Irrevocable Life Insurance Trust Planning for Lottery Proceeds

Some believe fortune lies just beyond in an Atlantic City or Las Vegas casino. Those who have won a jackpot say it is positively true. The federal Internal Revenue Service (“IRS”) restricts the transfer of future payments from a gaming or lottery win settlement. Estate planners advising clients with gaming or lottery proceed wins about the benefits of irrevocable life insurance trust (“ILIT”) transfer. ILIT affords a trust owner the option of convertibility to enhance the liquidity of an estate, while meeting tax payments that would otherwise encumber beneficiaries.

The Future Value of Proceeds

Lottery jackpots are especially valuable assets, that remind the owner of a win. Gaming and are typically cashed out upfront, while lottery payments are typically distributed in annual installments, though this depends on the state jurisdiction where they were attained. Lottery payments also continue after the winner is deceased. The federal IRS and state tax boards account for the present value of a lottery asset which is assigned capital gains taxation, plus the full amount of total future lottery proceeds for purposes of inheritance taxation. In circumstances where a gaming or lottery winner has not transferred payments from the win to an ILIT or other tax-exempt trust, and there are outstanding installments owed, an estate may lack sufficient funds to cover its income tax obligation.

IRS Taxation of a “Win”

Federal IRS estate tax rules for gaming and lottery assets are relatively transparent. Winnings above $5,000 or at least three hundred times the wager, are subject to withholding under federal law. A 25 percent tax rate is applied to all gaming, gambling, lottery, or sweepstakes winnings not already deducted by the payer. In some cases, a 28 percent rate of tax is applied to proceeds in response to a failure to provide a payer with tax ID information. Winnings less than the stated IRS base rate amount are exempt from federal taxation. An estate trust that owns assets connected to lottery or other gaming, is subject to fair market valuation.

The IRS rules for annual gift taxes also apply to gaming and lottery distributions made to designated beneficiaries while an estate owner is still living. The federal annual tax exemption requirement per gift in 2022 is $16,000 per recipient. Spousal gifts from gaming or lottery proceeds are separate from this rule. The IRS provides tax-free assignment for distributed estate property transferred to spouses, including unlimited gift amounts for citizens; and to the annual limit of $164,000 for non-citizens. Some states also apply an additional gift tax to amounts over a designated trust limit.

ILIT Limitations

There are limitations imposed on gaming and lottery proceeds not reinvested as transferable assets. The convertibility issue aside, there is a higher probability that an estate will be comprised if outstanding gaming or lottery proceed payments are subject to inheritance tax. In other words, the decision to not convert winnings to a tax-free shelter, means inheritance tax stands to greatly reduce the worth of an estate, as well as final distributions to heirs and beneficiaries. The IRS published standard annuity tables provide the official index for calculating the future value of gaming or lottery win payments.

There are also some state restrictions on cash transfers of winnings without estate or gift formation. Establishment of an ILIT affords an estate owner to transfer proceeds, without affecting family members with tax obligation. The unexpected win may feel like a boon, yet the gift and estate taxation of winnings is sometimes prohibitive without a tax shelter. Estate planners and planned giving specialists working with estate owners and their beneficiaries to plan for tax-exempt, nonprofit charitable giving distribution of residuals from future payment streams invested to increase earnings from this special class of assets.

Planning an ILIT

In the United States, federal and state rules of estate permit a gaming or lottery claimant to form a corporation, general partnership, limited partnership, limited liability company, revocable trust, or irrevocable trust for the purposes of transferring cash flows from a prize. An estate planner can advise a client about the planning of ILIT transfer to protect gaming or lottery proceeds from excess taxation in the future.

An irrevocable life insurance trust (“ILIT”) enhances estate liquidity, while meeting tax payments on gaming or lottery proceeds that would otherwise encumber beneficiaries.

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