One area where estate tax can really hurt those who are not prepared is their life insurance.  Most people who have life insurance own a policy on themselves in which they can decide who is the beneficiary who will receive the money.  For a lot of people that works fine but be aware that when the insured person keeps control of the life insurance policy in this way, on their death, the IRS considers the life insurance proceeds to be part of the estate for estate tax purposes even though the insured person never had that money during their lifetime.  Many people have insurance policies with benefit amounts of $250,000.00, $500,000.00, $1 million or more.  Combine that with a home which is paid off or has a lot of equity and some savings and estate tax could apply.  If estate tax applies, the impact could be great. If the pre-Bush tax cut rates return, the marginal estate tax rate on assets beyond the exemption threshold would be as high as 55 percent. 
  
There is, however, a way to prevent life insurance proceeds from being counted in one's estate and that is to create an Irrevocable Life Insurance Trust or ILIT.   Insurance policies are placed in ownership of the ILIT.  The most immediately effective way to do that is with a newly established life insurance policy because the estate tax benefit starts immediately.  If that is not possible, an existing life insurance policy can be transferred to the ILIT but there is a 3 year "lookback" rule which would mean that the insurance proceeds would still count as part of the insured's estate if death occurs less than 3 years after the policy is transferred.
  
So how does this trust operate?  When the trust is created, a trustee is appointed by the person creating the trust - the settlor.  The trustee is in charge of managing the trust and seeing to it that the insurance premiums are paid.  The beneficiary of the trust can be the settlor's spouse, domestic partner, children or other chosen beneficiary.  The insurance policy can be paid for in a couple of ways.  One is for the settlor to transfer a significant amount of money into the trust on which Gift Tax would be paid at the outset.  This money would be used to pay the premiums.  Alternatively, the settlor can annually give to the trustee up to $13,000.00 as an annual tax free gift.  The trust beneficiary(ies) must be notified that they have the right to withdraw that money from the trust.  In practice, they will not want to do that because that money will then be used to pay for the life insurance which will be of much greater benefit to them later.
  
When the settlor dies, the insurance proceeds are paid to the trust.  The money is used to benefit the trustees in the manner decided by the settlor when the trust was established.  The beneficiary can have rights to make certain withdrawals each year and the trustee can have power to use the money for the benefit of the beneficiaries (spouse, partner, children etc) under rules set up in the trust.  The trust can provide that children receive the funds of the trust in full at a certain age or it can be kept in trust for life and for multiple generations.
  
A caution with these sorts of trusts is that they are irrevocable.  Once established, the settlor cannot change them and cannot remove money put into them so care should be used when setting it up.  Some ability to change the trust or to replace the trustee if the trustee is not acting properly can be put into the trust with a post called a "trust protector."  The settlor who creates the trust cannot be the trustee or the trust protector but can choose people he or she knows and trusts.    While ILITs are not for everyone, for some individuals and families, they are a useful planning tool that can save a lot of money in estate taxes down the road.
  
This is just a short summary of how an irrevocable life insurance trust works.  For more information, please contact us for an appointment or consult with another competent estate planning attorney.