A client, whom we'll call Lou, is meeting with his life insurance agent, estate planning attorney, and tax advisor. They're talking about the end of the 2025 tax law, how it might affect Lou's tax position and liquidity needs, and what planning he might consider doing now in anticipation of the impending change.

After listening closely to his advisors, Lou continues to follow. “Unlike you guys, I'm not a student of tax law. But I am a student of politics. And my studies show that there will be no twilight. So I don't see that there is anything to plan. That said, I could be wrong. So I'm willing to hedge my bet, but not with any strategy that involves me parting with total control over the assets. I will look into life insurance because I know I can control it.

“I know you guys are thinking that we've visited the topic of life insurance and probate before and that you've covered the pros and cons of owning my policy outright versus owning it through a life insurance trust. irreversible life (ILIT). Yes, I know you were more pro-ILIT and I was worse, but I think it would be a good idea for you to dust off the presentation you gave me on that topic so I can get some decisions and get insurance only in case my health declines”.

The counselors almost unanimously respond, “You know, we just have the slides right here. Let's get started, but unlike last time, we're going to skip over your current plan layout and A/B trust because we know you understand how it all works. That leaves just four slides.”

You own the policy

You own the policy and name your A/B trust as the beneficiary. This is pretty straightforward. You own the policy, period. You can change the beneficiary, use the cash value, or hand it over. There are no income tax implications for your owning the policy unless and until you wrongly cash out of the policy, which you won't. There are no gift tax implications for paying premiums because you own the policy. When you die, the proceeds will be included in your gross estate, but there will be no tax as long as your wife Sue survives. Whatever is left in Sue's estate will be subject to estate tax when she dies. However, if Sue predeceases you, the income, along with the rest of your estate, will be taxed to the extent that it exceeds the exemption amount at that time.

An ILIT From the start

Once the trust is operational, the trustee, not you, applies for the policy and designates the ILIT as the beneficiary. If done this way and assuming the ILIT is drafted correctly, the insurance proceeds will be excluded from your estate from day 1. They will also be excluded from Sue's estate, so whatever remains in the ILIT after her death will be distributed to the children have tax-free property. ILIT can make funds available to your or Sue's estate through asset purchases or loans.

You will pay the premiums through annual gifts to ILIT. A special provision in the ILIT provides a mechanism by which those gifts can qualify for the annual gift tax exemption of $18,000 per year per recipient in 2024, thereby not using up any of the gift tax exemption throughout life. There are other ways to finance premiums, but they can be complicated, burdensome, and possibly contraindicated for someone like you who has deep reservations about using an ILIT in the first place.

The ILIT would be designed as a so-called “grantor trust”, meaning that while the policy and any other assets the ILIT owns are outside your estate, you will be taxed on any income or capital gains the ILIT generates from the holdings of the ILIT. his. At the moment, there would be no such income, as the ILIT would only own the policy and any cash value in the policy would not be taxed as it grows. However, that giver trust status can come in handy down the road. For example, if you decide to transfer income-producing assets to the ILIT to generate cash flow to contribute to premiums and, therefore, reduce your gifts, the ILIT will keep (and apply) the cash, but you will to pay tax on that income. Since under current law, your tax payment is not a gift, this is a good way to make tax-efficient transfers to the ILIT. Grantor trust status will also come in handy if you want to make certain ILIT transactions without incurring income tax. More on that in a moment, but in anticipation of your questions, here are some of the downsides of ILIT.

You do not own the policy. Full stop. You cannot change the benefits, use the cash value or do anything else with it. ILIT is exactly what it says it is: irreversible, meaning you can't change it. That said, and although we know you'll cringe when we say this, we can draft ILITs with several provisions that add a measure of flexibility for you and, as with your current trusts, solid protection for your beneficiaries. So, while irreversible, it's not quite “set it and forget it.”

Of course, we would be remiss not to point out that the mechanism that qualifies annual gifts for the exemption requires annual notification to recipients. We can help you set up a system for this.

You move your policy to an ILIT

The logistics of this are simple. We design the ILIT and when it's ready, you assign the policy to the ILIT, who becomes the new beneficiary. You will fund the premium using the same mechanism we discussed earlier. That's the easy part, because now, the plot thickens.

There are two ways to move the policy to ILIT. You can give it to ILIT, or you can sell it. Each route has its own set of fees. As with any gift, you will need to assign a value to the policy for gift tax purposes. Estimating the gift tax for a life insurance policy is beyond the scope of this discussion, but for now, let's just say we'll help you with that when the time comes. The most serious downside to a gift of a policy is the “3-year rule.”

If you die within three years of the transfer to the ILIT, the policy will be in your estate as if you had never transferred it. The income is still paid to the ILIT, but again, it will be included in your estate.

Because of the 3-year rule, an ILIT created by one spouse primarily for the other usually provides that if the income is caught by that rule and, here, if Sue survives you, the trust can function as a type of marital deduction trust that would protect the income from estate tax until Sue passed away. The ILIT would not exclude the income from both of your estates, but just as your “A” trust does, it would defer the estate tax until the death of the surviving spouse, in this case, Sue.

If such a conditional marriage provision does not suit you, we may consider another option. According to the old life insurance principle that there's no problem you can't fix with a higher premium, if the new ILIT could buy a term policy and keep it in force for three years, it would have money to cover the tax if

The 3-year rule traps income. That way, it apparently doesn't need to use the conditional marital deduction and can retain the property exemption for both spouses.

As we mentioned, the alternative to giving the policy to ILIT is to sell it. A bona fide sale, meaning one that passes the IRS's “Who do you think you're kidding” test, would avoid the 3-year rule. The policy will need to be appraised by a professional to withstand any challenge from the IRS that you sold it for less than full value. Any difference between the full value and the sale price would be a gift, bringing back the 3-year rule.

The other aspect of the sale that does not amount to a gift is that the buyer, here, ILIT, must pay for the policy. You can finance the purchase by giving the funds to ILIT under an interest-bearing note. This story only gets more complicated as it unfolds, both administratively and tax-wise.

The good news about the sale is that because the ILIT is a grantor trust, there would be no income tax implications for the sale or financing arrangement. And the grantor trust status would ensure that the insurance proceeds are income tax free when received by the ILIT.

An ILIT owns the policy, but you want it back

You wouldn't be the first person to experience a case of ILIT regret. We will give up a list of symptoms of this disease and talk about possible cures.

Remember, you can't just ask the ILIT administrator to return your policy. You will have to buy it, which presents some problems. First, the trustee will not be obligated to sell it to you. The trustee could have some serious fiduciary issues with any beneficiary who asserts that, for whatever reason, the sale was not warranted or justified. Of course, the trustee will have to receive full value for the policy, as determined by the appraisal. The good news is that, once again, because the ILIT is a grantor trust, the sale will have no income tax implications.

Another way to “buy back” the policy is for the ILIT to have a so-called “substitute” or “leg” power, which would essentially allow you to exchange cash or property of equal value for the policy. Revenue Ruling 2011-28 says you can have this right without risking the asset exclusion from the policy. You must comply with certain rules, but one advantage of a power of exchange over a pure sale is that it does not involve the trustee's discretion. The trustee must be sure to receive full value for the policy. We could cover more, but we have to leave it here.

Lou says, “Okay, I'll talk it over with Sue. In the meantime, let's get on with insurance.”