Are Irrevocable Life Insurance Trusts taxable - when and why? With a new presidential debate on the horizon, wealthy individuals are looking at every option available to shelter their assets.

Depending on the election outcome, the estate tax exclusion amount of $11.58 million could be significantly reduced. This will cause a large estate to be subject to paying more in estate taxes. Knowing about this potential change, many individuals are rushing to make changes to their estate planning documents. Speak with your estate attorney to see if these options could help you shelter your estate from paying high estate taxes.

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Tax Haven State

South Dakota is a top jurisdiction for trust law. The advantages of using a jurisdiction like South Dakota will offer you many options and flexibility. South Dakota is an industry leader with trust law because they pride themselves on being a sanctuary for trusts. This is accomplished by the South Dakota task force. The goal of this task force is to provide innovative solutions for individuals looking to shelter their estate. The five main benefits of South Dakota are privacy laws, dynastic trusts last forever, asset protection trusts, directed trust statutes, and no state income taxes.

Income tax plays a significant role in the planning of how a trust is distributed. A state with a high-income tax rate can be detrimental on the proceeds that are paid to beneficiaries. A primary aspect of the estate planning process, with an estate attorney, is finding ways to shelter the hard-earned money that you worked for from receiving hefty tax bills. South Dakota does not have a state income tax or a capital gains tax. Whether taxes are owed on an Irrevocable Life Insurance Trust depends on the administration. At least South Dakota does not tax insurance trusts. 

In addition, there is no state LLC or LLP taxes, no ad valorem tax, and no city or local taxes, no dividends, and no interest tax. The IRS is another matter around the taxable nature of an ILIT. 

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Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust gives grantors two main benefits; control over the life insurance assets after death, and a shelter from paying high estate taxes. The latter, on whether an ILIT is taxable depends on the how the trusts are administered. For wealthy individuals, a single life insurance policy could push them over the estate tax exclusion amount. The current exclusion has been high enough to shelter most married individuals, however, if the exclusion amount is reduced, it can have a very high tax consequence. When an Irrevocable Life Insurance Trust is created, the life insurance policy is owned by the trust. It is important to know that irrevocable means that the trust cannot be changed. Once an irrevocable life insurance trust is created the terms of the trust cannot be modified, amended or terminated without approval of the grantors named beneficiary or beneficiaries. A trust can also be revocable. A revocable trust,  the provisions of the trust can be altered or canceled dependent on the grantor. However, it is includible in the owner's estate.

Another key component of an Irrevocable Life Insurance Trust is it can be either Directed or Delegated. Directed/Delegated trust agreements give beneficiaries more control over how the assets are managed and how trustees are picked. This does not affect the taxable nature of an Irrevocable Life Insurance Trust. 

Since the Irrevocable Life Insurance trust is irrevocable, the original owner no longer has control over the policy. The creator of the Irrevocable Life Insurance Trust cannot also serve as trustee, if they want to keep the proceeds out of their estate. However, they can control how premiums will be paid, who will receive the benefits, and how the payments will be made to beneficiaries.

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Family Limited Partnership

Family Limited Partnerships (FLP) are used for a variety of different things. However, they are best used in estate planning to create asset protection and to minimize the impact of estate taxes. FLPs allow families to reduce the impact of estate taxes by using distributions known as gifts. Individuals that use an FLP can gift interests to other individuals. This gift can be tax free up to the annual gift exclusion amount of $15,000. FLPs are viable structures for sheltering an estate, but they must be properly drafted. If the FLP is drafted properly, and carefully implicated, it can provide a significant valuation discount. Be aware, the IRS is very familiar with these types of transfers and knows how they avoid estate tax. Therefore, they have been cracking down on the creation of FLPs.

When a FLP is taxed, generally, it is taxed similar to a general partnership. This means that the profits that are received, particularly from a business, are passed directly to the partners and reported as income. This is all based off their percentage of ownership their "interest”, and will be reported on their individual tax returns. There can be multiple family members added to the FLP as limited partners. If there is a family-owned business or assets to be passed, then setting up an FLP is another option. Also, the FLP does not have a corporate tax, similar to a corporation, and the assets are not taxed as assets pass between partners.

To setup a FLP, typically, a family will create the general partnership and all the heirs are limited partners. One can then transfer the interest to another, but cannot exceed the exclusion amount of $15,000 per person. This will reduce the overall value of the estate. Key items the IRS looks for in this transfer is that the transfer of property was a bona fide sale for an adequate and full consideration in money and money’s worth. If not, then it will not qualify for the exception regarding section 2036. The four main requirements for inclusion under Section 2036 is transfer, statutory time frame, retention, and requisite interest or power.

These are just few ways that individuals could use to reduce their estate tax burden. The answer of are ILITs taxable depends on how they are structured and administered. It is important to discuss with your estate planning attorney about the options that pertains to your particular situation. Using a tax haven, an Irrevocable Life Insurance Trust, or a FLP for your estate can be a great option. If you use a tax haven like South Dakota be sure to understand that you also have choose and control when selecting the trustee who will manage the assets.

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