With a federal estate tax rate of 40%, estate planning conversations often start and stop with the relatively high federal exemption (currently $15 million for individuals and $30 million for married couples). That can make estate tax exposure feel remote. In practice, however, many taxpayers may face a different reality at the state level.
For example, states such as New York impose their own estate tax, with a significantly lower exemption (currently $7.35 million). New York’s so-called estate tax “cliff” can create an unexpected result: if a taxable estate exceeds the exemption by more than 5%, the entire estate—not just the excess—may be subject to estate tax. When factoring in a residence, retirement accounts, investment portfolios, and other assets, some estates can approach or exceed that threshold more quickly than anticipated.
Life insurance can further complicate this analysis. Under Internal Revenue Code (“IRC”) section 2042, death benefits from a policy insuring the decedent’s life are generally includible in the decedent’s gross estate if the decedent was the owner of the policy or if the proceeds are payable to the decedent’s estate. This inclusion applies even if the proceeds are payable to a third-party beneficiary. As a result, life insurance intended to provide liquidity or support beneficiaries can inadvertently increase estate tax exposure.
One planning technique to address this issue is the use of an irrevocable life insurance trust (ILIT). Properly structured, an ILIT owns the policy and removes any “incidents of ownership” from the insured. This generally means the insured cannot retain powers such as changing beneficiaries, surrendering the policy, or borrowing against it. If implemented correctly, the policy proceeds may be excluded from the insured’s taxable estate.
Timing, however, is critical. Under IRC section 2035, if an existing policy is transferred to an ILIT and the insured dies within three years of the transfer, the proceeds may be pulled back into the estate. To mitigate this risk, practitioners often recommend that the ILIT purchase new policies directly, using contributions from the insured.
While ILITs are not appropriate in every case, they remain a commonly used tool for managing estate tax exposure, particularly where life insurance plays a significant role in an overall estate plan.
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