Calculating Gross Estate: Trustee's Guide To Life Insurance

When a person dies, their executor, beneficiaries, or trustee calculates the value of their gross estate by adding up the fair market value of all their assets. This includes bank accounts, real estate, vehicles, and any other properties. Life insurance policies are also included in the calculation of the gross estate. If the deceased took out the policy on their own life, then the death benefit, or the total payout amount to the beneficiaries, is included in the gross estate. On the other hand, if the deceased owned the policy on someone else's life, only the cash value is included. Additionally, life insurance owned by the deceased that is transferred to an irrevocable life insurance trust within three years of their death must also be included in the gross estate.

Understanding the three-year rule

The three-year rule is a provision of the US Internal Revenue Code that determines the assets included in a decedent's gross estate. The rule applies to transfers of assets, including trusts, within three years of the date of death. If a decedent's taxable estate exceeds the estate tax exemption, the value of such assets increases the estate's tax liability.

The rule was enacted by Congress to discourage attempts to avoid estate taxes by transferring property when death is imminent. It applies to transfers of property, including gifts of life insurance proceeds, where the decedent retained certain powers or ownership interests.

The three-year rule effectively brings back into a decedent's estate for tax purposes both directly owned assets and beneficial interests in assets that would have been included in the estate if no transfer had occurred. This includes revocable transfers, transfers with a retained life interest, transfers upon death, transfers of life insurance proceeds, and transfers where the decedent retains any powers or interests in the assets.

The rule does not apply to outright sales of assets for their full fair market value, even if the sale occurred during the three-year period. Most gifts are also excluded, but gifts exceeding the annual gift tax exclusion, plus the taxes paid on them, and certain gifts of life insurance proceeds are subject to the rule.

The three-year rule can be a complex issue, and it is important to seek professional advice when dealing with estate planning and estate taxes. There are ways to mitigate the impact of the rule, such as establishing an irrevocable life insurance trust (ILIT) or using a grantor trust.

When considering the three-year rule, it is important to remember that it only applies to transfers made within three years of death. If a transfer occurs more than three years before death, the proceeds from the policy are generally not included in the decedent's estate for tax purposes.

Using an irrevocable life insurance trust

An irrevocable life insurance trust (ILIT) is a legal arrangement that seeks to minimise your current tax burden and the impact of taxes on your estate. It does this by transferring assets from your name to a separate legal entity (the trust).

The trustee, who can be a friend, relative, or independent professional, uses these assets to purchase a life insurance policy in your name and continues to pay the premiums. When you die, the policy's death benefit is paid directly to the trust, which will then distribute the proceeds to the beneficiaries you have named.

Benefits of an Irrevocable Life Insurance Trust

Tax Benefits

By removing taxable assets from your current portfolio, an ILIT may help lower your current tax burden. It also protects the benefits stemming from a life insurance policy from estate taxes.

Estate Planning Benefits

In addition to giving you a tax-efficient way to transfer wealth to your beneficiaries, ILITs may also help with asset protection and government benefit protection.

Legacy Benefits

Since the proceeds of a life insurance policy are considered a financial asset by the government, transferring ownership to a trust can make it easier for your beneficiaries to qualify for Medicaid and other government assistance programs.

Downsides of an Irrevocable Life Insurance Trust

The only major downside is that ILITs are irrevocable. A revocable trust can be easily modified or terminated because the assets remain your property, but you relinquish control over assets when you gift them to an irrevocable trust. Therefore, the trust cannot be modified without legal action or the consent of the beneficiaries.

How to Set Up an ILIT

Since ILITs are complicated legal instruments, it's important to work with experts in the field to make sure the trust is set up and funded appropriately. Be sure to consult a tax attorney, trust officer, or financial professional to see if an ILIT is the right choice for you.

Using a revocable trust

A revocable trust gives you flexibility and control over an irrevocable trust. You can amend or revoke it at any time. You can also file taxes for the assets in the trust under your own social security number.

If you become incapacitated, a revocable trust allows your successor trustee to continue administering your life insurance policy on your behalf. It is also beneficial if you are well under the estate tax exemption amount.

However, the death benefit value of the life insurance will be included in your gross estate for estate tax purposes.

A revocable life insurance trust (RLT) can be particularly beneficial if you are seeking more control over your life insurance policies. It allows the grantor to change the trust at any time, providing more control over the life insurance policies within their estate planning strategy.

This type of trust is also a good strategy if you have a special-needs child who will require care after you are gone. A revocable special needs trust holds funds for your child and defines when and how that should be spent. Life insurance proceeds aren't taxed as they go into the trust, and the trustee manages those funds according to your wishes.

Estate planning with a life insurance trust

Types of Trusts

There are several types of trusts that you can choose from, each with its own advantages and disadvantages. Here are some common types:

• Discretionary Trusts: These trusts give trustees a high level of discretion in deciding which beneficiaries to pay and how much they receive. They use your letter of wishes as a guide, which outlines your intentions for how the trustees should administer the trust.
• Flexible Trusts: These trusts have two types of beneficiaries, default beneficiaries and discretionary beneficiaries. Default beneficiaries are entitled to any income from the trust, while discretionary beneficiaries only receive payments if the trustees appoint them during the trust period.
• Survivor's Discretionary Trust: This type of trust is often used for joint life insurance policies and pays out to the surviving policy owner. If both policy owners die within a certain period (usually 30 days), the beneficiaries can receive the same benefits as a Discretionary Trust.
• Absolute Trust: In this type of trust, the beneficiaries are named individuals who cannot be changed in the future, including any children born later or a spouse following a divorce. Absolute Trusts allow for quicker pay-outs without long legal delays, and Inheritance Tax is typically nil or negligible.

Benefits of a Life Insurance Trust

One of the main benefits of a life insurance trust is that it gives you control over your assets. You can decide who will benefit from your life insurance policy and who will manage it. Additionally, a life insurance trust can speed up the payout process, as your loved ones won't have to wait for probate to access the funds.

Another significant advantage is the potential reduction in inheritance tax. By placing your life insurance policy in a trust, it is legally owned by the trustees and is not considered part of your estate. This means that it won't be subject to inheritance tax, resulting in a higher payout for your loved ones.

Downsides of a Life Insurance Trust

It's important to consider the downsides of setting up a life insurance trust. Once established, the decision is usually irreversible, and you will lose some control as any decisions must be signed off by the named trustees. Additionally, there may be legal and tax implications, and you will be handing over legal ownership of your life insurance policy to the trustees.

Setting Up a Life Insurance Trust

When setting up a life insurance trust, it's essential to seek independent financial and legal advice. You will need to decide on the type of trust that best suits your needs and goals. If you already have a life insurance policy, you can transfer ownership to the trust by completing the necessary forms from your insurance company or broker. If you don't have a policy yet, it's recommended to set up the trust first and then apply for insurance on your life, with the trust as the original owner.

Premium Payments

Even after setting up the trust, you will need to ensure that premiums are paid annually. This process can be a bit more complicated with a trust, but it will become routine. The trustees will receive premium notices, and you will contribute the amount to the trust as a gift. The trustees will then notify the beneficiaries of their right to withdraw their proportionate share, allowing your contribution to qualify for the annual gift tax exclusion.

Calculating the value of your gross estate

The "gross estate" is the sum of the fair market value of all your estate's assets at the time of your death. This value is used by your executor, beneficiaries, or trustee to calculate your estate's tax liability.

Financial Accounts

All your financial accounts, such as checking, savings, and money market accounts, are included in the calculation. This includes certificates of deposit, cash, cash equivalents, investment accounts, exchange-traded funds, bonds, mutual funds, and other investment securities. If these accounts are in your sole name or placed in a revocable living trust, their entire value is included. If you have a joint account with your spouse, you include 50% of the value, as spouses have rights of survivorship. However, if the joint account is with someone other than your spouse, you include 100% of the value unless you can prove that the other owner contributed to the account.

Personal Effects

Personal items such as furniture, clothing, jewellery, antiques, collectibles, artwork, books, firearms, computers, and electronics are also included in the calculation. The executor of your estate may need to arrange appraisals for items like antiques, jewellery, artwork, and collectibles to determine their value.

Vehicles, Boats, and Airplanes

The rules for these assets mirror those for financial accounts. If they are in your sole name or the name of your revocable living trust, include their entire value. If they are jointly owned with your spouse, include 50% of the value, and if with someone else, include 100% unless the other owners can prove they contributed to the purchase.

Mortgages and Personal Loans

You also need to include any mortgages held by you that another person is paying off, as well as any personal loans you have made to others.

Unpaid Wages, Bonuses, Commissions, and Royalties

Any unpaid wages, bonuses, commissions, and royalties owed to you at the time of your death are included in your gross estate calculation, contributing dollar for dollar.

Life Insurance

If you have a life insurance policy, the rules vary depending on the type of policy:

• If the policy is on your own life, the death benefit (total payout to beneficiaries) is included in your gross estate.
• If you own the policy on someone else's life, only the cash value is included.
• If you transfer ownership of the policy to an irrevocable life insurance trust within three years of your death, this must be included in your gross estate.

Retirement Accounts

Your retirement accounts, including Roth and traditional IRAs, Simple and SEP IRAs, 401(k)s, annuities, and 403(b)s, are included in your gross estate at their full value.

Closely-Held Business Interests

If you have closely-held interests in sole proprietorships, partnerships, limited liability companies (LLCs), or closely-held corporations, include the total value of your ownership interest in the calculation.

Real Estate

Real estate follows similar rules to financial accounts and vehicles. Include the full value of the property if it is in your sole name or a revocable living trust. If it is jointly owned with your spouse, include 50% of the value, and if with someone else, include 100% unless the other owners can prove they contributed. You can deduct any liens against the property, such as mortgages, from the value.

Certain Trust Assets

Certain trusts of which you are a beneficiary, including those over which you have a "general power of appointment," are included in your gross estate at the full value of the trust property. This includes an "A Trust" established for a surviving spouse using "AB Trust" planning but does not include irrevocable living trusts.

Taxable Lifetime Gifts

If you have made gifts in excess of the annual gift tax exclusion amount in a given year, you need to include these in your gross estate calculation. The exclusion amount is $15,000 per person per year, adjusted periodically for inflation.

It is important to note that the laws and regulations regarding estate planning and taxation can be complex and vary over time. The information provided here is a general guide, and it is always recommended to consult with a qualified professional, such as an estate planning attorney or a certified public accountant, for personalised advice.

Frequently asked questions