So you’ve decided to fund your business succession plan with a life insurance policy. Smart move. However, don’t make the mistake of leaving the insurance proceeds to Uncle Sam. In this article, I discuss the importance of Irrevocable Life Insurance Trusts (“ILIT”).

Without proper planning, a departing owner may leave a business in dire straits. Succession planning allows for business continuity when the owner dies, retires or is otherwise unable to run the business. Business owners can use life insurance to fund succession plans. Life insurance that funds succession plans will create a sum of money at death that will be used to pay your family or your estate the full value of your ownership interest.

Life insurance is paid out at the death of the insured person. It’s usually paid as a lump sum amount to the beneficiaries. The insurance benefits are not considered income. Therefore, the beneficiaries do not have to pay income tax on this amount. But, any interest earned on these proceeds are taxed. While your beneficiaries may not have to pay taxes on the benefits, the government will consider the lump sum amount as part of your taxable estate.

The government doesn’t tax life insurance proceeds if your spouse is the beneficiary of the policy. Spouses are allowed to transfer property to one another tax free. But, if you name your child or business partner as the beneficiary of your 1 million dollar policy, then that amount will be included in your taxable estate. If the total amount of your taxable estate exceeds the current state or federal tax exemption, then your policy will be taxed.

To prevent the government from taxing policies intended to fund the business, I recommend an ILIT. An ILIT will allow life insurance proceeds to pass to beneficiaries other than spouses and avoid estate taxes. Here’s how it works. First, you create the ILIT and transfer sufficient assets into the trust to purchase the life insurance policy and pay the premiums. Your trustee will then purchase the life insurance policy and pay all remaining premiums. The beneficiary of the policy is the ILIT. (Your heirs will ultimately receive the proceeds because they are named as the beneficiaries of the ILIT.) Upon your death, the benefits are paid into the ILIT and are managed and distributed according to the terms of the trust.

While ILITs are great tax avoidance devices, there are caveats to consider before you contact an attorney to employ this strategy. It’s irrevocable. This means, once it’s created, you lose control over it and you will not be able to change the beneficiary. Also, if you are wanting to transfer an existing life insurance policy, you must do it right away. If you die within three years of the transfer, the policy will be included in your taxable estate. Finally, depending on the annual premiums due on the policy, there may be a gift tax consequence. Since you can’t pay the premiums yourself, your transfer of money to the ILIT to pay the premiums are considered gifts. If the gifts exceed the annual gift tax exclusion, (currently $14,000), then it will be taxed. However, use of Crummey trust provisions will help avoid the gift tax. (Crummey Trusts will be explored in detail later.)

In conclusion, ILITs are excellent vehicles for avoiding estate taxes. When properly structured, ILITs allow individuals to pass life insurance proceeds to their heirs tax free. Because these trusts come under IRS scrutiny, individuals should consult with an attorney experienced in drafting complex trusts.

***Not everyone will owe estate taxes at their death. In 2016, the federal estate tax only affects people who die leaving a taxable estate of more than $5.45 million or couples leaving more than $10.9 million.***

***The State of Illinois is one of a few states that have separate estate taxes. The current estate tax in Illinois is $4 million.***