Information on Irrevocable Life Insurance Trusts (ILIT)

An irrevocable life insurance trust or "ILIT" is a trust which is designed to hold life insurance and pass the death benefit from such insurance to the beneficiaries of the trust without incurring any income or estate taxes on the transfer. While life insurance proceeds are free of income taxes, the death benefit is includable in the insured's estate for estate tax purposes if the insured is also the owner of the life insurance policy. If properly set up and administered, the ILIT becomes the owner of the life insurance policy, thereby excluding the proceeds from the death benefit from inclusion in your taxable estate, unless you die within three years from the date you transferred ownership in the policy into the trust, as explained below. The ILIT remains a popular estate planning device even in the current state of uncertainty regarding the future of estate taxes.

An ILIT is irrevocable, meaning it cannot be revoked, changed or amended once it is created without a court order. Experienced estate planning attorneys are able to draft the document to allow some flexibility for changed circumstances, including provisions in the event the estate tax is permanently repealed.

In order to avoid inclusion in the insured's taxable estate, it is important to avoid any "incidences of ownership". Incidences of ownership include retention of the following powers:

  • The ability to borrow against the life insurance policy
  • Pay premiums with policy loans
  • Pledge the policy as collateral for a loan
  • Add or change beneficiaries
  • Cancel or surrender the policy
  • Assign the policy or revoke a policy assignment

If the IRS deems the insured retained any of the above "incidences of ownership," the full amount of the policy will be included in the insured's estate.

Crummey Trust Provisions

In order to pay the premiums on the life insurance policy, the grantor will make a gift to the trust to cover the amount of the premiums. Currently, an individual may gift up to $12,000 per year to any one recipient without incurring any gift tax on the transfer. However, in order to qualify for this exemption from gift tax, the gift must be of a present, not a future, interest. The Crummey Trust provision solves this problem by giving the beneficiaries of the trust the right to demand or withdraw their share of the money contributed to the trust by the grantor. This demand or withdrawal right elapses after a certain specified period of time, usually 30 days. This provision is referred to as a "Crummey Power", and is named after D. Clifford Crummey, whose court case resulted in the approval of the withdrawal right.

Using Crummey Powers avoids the imposition of any gift tax as long as there are a sufficient number of beneficiaries to cover the cost of the life insurance premium. When the grantor makes a contribution to the trust (typically to pay the premium on the life insurance), the trustee sends a written notice to the beneficiaries, giving them notice of their right to withdraw their share of the contribution to the trust. It is generally advisable for the trustee to retain a copy of the written notice to the beneficiaries and proof of delivery of the notice.

There is always a risk that a beneficiary may elect to withdraw their share of the contribution to the trust. It is therefore advisable to talk to the beneficiaries and explain that it is in their best long-term interest to allow the withdrawal right to lapse.

Three-Year Rule

In order to prevent people from circumventing the payment of estate taxes by utilizing "deathbed" transfers, the IRS imposed a rule regarding transfers of ownership of existing life insurance policies into an ILIT. If the insured fails to survive 36 months from the date of transferring ownership in a life insurance policy into the ILIT, the entire value of the policy is brought back into the estate for federal estate tax purposes. This is sometimes referred to as the "Three-Year" or "36 Month" rule. In order to avoid this problem, most practitioners suggest that you establish the ILIT first, then acquire a new life insurance policy naming the trust as the owner of the policy. Careful coordination is generally required between the estate planning attorney and the life insurance agent to ensure that the application and corresponding paperwork acquiring the policy is correctly filled out.

If existing life insurance policies are transferred to the ILIT, the value of these policies must be determined for gift tax purposes. IRS Form 712 is used to determine the value of the policies transferred, and withdrawal notices are sent to the beneficiaries. If the value of the policies transferred exceeds the amount of available annual exclusions, a policy loan may be structured to reduce the value of the policy transferred.

Role of the Trustee

The Trustee plays an important role in the administration of the ILIT. The trustee receives the premium notice, sends the Crummey notices to the beneficiaries, pays the premium, and is generally responsible for ensuring that all the administrative procedures required of an ILIT are properly taken care of. Failure to correctly administer the ILIT could jeopardize the validity of the ILIT and subject the life insurance proceeds to inclusion in the insured's taxable estate.

The grantor cannot be the trustee of the trust, and it is generally not advisable to have the grantor's spouse serve as trustee of the trust. Some banks and financial institutions will serve as the trustee of an ILIT, but many banks and financial institutions will decline to act as the trustee of an ILIT unless they are acting as trustee of the grantor's other trusts or are actively managing the grantor's assets. A good candidate for the trustee of the ILIT is an accountant or other trusted family advisor, or a financially savvy family member of the grantor. Due to the responsibilities and active role the trustee must play in administering an ILIT, it is important to select a trustee who is capable of properly carrying out the duties required of the trustee.

Seek Experienced Legal Counsel

ILITs are an important estate planning technique, but they must be properly drafted and administered. Mistakes in the formation or administration of an ILIT could result in the IRS challenging the validity of the trust and could result in taxation of the entire life insurance policy proceeds. Selecting an attorney experienced in advanced estate planning techniques and the planning, formation and administration of an ILIT is crucial. Law Offices of Scott C. Soady, APC can help.

You may contact us online, call us at 877-435-7411, or e mail us with this or any other estate planning issue. We would be pleased to offer you a complimentary in-house consultation to discuss ILITs and other legal strategies.

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