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Irrevocable Life Insurance Trusts (ILITs)

The ILIT

An irrevocable life insurance trust (ILIT) is an estate planning tool generally used to provide liquidity that may be used to pay off estate taxes.  It does this by keeping the proceeds from life insurance policies outside of the insured’s taxable estate.  According to the IRS, if a policy owner can withdraw cash value from a policy, or change the policy beneficiary (among other powers), then the policy owner has “incidents of ownership” over the proceeds.  If this is the case, the policy will be included in the owner’s taxable estate under IRC Section 2042.  In other words, if you own a $1 million life insurance policy, your taxable estate is increased by $1 million, and so will be more vulnerable to estate taxes upon your death.

In order to avoid this, an ILIT can be drafted to hold the policy.  The trust becomes the owner and beneficiary of the insurance policy, thereby removing it from your taxable estate.  When the insured person dies, the money from the policy goes into the trust, to be administered tax-free to the trust’s beneficiaries (different from the policy beneficiary, remember…the policy beneficiary is the trust itself) by the trustee.  If the estate of the insured needs cash to pay the estate tax (or other expenses), non-liquid assets from the estate can be “sold” to the ILIT in exchange for the cash, providing the estate with the needed liquidity.

Policy Premium Payments

Sounds simple, right?  Well, not quite.  Insurance policy premiums payments can cause a glitch.  Usually, the amount of the premium payment is paid to the trust in the form of an annual gift (which the trust then uses to pay the premium on the policy it owns).  The problem is that gifts to a trust don’t normally qualify as “present interest” gifts, and so cannot be considered for the gift tax annual exclusion.  In other words, when you make payments to the trust to cover the insurance premium, you will have to pay the gift tax.

However, if the trust beneficiaries are given “Crummey powers,” this may be avoided as well.  The Crummey power gives the beneficiary the right to withdraw the gift within a certain amount of time; if they do not, the gift remains part of the trust.  The unspoken understanding, of course, is that the beneficiary will not choose to exercise their withdrawal rights.  As long as a notice is sent informing the beneficiary of their withdrawal right, the Crummey power qualifies the gift as a “present interest,” thereby making it subject to the annual gift tax exclusion. 

Note that if the trust has more than one beneficiary (as ILITS usually do), a “hanging” Crummey power should be used.  When a trust has more than one beneficiary, the IRS will consider the lapse of a Crummey power to be a taxable gift to the other beneficiaries of the trust, if the amount that could have been withdrawn exceeds the greater of $5,000 or 5% of the value of the trust (the so-called “five and five” rule).  A hanging Crummey power allows the holder’s withdrawal right to lapse only to the extent of the IRS “five and five” limitation, allowing the remaining amount (the annual exclusion amount minus the five and five amount) to “hang” over into future years, when an additional amount can lapse without taxable transfer.  (For more information about Crummey trusts and Crummey powers, please see related articles.)

Some Additional Remarks

Remember that the ILIT’s trustee should be a third party, not you or your spouse, since this would cause the policy to be included in your estate (defeating the point of the trust).  It is also best if the trust is the original owner of the life insurance policy.  If you as the policy owner transfer your ownership to the trust, the policy proceeds will be included in your estate for estate tax purpose if you die within three years of making the transfer (IRC Section 2035 (a)).  No such waiting period applies if the ILIT is the original owner of the policy. 

Also note that if the spouse of the insured is going to be a beneficiary of the trust, then the spouse must not also be a grantor of the trust, or the policy proceeds will be considered part of their estate.  If community property dollars (in other words, funds or properties acquired during marriage in community property states such as California) are used to fund the trust, then both spouses are considered grantors.  This means that only separate property of the insured should be used to fund the trust, so that the uninsured spouse will not be considered a grantor.  You don’t want the spouse to have any share in the funds or properties used to pay the premiums, or the spouse will be deemed to have “incidents of ownership” in the policy and the proceeds will be included in the spouse’s estate for estate tax purposes on his or her subsequent passing.

By Genevieve Hoffman 7/15/10

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