In working with the closely held family business, I have found the Irrevocable Life Insurance Trust to be an excellent tool when properly used. An Irrevocable Life Insurance Trust is a tool to provide liquidity in an estate for the second generation to pay estate taxes. Once established, an Irrevocable Life Insurance Trust can prevent the already intact life insurance proceeds from being taxed as part of the insured's estate.

In many cases, the closely held business represents a large portion of the entrepreneur's estate. At death, both the IRS and State governments want their cut of the person's net worth in the form of estate taxes. In the worst case, the business may need to be sold simply to provide the liquidity to pay the estate taxes. Distressed sales – property, stock or other assets sold urgently- after the death of the founder are often at significant discounts with devastating results for the family. We use the Irrevocable Life Insurance Trust as a solution to avoid this disastrous result.

The Irrevocable Life Insurance Trust is a trust which holds a life insurance policy on the company owner's life and often on the life of their spouse (referred to as second to die policies). A key feature is that the trust's ownership of the policy and the ultimate death benefit proceeds, are not included in the estate of the business owner. For example, think of it as buying a life insurance policy on your life but the beneficiaries are your children, and the proceeds are not part of your estate.

Each year the insured (parent) makes a gift of cash (this amount is usually less than the annual exemption times the number of beneficiaries) into the Irrevocable Life Insurance Trust, and the trustee uses this cash to pay the annual premium on the life insurance policy. Upon receipt of the cash, the trustee sends Crummey letters to the ultimate beneficiaries (children) which provide them the opportunity to remove the cash if they want. In this way, the gift is considered a gift of a "present interest" and qualifies for the annual exclusion which is currently $14,000. The children understand the purpose of the trust and opt to leave the cash in the trust for payment of the insurance premiums.

What are the steps for establishing an Irrevocable Life Insurance Trust?

  • An attorney must draft the trust agreement
  • An independent trustee is selected
  • A taxpayer identification number is obtained
  • A bank account is opened in the name of the trust
  • The trustee obtains quotes and selects an appropriate policy
  • The insured makes a gift of cash into the trust
  • The Trustee sends Crummey letters
  • The Trustee makes the premium payments

On death, the Trustee makes a claim for the insurance proceeds. The trust then loans funds to the estate or purchases assets of the estate to provide liquidity to the estate for paying taxes.

Still curious to learn more about Irrevocable Life Insurance Trusts? Our team at Delap is happy to answer any questions regarding this tax concept, or any other accounting and finance challenges you may be facing.

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Delap LLP is one of Portland's largest local tax, audit, and consulting accounting firms, located in Lake Oswego, Oregon.