If you own a business, your interest in the business may be one of your largest assets. Estate and tax planning as a business owner is a delicate but crucial process because business interests are includable in a business owner's taxable estate. If not properly planned for, your beneficiaries may not have sufficient liquid funds to satisfy federal estate and gift tax liabilities, if your estate is subject to such tax.
This article addresses irrevocable life insurance trusts (ILIT) as an estate and gift tax planning tool specifically for business owners.
What is an ILIT?
An ILIT is a trust that is set up to hold and manage life insurance policies. An ILIT is created by a grantor (for example, a business owner) who names a trustee to manage the ILIT and beneficiaries to receive the insurance policy benefits upon the death of the grantor. Once created, the trustee of the ILIT purchases a life insurance policy on the life of the grantor. The ILIT continues to hold and own the life insurance policy until the death of the grantor. Each year, the grantor contributes money to the ILIT, which the trustee uses to pay the insurance premium.
The grantor cannot retain the right to assign, cancel, revoke or otherwise change the insurance policy as the grantor would then be deemed the owner of the policy. This would defeat the purposes of an ILIT for a business owner, which are the tax advantages detailed below.
Tax Planning With an ILIT
The Lifetime Exclusion
In 2024, taxpayers can exclude up to $13.61 million per individual or $27.22 million per married couple (the Lifetime Exclusion) from federal estate tax. This means that taxpayers can transfer this amount of assets either during their lifetime or at death without paying federal gift or estate tax. However, any amount transferred beyond the Lifetime Exclusion is taxed at the steep 40% estate and gift tax rate.
The current Lifetime Exclusion is historically high thanks to the Tax Cuts and Jobs Act of 2017 (the TCJA). The TCJA made significant changes to the federal gift and estate tax laws, including the increase of the Lifetime Exclusion amount from $5.6 million per individual to $11.8 million per individual (adjusted for inflation).
Unless Congress extends it, the TCJA is set to "sunset" on Dec. 31, 2025. If no congressional action is taken, the Lifetime Exclusion amount will revert to its pre-2017 amount of $5.6 million per individual (adjusted for inflation from 2017). If the TCJA is not extended, the 2026 Lifetime Exclusion amount is estimated to be around $6-7 million per individual and $12-14 million per married couple. This decrease would surely subject a greater number of estates to the federal gift and estate tax. Further, the decrease would result in higher federal gift and estate tax liability for those already subject to the tax.
ILITs as Tax Planning Devices
ILITs are great gift and estate tax planning tools for business owners for two reasons. First, because the ILIT owns the life insurance policy.The value of the policy is completely removed from the business owner's taxable estate value at death. Thus, the value of the ILIT does not impact whether—or how much—federal gift and estate tax is owed by the business owner's estate.
Second, and especially applicable, ILITs can be used to pay federal estate and gift taxes owed on the business owner's estate after the owner's death. If you are a business owner, chances are that a significant portion of your estate value is tied up in your business. If your business and other assets are worth more than the Lifetime Exclusion amount, your estate will likely be subject to federal gift and estate taxes. The issue, however, is that business interests are illiquid assets. This may make it difficult for estate beneficiaries to obtain the necessary cash to pay the gift and estate tax.
Enter the ILIT
At the business owner's death, the ILIT trustee collects the life insurance policy proceeds. The cash received can then be used to pay estate taxes or other debts of the estate. This effectively helps solve the liquidity issue that may present itself if the majority of the taxable estate is the business owner's business interest(s).
In sum, the benefit of an ILIT to a business owner is two-fold: (1) it decreases a business owner's taxable estate value and (2) it provides liquidity to pay estate tax liabilities. Please note, this article is meant to provide a general overview of ILITs and their benefits. Consulting an attorney is advisable for a more detailed explanation of how an ILIT may benefit you and assist in your specific tax planning strategies.
Originally published by Utah Business
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.