Today’s Estate Planning Strategies

How to use ILIT-owned UL with an indemnity LTCi rider

By Russell E. Towers JD, CLU, ChFC

Mr. Towers is Towers is vice president, business and estate planning, with Brokers’ Service Marketing Group, Providence, RI. Connect with him by e-mail: [email protected]

A popular new product that has aroused the interest of many estate planners is a Guaranteed No-Lapse UL Policy with an “Indemnity” Type of Long Term Care (LTC) Rider. This type of policy would typically be owned by an Irrevocable Life Insurance Trust (ILIT) to provide an income and estate-tax-free death benefit. And the “indemnity” LTC rider would be available to provide potential LTC benefit payments to the ILIT to offset extended care medical costs of the insured estate owner.

The “indemnity” type of rider is crucial for the ultimate life insurance death benefits to be estate tax free. That’s because any rider benefits will be paid only to the ILIT as policy owner, and NOT used to pay extended care costs directly to the extended care provider. Because the payment of LTC benefits are paid only to the ILIT and are NOT required to pay for any specific extended care expenses incurred, this “indemnity” type of LTC rider should NOT create an “incident of ownership” in the UL policy. Any “incidents of ownership” in a life insurance policy would cause the life insurance death proceeds to be included in the gross estate of the insured estate owner.

Indemnity vs. Reimbursement

This important “indemnity” type of LTC rider is contrasted with so-called “reimbursement” type of LTC riders. “Reimbursement” type of LTC riders would pay extended care benefit payments directly to the provider on behalf of the insured. Most commentators have taken the position that this “reimbursement” type of LTC rider on a UL policy owned by an ILIT would be considered an “incident of ownership” that would cause the life insurance death proceeds to be included in the gross estate of the insured.

Client Profile:

Your clients are successful business owners, professionals, and wealthy individuals who may have gross estates large enough to be exposed to federal estate taxes, state death taxes, and “income in respect of decedent” (IRD) income taxes on their QRP/IRA assets. Here are some key features of an “indemnity” type of LTC rider on a base no-lapse UL policy:

  • Income and estate tax free death benefit to offset estate and income taxes due at your death in a financially efficient manner.
  • Special “indemnity” Long Term Care rider that provides tax free restoration of personal funds used to pay extended care expenses
  • Base policy is a guaranteed no-lapse Universal Life policy with an extremely competitive Internal Rate of Return (IRR) out to life expectancy and beyond
  • Low present value cost provides protection against death and extended care expenses in the same product package

Planning Options Available When “Indemnity” Ltc Rider Benefits Are Paid To An Ilit

Assuming that a no-lapse UL policy with an “indemnity” LTC rider is owned by an ILIT, here are some planning options available to the insured and family to either offset or pay for any extended care medical costs:

OPTION #1: Carrier makes income tax free ltc claim payments to the ilit. ilit “keeps cash” in the ilit to be invested in a side fund.

  • ILIT keeps LTC claim payments in the trust and invests in stock, bonds, mutual funds etc.
  • This trust owned portfolio of financial assets is estate tax free and will offset extended care LTC costs which are paid out of pocket by the estate owner
  • The estate owner pays any LTC care costs out of pocket from other personal assets. These payments for LTC medical services will reduce the gross estate for estate tax purposes by the amount of these out of pocket payments.
  • At death, the life insurance proceeds paid to the ILIT from the base UL policy are income and estate tax free.
Because the payment of LTC benefits are paid only to the ILIT and are NOT required to pay for any specific extended care expenses incurred, this “indemnity” type of LTC rider should NOT create an “incident of ownership” in the UL policy

OPTION #2: Carrier makes income tax free ltc claim payments to the ilit. ilit “loans cash” to insured estate owner.

  • ILIT makes a loan to the estate owner. An interest only note payable at current AFR rate is executed between the trust and the estate owner.
  • The estate owner uses the cash received from the loan to pay extended care LTC expenses.
  • The estate owner makes annual interest payments on the note to the ILIT from other personal resources.
  • At death, the estate of the deceased pays off the loan principal on the note to the ILIT from other estate assets and takes an estate tax deduction for debts paid from the estate on Line 2 of the Form 706 U.S. Estate Tax return (IRC Section 2053(a)).
  • At death, the death proceeds paid to the ILIT from the UL base policy are income and estate tax free
    Option #3: Carrier makes income tax free ltc claim payments to the ilit. ilit “distributes cash” to ilit beneficiary (adult child)
  • ILIT trustee uses discretionary authority granted in a well-drafted trust document to make distributions of trust principal to any one or more of the trust beneficiaries (adult children of insured estate owner)
  • This cash distribution is a tax free distribution of trust principal to the adult child. The character of the income (tax free LTC benefits) retains its character when distributed to trust beneficiaries
  • The adult child “voluntarily” (under no obligation) makes an unlimited gift tax exclusion gift of this cash on behalf of the parent to pay the LTC medical expenses of the parent under IRC Section 2503(e).
  • At death, the death proceeds paid to the ILIT from the UL base policy are income and estate tax free.

The “indemnity” type of LTC rider we are talking about may either be a “qualified” LTC rider under IRC Sec 7702B … or an accelerated death benefit rider for “chronic illness” under IRC Section 101(g). Both types of “indemnity” riders pay income tax free benefit claim payments to the policy owner when triggered. Any tax free benefits paid under both types of riders will reduce the life insurance death benefit dollar for dollar.

As a financial services professional, you must advise your client on what type of protection product will match your client’s needs:

  • a “stand-alone” annual premium traditional LTC product
  • a “linked-benefit” single premium or flexible premium life insurance-LTC product
  • an annual premium no-lapse UL life policy with a “reimbursement” type of LTC rider or
  • an annual premium no-lapse UL policy with an “indemnity” type of LTC rider.

With so many different LTC options available to transfer the risk of extended care expenses, it’s important to know the facts surrounding each case. The different product types that can provide LTC protection offer flexible options that should be presented to your clients so they can make an informed choice. The “indemnity” type of LTC rider on a no-lapse UL policy owned by an ILIT is particularly well-suited to accomplish multiple protection needs in a tax efficient manner.