps to reduce the taxable value of your estate and facilitate tax efficient transfers. One tool that can be part of the plan is in an irrevocable life insurance trust (ILIT). To receive the important tax benefits of the ILIT, you as the grantor cannot act as the trustee.
Life insurance policies that are in your direct personal possession would be part of your estate, so you could convey them into an irrevocable life insurance trust to remove them from the estate. There is a three-year look back rule governing this practice, so you have to live for at least three years after you transfer the policies into the trust for the strategy to work.
Of course, the trust itself could purchase life insurance policies, and premiums must be paid out of a trust checking account by the trustee. You could give gifts to the trust so that there is liquidity to pay premiums using the $15,000 per year, per person exclusion. These would essentially be present gifts to the beneficiaries, so this is possible.
However, the trustee must notify the beneficiaries about the gifts through a Crummy letter, which would inform them that they have the right to withdraw a share of the contributions. They would of course decline to do so.
When you establish the trust, you can instruct the trustee with regard to the nature of the distributions that will be received by the beneficiaries when the proceeds are eventually collected.
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We are here to help if you would like to discuss irrevocable life insurance trusts or any other estate planning matter with a licensed attorney. You can give us a call at (585) 546-1734 to set up an appointment, and there is a contact form on this website you can use if you would prefer to send us a message.