Estate planning is a complex process that aims to safeguard generational wealth and ensure a smooth transition of assets to heirs. An Irrevocable Life Insurance Trust (ILIT) is a great estate planning tool. However, one downside is that assets in an ILIT generally do not receive a step-up in basis at the grantor's death and are potentially subject to capital gains taxes.
A potential solution is the substitution clause, which can help shield beneficiaries from capital gains taxes on any assets sold once inherited from the ILIT.
An ILIT is a specialized trust that holds a life insurance policy. This trust is irrevocable, meaning the terms of the trust generally cannot be modified, and the life insurance cannot be reclaimed by the individual/insured once established. The primary purpose of an ILIT is to remove the life insurance proceeds from your taxable estate, reducing the burden of estate taxes for beneficiaries.
When heirs inherit assets, they typically receive a stepped-up basis, which adjusts the asset to the current market value at the time of the owner’s death (as opposed to the asset's value at the time it was originally purchased). If the ILIT is funded with highly appreciated assets, like stocks or real estate, the heirs could face substantial capital gains taxes when selling those assets. This is where the substitution clause can be beneficial.
The substitution clause allows the trustee to swap assets of equal value between the ILIT and the estate. For example, if the ILIT owns stock valued at $50,000 and is expected to appreciate to $100,000 by the time the grantor dies. The heirs must pay capital gains tax on the gain of $50,000 when the stock is eventually sold.
Now, let’s assume that the grantor owns a car currently valued at $50,000 and, for simplicity, originally paid $50,000 for it, and it is not expected to appreciate (or depreciate) in value. The trustee can swap out the shares of stock for the car worth $50,000. In this scenario, the beneficiary will not have to pay any capital gains when the vehicle is sold. Now, with the shares of stock back in the estate, the beneficiary can enjoy the benefit of the stepped-up basis of the stock when the grantor passes and the stock is inherited. It’s important to remember that the stock's appreciation will now be included in the taxable estate. Therefore, it is essential to consult a qualified professional regarding which assets will be utilized in the arrangement.
The substitution clause offers a strategic advantage by enabling heirs to inherit wealth without a capital gains tax. When crafting an estate plan, consult a qualified estate planning attorney and insurance advisors to explore how best to serve your goals.
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