Case Study: An Estate Tax Sunset and Life Insurance Strategy

Background: For the 2026 tax year and thereafter, the estate tax exemption is set to “sunset” back to pre-2018 levels under the Tax Cuts and Jobs Act (TCJA). The current exemption of approximately $13.99 million per individual ($27.98 million per couple) for 2025 is expected to revert to around $7 million per individual ($14 million per couple), exposing more estates to potential estate tax liabilities. Depending on the political climate, new tax laws might pass and exemption amounts may stay high. But you owe it to your clients to help them consider their options.

Case Study Client Profile:

 

• Names: John and Mary Smith
• Ages: 67 and 65
• Net Worth: $30 million
• Primary Assets: Real estate, investments, and family business interests.
• Estate Planning Concern: The Smiths are concerned about a significant estate tax burden for their heirs if the estate exemption drops in 2026 unless new legislation is implemented.

 

Challenge

 

John and Mary’s combined estate is well above the projected 2026 estate exemption. If the exemption drops, only $14 million will be exempt from estate taxes, leaving $16 million of their $30 million net worth exposed to estate taxation. With the federal estate tax rate at 40%, their heirs could face a tax bill of around $6.4 million.

 

The Smiths’ goals include:

 

1. Protecting their estate from large tax liabilities.
2. Ensuring sufficient liquidity to cover potential estate taxes without liquidating family assets or business interests.
3. Leaving a legacy for their children and grandchildren.

 

Potential Solution: Irrevocable Life Insurance Trust (ILIT)

 

An Irrevocable Life Insurance Trust (ILIT) funded by a life insurance policy can offer the Smiths a strategic way to address their estate tax exposure.

 

Strategy Steps

 

1. Establish an ILIT:
   • The Smiths work with an attorney to establish an ILIT, a trust that will hold a life insurance policy outside of their taxable estate.
   • Since the trust is irrevocable, the assets (including the life insurance proceeds) held within it will not be included in their estate, thus avoiding estate tax upon their passing.
2. Life Insurance Policy Purchase:
   • The ILIT purchases a second-to-die (survivorship) life insurance policy on John and Mary. This policy pays out only upon the death of the second spouse, providing funds precisely when estate taxes are due.
   • The Smiths fund the ILIT with annual gifts up to the allowable tax-free gift limits, which the ILIT trustee uses to pay the policy premiums.
3. Benefits of the ILIT and Life Insurance:
   • Liquidity for Estate Taxes: The life insurance proceeds provide liquidity for estate taxes and expenses. Upon the Smiths’ deaths, the ILIT receives the death benefit tax-free, which can be used to cover estate taxes without liquidating family assets or disrupting their business.
   • Exclusion from Estate: Because the ILIT owns the policy, the death benefit is excluded from the Smiths’ estate, protecting their heirs from an additional estate tax burden.
   • Leveraging Current Exemptions: By establishing the ILIT before the exemption decrease, the Smiths can utilize the current higher exemption amount, which may safeguard future estate planning flexibility.

 

Potential Outcome

 

Upon the Smiths’ passing, their estate faces the following scenario:

 

• Estate Value: $30 million
• Exemption (post-2026): $14 million
• Taxable Estate: $16 million
• Estate Tax Due (40%): $6.4 million

 

The life insurance policy held in the ILIT has a death benefit of approximately $6.4 million, matching the estate tax liability. The ILIT uses the insurance proceeds to pay the estate taxes, preserving the Smiths’ business and other assets intact for their heirs.

 

Considerations for the Smiths

 

1. Annual Gifting for Premium Payments: The Smiths must continue gifting to the ILIT for premium payments, staying within gift tax exclusion limits (or possibly using the lifetime exemption amounts if larger amounts are needed).
2. Reviewing Changes in Legislation: Estate tax laws can change, so it’s essential for the Smiths to review their estate plan periodically to ensure it aligns with current tax laws.
3. Alternative Uses of ILIT Funds: Should estate tax laws change further, the life insurance proceeds in the ILIT can still serve as a flexible wealth transfer tool, offering their heirs financial security.

 

Conclusion

 

In this case, life insurance through an ILIT proves to be a practical solution for mitigating potential estate tax liability. By leveraging life insurance and planning in advance of the sunset, the Smiths protect their estate and provide their heirs with liquidity to handle tax obligations without sacrificing core family assets. This strategy is particularly beneficial for high-net-worth individuals anticipating significant changes to estate tax thresholds in the coming years.

 

Call our Advanced Planning Team at 800.440.1088. We can help you design strategies for your clients to address the upcoming sunset of the current high lifetime estate & gift tax exclusion amounts before 2026.