What it means
If a person owns their own life insurance policy, the death benefit generally counts as part of their estate. For larger estates, this can add to estate tax.
By putting the policy into a trust, usually an irrevocable life insurance trust, the benefit can be paid outside the estate. The trust is the owner and beneficiary of the policy, and the trustee pays the premiums using money given to the trust by the insured person or family.
When the insured dies, the insurer pays the trust, and the trustee distributes the money according to the trust document, for instance to children or to pay estate costs. An important timing rule applies in the United States.
If an existing policy is transferred to the trust and the insured dies within three years, the payout is usually pulled back into the estate. To avoid this, many people have the trust buy a new policy from the start.
Gifts to fund the premiums are usually structured so that they qualify for the annual gift tax exclusion, using a notice to beneficiaries known as a Crummey notice. This detail needs to be followed carefully, or the gifts can use up the person's lifetime tax allowance.
Professional advice is essential. Businesses use similar arrangements as well, for example to fund a buy-sell agreement between partners or to provide cash to a family firm on the death of a founder.
The benefit is liquidity, meaning cash is available when needed without forcing a sale of assets. The costs and limits should be weighed as well.
Premiums continue for years, the trust needs a trustee and annual administration, and an irrevocable trust cannot easily be reversed if circumstances change.
In practice
Real-world examples.
Example
A business owner with a $15,000,000 estate sets up a trust that buys a $3,000,000 policy on his life. When he dies, the trustee uses the payout to give his children cash, so they do not need to sell the company.
Example
A couple funds an irrevocable trust each year with annual gifts within the gift tax exclusion, which the trustee uses to pay the premiums on a policy covering both of them. The policy pays out on the second death.
Example
Two partners in a consulting firm each have a policy owned by a trust, linked to a buy-sell agreement. When one dies, the trust pays the surviving partner to buy out the deceased partner's share.
Formula
Calculation
Estate tax saved = Death benefit x Estate tax rate (if the estate is above the tax-free threshold)
A person has a taxable estate above the tax-free limit and a $2,000,000 life policy. Assume an estate tax rate of 40%. If she owns the policy, the death benefit adds to her estate and costs 2,000,000 x 0.40 = $800,000 in tax.
If a trust owns the policy from the start, the $2,000,000 is paid to the trust free of estate tax, so the family keeps the extra $800,000. If the premiums are $30,000 a year for 25 years, the total cost of 30,000 x 25 = $750,000 is still less than the tax saved.Case study
Seen in the real world.
Harlow & Finch is an illustrative, fictional family business worth $20,000,000. The founder worried that his heirs would be forced to sell it to pay estate tax.
His adviser set up a trust to own a $4,000,000 survivorship policy, and the founder gave the trust $60,000 a year to pay the premiums. The trustee kept a record of each gift and sent the required notices to the beneficiaries.
When the founder died ten years later, the trust received $4,000,000 and lent part of it to the estate to pay tax. The illustrative lesson is that the policy provided liquidity at the right time, but only because the trust had been set up well in advance. The family later said that the main benefit was avoiding a forced sale of the company in a weak market.
Watch out
Common mistakes.
- Transferring an existing policy to the trust and dying within three years, which can bring the payout back into the estate.
- Paying premiums directly from the insured's account, which can undermine the trust's ownership.
- Assuming the arrangement is useful for every estate, when small estates may owe no estate tax at all.
Questions
People also ask.
What is TOLI used for?
It is used to keep a death benefit outside the taxable estate and to provide cash for heirs or for a business.
Who controls the policy?
The trustee owns and manages the policy, following the trust document, and the insured person generally cannot change the beneficiaries.
Can the trust be changed later?
An irrevocable trust generally cannot be changed easily, so it should be designed carefully with legal and tax advice, and the rules differ between countries and states.
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