Latest / VoraPrep Audio — Professional Licensure & Certification Exam Prep / CFP-RISK: Advanced Life Insurance Strategies: ILITs, Life Settlements, and Split-Dollar
Transcript
- Welcome to VoraPrep Audio. Today we're talking about advanced life insurance strategies. These are the tools you'll see on the exam when a scenario involves a wealthy client with a complex problem. Imagine your client is Eleanor. She’s a widow who built a successful family business. The problem is, almost all of her net worth is tied up in that business. It's not liquid cash. She wants her children to take over, but there’s a major roadblock: estate taxes. When Eleanor passes away, her estate will owe a significant amount of tax. That tax bill must be paid in cash, and it's due relatively soon after death. Where would her children get that much cash on short notice? They might be forced to sell the very business Eleanor wanted them to have. And they'd likely have to sell it at a discount because of the time pressure. This is the exact liquidity crisis these strategies are designed to solve. The main tool for this is the Irrevocable Life Insurance Trust, or ILIT. The entire purpose of an ILIT is to own a life insurance policy. This ensures the death benefit is not considered part of the person's taxable estate. Think of it like a secure lockbox. Eleanor, the grantor, puts cash into the lockbox. The lockbox then buys a life insurance policy on her. She gives the key to a trustee, who is a trusted, independent manager. And here’s the critical part: she can’t get back in the box. It’s irrevocable. Because she no longer owns or controls the contents, the IRS doesn't count it as her asset. When she passes away, the trustee opens the box. The trustee collects the tax-free death benefit and uses it to pay the estate tax bill. This saves the family business. Her children, the beneficiaries, get the business, just as she wanted. Now, how does the trust pay the policy premiums each year? Eleanor makes gifts to the trust. To make sure those gifts aren't taxable, they need to qualify for the annual gift tax exclusion. For a gift to qualify, the beneficiaries must have a short window of time where they could theoretically withdraw the money. This right is called a "Crummey power." It's a key feature you need to know. One more crucial detail about the trustee—the person with the key. It has to be an independent third party. If Eleanor served as her own trustee, she'd have what the IRS calls "incidents of ownership." She would still have control. That would pull the entire policy right back into her taxable estate, completely defeating the purpose. This brings us to a huge trap on the exam: the three-year look-back rule. Let's say your client already owns a large life insurance policy. They want to move it into an ILIT. If they transfer that existing policy and then die within three years of the transfer, the IRS pulls the death benefit back into their estate. The correct way to do it is for the grantor to create the trust and fund it with cash. Then, the trustee buys a brand new policy on the grantor's life. This way, the grantor never personally owned the policy. There was nothing to transfer, so the three-year rule doesn't apply. Next, let's discuss a different situation. Sometimes the problem is a policy someone has right now that they don't need or can't afford anymore. This is where life settlements come in. A life settlement is the sale of an existing life insurance policy to a third-party investor. The investor pays the owner a lump sum of cash. This amount is more than the policy’s cash surrender value, but less than the death benefit. The investor then takes over the premium payments and becomes the new beneficiary. You'll see two main types. The first is a viatical settlement. This is specifically for someone who is terminally ill. A doctor must certify they have a life expectancy of 24 months or less. The tax treatment here is very favorable. The proceeds are generally received tax-free. The other category is simply called a life settlement. This is for someone who is not terminally ill, but is often older and has had a change in financial circumstances. For a life settlement, the proceeds are taxable. The calculation is specific. The cost basis in the policy is the total amount of premiums paid. Any gain on the sale is the sale price minus this cost basis. The key rule to remember is that this gain is split into two parts for tax purposes. The first part is taxed as ordinary income. This is the portion of the gain that is equal to the policy's cash surrender value minus the cost basis. The IRS views this as the tax-deferred interest that built up inside the policy. The second part is taxed as a long-term capital gain. This is the remaining portion of the gain, which is the sale price minus the cash surrender value. A common wrong answer on the exam is to treat the entire gain as a capital gain. Remember, the gain up to the cash value is ordinary income. Only the profit above that amount gets capital gains treatment. The final strategy we need to cover is a split-dollar arrangement. This isn't a type of insurance. It's a way for two parties to share the costs and benefits of a policy. It's almost always between an employer and a key employee. It’s a great way to reward and retain top talent. The basic idea is the company helps the employee pay for a large permanent life insurance policy. In exchange, when the employee dies, the company gets its contributions back first from the death benefit. The employee’s family gets the rest. There are two ways to set this up. The difference is all about who owns the policy. The first is the endorsement method. In this setup, the employer owns the policy. The company "endorses" a portion of the death benefit over to the employee's family. Since the employee is receiving a valuable benefit, they have to pay tax on it. Each year, they recognize taxable income equal to the "economic benefit" of the coverage. The second way is the collateral assignment method. In this case, the employee owns the policy. The employer's premium payments are treated as loans to the employee. To secure these loans, the employee assigns the policy to the employer as collateral. As long as the loans charge an appropriate interest rate, there is generally no taxable income to the employee. So when you see these questions, first figure out the client's goal. Are they trying to create liquidity for estate taxes? That points to an ILIT. Are they trying to get cash from a policy they no longer need? That's a life settlement. Is an employer trying to retain a key executive? That sounds like a split-dollar plan. Match the goal to the tool, then watch for specific rules, like the three-year look-back or the settlement tax calculation. VoraPrep is a full exam-prep app — lessons, practice questions, and an AI tutor in one place. 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