Stanley - The family fortune

Part 2 of a 2-part series

What if I told you that there was a way for you to create an estate that could benefit heirs for generations to come, free from the claims of creditors? Sound too good to be true? Well, not quite.

The irrevocable life insurance trust (ILIT) is a vehicle for creating and preserving family wealth. The ILIT is like other trusts with a grantor, a trustee, and one or more beneficiaries. An ILIT is formed by having your attorney draft a trust document and by contacting your insurance agent to apply for life insurance. It's the life insurance that makes it possible for anyone to create a family fortune.

Typically, during the grantor's lifetime the trust is unfunded, meaning that the only asset is the life insurance. Because no income is generated by the trust, generally, you make gifts to the trust sufficient to enable the trustee to pay premiums. Also, because there is no trust income and the only trust asset is the life insurance cash value, it's unlikely that any distributions will be made.

Following the insured's death, the trustee collects and invests the life insurance proceeds. Dispositive provisions in the trust determine how income and principal are distributed. Although most states have laws that limit the number of years that a trust may endure, usually the lifetime of living beneficiaries plus 21 years, a few states allow the trust to continue for as long as you like.

If the trust is properly established, assets should be outside the reach of the both the grantor's and the beneficiaries' creditors.

As good as this all sounds, it gets even better when the tax consequences are considered. With a little planning, the trust can be created and funded free of gift, estate, generation-skipping, and income taxes.

Gift taxes

Even after the 2001 Tax Act, the federal gift tax remains with us, and your payment of premiums on a policy owned by the ILIT is considered a gift for gift tax purposes. But, if the trust is properly drafted, a gift of premium payments to the trust should qualify for the gift tax annual exclusion. This means that you can gift up to $11,000 in premiums per beneficiary each year without making a taxable gift.

To qualify premium gifts for the annual exclusion, the gifts must be made to the trust and the beneficiaries must be given the power to withdraw the gifts from the trust for a limited period of time. Most beneficiaries don't have to be told that they'll be better off in the long run by not touching the gifts.

Estate taxes

Although the 2001 Tax Act phases out and eventually repeals the federal estate tax, the tax remains in force through 2009 and is set to return in 2011. Consequently, it makes sense to "bullet proof" the ILIT against the federal estate tax.

As a general rule, so long as the trustee is owner and beneficiary of the policy from the outset and you do not possess any incidents of ownership in the policy, the death proceeds are excluded from the your estate.

Generation-skipping taxes

Like the estate tax, the generation-skipping tax is also phased out and repealed over the next several years. But it too remains in force through 2009 and returns with a vengeance in 2011. This particularly onerous tax applies to transfers to beneficiaries who are more than one generation removed from you, such as grandchildren and great-grandchildren.

The tax is in addition to estate and gift taxes and the flat rate is whatever the highest estate tax rate happens to be -- 50 percent in 2002. The good news is that you currently have a $1 million exemption (indexed for inflation) that can be allocated as you wish. By allocating the exemption to gifts used to purchase life insurance by the ILIT, you may exempt the trust assets from generation-skipping taxes for as long as the ILIT lasts.

Income taxes

Finally, the death proceeds should be income tax free when received by the ILIT (pursuant to IRC 101(a)). That's one of the things that distinguishes life insurance from other assets. The appreciation on other assets you give away during life is subject to income or capital gains taxes when your heirs sell them.

In fact, under the 2001 Tax Act, in 2010, the year for which estate tax is repealed, even the basis of assets other than life insurance passed on at death carries over to the heirs (a step-up in basis is retained for up to $1.3 million of property acquired from a decedent plus an additional $3 million of property transferred to a spouse).

The bottom line is that the ILIT is not only a way to create a long-term, creditor-exempt family fortune, it's a way to do it free of income and transfer taxes.

Conclusion

If you're healthy enough to qualify for life insurance and want to create a legacy that will benefit heirs for years to come, you should consider the ILIT. For less than the cost of a Caribbean cruise, your attorney can draft the document and for the price of one month's premium, your life insurance agent can bind the insurance and start the underwriting process. In an uncertain world, the prize goes to those who take action. Why not take action today?

Sharon Stanley is a representative of The Prudential Insurance Co. of America in Cape Girardeau. (334-2603 )