Advanced Underwriting Consultants

Question of the Day – October 3

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: What is a standby irrevocable life insurance trust (standby ILIT) and how is it used?

Answer: A standby ILIT is a strategy for a married couple to own survivorship life insurance, giving the spouses current access to cash value while planning for removing the insurance from the taxable estate in the future.

Say that husband and wife are insured under a second to die policy.   If husband is expected to have the shorter life expectancy, he is named as initial owner of the policy.  Spouse is named as primary contingent owner and an unfunded ILIT (the standby ILIT) is named as secondary contingent owner.  The ILIT is drafted and executed, however it is left in standby mode.  Nothing beyond a nominal amount is transferred to the trust.

While husband is alive, he has full access to cash value accumulations in the policy.  He can use those accumulations tax-free to supplement retirement income by withdrawing cash values up to basis and borrowing amounts in excess of basis.

At the husband’s first death, wife becomes the owner of the policy.  If there are no estate tax concerns, she becomes the owner of the policy and can continue to utilize cash values for supplemental retirement income.  She can direct the death proceeds directly to her beneficiaries or to a trust set up for their benefit.

If estate taxes are a concern, the wife can disclaim her interest in the second to die policy.  Her disclaimer allows the policy to pass to the secondary contingent owner, the ILIT.  The cash value of the policy is an asset in the husband’s estate and will force utilization of his exemption amount.  If the cash value is greater than the exemption amount, then estate taxes will have to be paid.  Since the disclaimer by the wife results in her never having owned the policy, she is not a transferor for purposes of Section 2035 and the three-year look back rule will not apply.

If, on the other hand, the wife dies first, husband continues to own policy and utilize cash values as needed.  He can direct the death proceeds directly to his beneficiaries or to a trust set up for their benefit.

If estate taxes continue to be an issue, at wife’s death, husband can absolutely assign the second to die policy to the ILIT.  Section 2035’s three-year rule does apply and the gift is a taxable gift subject to the $5 million gift tax exemption amount.  However, once the three years transpires, the death proceeds will be excluded from the husband’s taxable estate.

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