How Linked Benefit Insurance Fits Into an ILIT Strategy

Situation: Several years ago, insurers began combining two different forms of insurance coverage by offering life insurance policies with long-term care/chronic care riders. With this type of coverage, if during the insured’s lifetime long-term coverage is required, the policy pays coverage to help offset costs and the death benefit is reduced. However, if the insured never requires long-term care coverage, or only uses a portion of the long-term care benefit, any remaining life insurance death benefit will be available for heirs upon the death of the insured.

Although this hybrid “linked-benefit” product efficiently combines two important forms of insurance, it also creates a challenge for estate planning purposes. Specifically, if a life insurance policy is owned by the insured, the policy’s proceeds can be accessed by creditors and are subject to estate tax at death. To remove the proceeds from reach of creditors, often an irrevocable life insurance trust (ILIT) is created to be the owner and beneficiary of the policy. Although the recent increase in the amount exempted from federal estate tax shelters most everyone except the ultra-high net worth clients, there are still many states with lower state death taxes where individuals will still seek use of the irrevocable life insurance trust. For example, Minnesota, Washington, Oregon, and Massachusetts have relatively small state death tax exemption. So, it is not unusual for moderately well-to-do individuals in states with low “death tax” exemptions to establish ILITs to avoid state death tax.

The Irrevocable Life Insurance Trust (ILIT) is one of the Irrevocable Life Insurance Trust (ILIT) is one of the most commonly used estate planning tools. When properly established and managed life insurance proceeds escape estate, gift, and generation-skipping tax, while still providing liquidity to an insured’s estate. However, where an ILIT owns a linked-benefit product and the trustee makes distributions to the insured or reimbursements to facility for the benefit of the insured, the entire trust can be included in the insured’s taxable estate. Thus, the question becomes: Is it possible for an ILIT to own a linked benefit product to ensure the policy proceeds are outside of the estate, but still make the funds available to provide for long-term care needs?

Financial advisors are increasingly being asked by moderately well-to-do individuals who live in states with modest estate tax exemptions about owning linked-benefit products in an ILIT. This Counselor’s Corner will attempt to provide some guidance regarding this question.

Solution: Section 2042 is the primary Internal Revenue Code provision to describe the conditions under which life insurance will be included in an insured’s estate for estate tax purposes.1 Consequently, keeping a linked-benefit product on a decedent’s life out of his/her estate is only possible when it avoids the reach of this provision. Under Section 2042 life insurance proceeds are included in an insured/decedent’s estate if (a) the proceeds are receivable by the insured’s executor, or (b) to the extent received by other beneficiaries, the insured possessed at his death any incidents of ownership either alone or in conjunction with any other person.

To understand whether a linked-benefit product will be included in an insured’s estate when owned by a properly designed ILIT, we must first understand Section 2042 and then examine the product to determine if there is anything within the contract terms that may cause estate inclusion. Both the receivable by the executor and incidents of ownership aspects of code Section 2042 are more intricate than first meets the eye.