Taxpayer Victory Makes Tax-Free Life Insurance Better

Let's set the stage (with a true story) for a must-do tax-saving strategy. Joe from North Carolina had just gone to the big business in the sky.

Let's set the stage (with a true story) for a must-do tax-saving strategy. Joe from North Carolina had just gone to the big business in the sky. His wife had preceded him 2 years before. Joe’s son, Sam, called me looking for some post-death tax planning.

Sam sent me a thick stack of papers. Joe’s $1 million life insurance policy was the key issue. Over the years, Joe had paid $220,000 in premiums. When Joe died, the cash surrender value (CSV) of the policy was $459,000. (Remember, when you die the CSV dies with you.) The sad truth is that Joe had an investment of $459,000 and an insurance policy of only $541,000 (the difference between the $1 million death benefit and the CSV). Even worse, if the $1 million death benefit is included in Joe’s estate, the estate tax would be $550,000. Joe’s heirs would get only $450,000 ($9,000 less than Joe’s $459,000 investment.)

But Joe was a planner. Six years before he died, he transferred the policy to an irrevocable life insurance trust (ILIT). An ILIT—when you follow a ton of rules—keeps life insurance proceeds out of your estate. Good move, Joe.

But wait! Is there a fly in the ointment? The last 4 years of Joe’s life, he loaned the ILIT the money to pay the premiums and took back notes from the trustee as evidence of the loans. Did Joe’s lending money to the ILIT to pay premiums cause that $1 million policy to be taxable in his estate? If so, $550,000 would be lost to the IRS.

One of the technical traps concerning an ILIT is the incident of ownership rule. Violate the rule and your hoped-for protection from the ILIT fails. The IRS nails you with a violation of the incidents of ownership rule if you create an ILIT and retain certain powers, such as the power to change the beneficiary; to surrender or cancel the policy; to assign the policy; to revoke an assignment; to pledge the policy for a loan; or to borrow against the CSV. You never want to trip over one of these costly tax mistakes.

Victory for the good guys: The IRS decided (in Letter Ruling 9809032) that the loans were not an incident of ownership. When the taxpayer in the Letter Ruling died, five notes—with interest at prevailing rates—were included as an asset in his estate. Joe’s real life situation is almost identical to the Letter Ruling facts. Result: Joe’s $1 million insurance proceeds are tax-free.

An ILIT is a wonderful tax tool. Loaning money to your ILIT (instead of gifting the funds) to pay the insurance premiums provides great flexibility. Life insurance is the backbone of most estate plans. If done right, everything is tax-free under the law.

To learn more, read Strategy #01 “Wealth Creation Trust” (same as ILIT); Strategy #3A “The Magic of Life Insurance . . . Why and How the Rich Buy Life Insurance”; and Strategy #3B “Analyze Existing Insurance Policies” ($19 each, $29 for any two or $37 for all three). Write to Book Division, Blackman Kallick Bartelstein, LLP, at the address listed above. Or learn more at