An irrevocable life insurance trust, or ILIT, is a trust that a person creates to exclude insurance proceeds from that person’s taxable estate. Insurance proceeds are not subject to income tax, but if at your death you hold any “incidents of ownership” over an insurance policy on your life, the insurance proceeds will be included in your taxable estate. See Internal Revenue Code § 2042 and regulations thereunder.
You will be deemed to have “incidents of ownership” if, among other things:
- You actually own the policy
- You pay the premiums on the policy
- You retain the power to designate the beneficiary of the policy
- You retain the power to change the ownership of the policy
- You have any other significant form of control over the policy
One method of avoiding holding incidents of ownership over an insurance policy at death is to transfer an existing policy to an irrevocable insurance trust or having the ILIT purchase a new policy on your life.
Another method of attempting to avoid incidents of ownership is to have your spouse own the insurance policies on your life. However this often does not work because the policy is then included in your spouse’s taxable estate at death. If your spouse is the first to die, the policy may come back to you and be part of your estate again. There are other reasons that make it difficult to avoid all incidents of ownership if your spouse owns your policy. We believe the best approach is for the ILIT to own the insurance policy and be the beneficiary of the policy.
Three Year Waiting Period
If an existing policy is transferred to an ILIT, there is a three-year waiting period before the policy proceeds will be excluded from your estate. Accordingly, even if you transfer you policy to an ILIT, if you die within three years of such transfer, the insurance proceeds will be included in your taxable estate. If possible, the ILIT should obtain the insurance on your life directly with a new policy so that the ILIT is the initial owner of the policy. This avoids the three-year waiting period.
If you own a whole life or variable life policy or any type of insurance policy with a cash surrender value when you transfer such policy to an ILIT, this transfer is a taxable gift of the amount of cash surrender value. Obviously the purchase of new policy by the ILIT will not result in a taxable gift.
You, as the insured under the policy transferred to the ILIT will be the “grantor” of the ILIT. You cannot be the trustee. Although it is possible to have your spouse be the sole trustee, extreme care must be taken in the administration of the ILIT, and the terms of the ILIT must be carefully drafted to avoid inclusion of the insurance proceeds in your spouse trustee’s taxable estate. It is preferable to have an independent trustee-i.e., a trustee who is not a member of your immediate family. A professional fiduciary may be the best choice here.
Joint and Survivor Insurance
If you and your spouse own a joint-and-survivor insurance policy, this policy must be placed in a different kind of ILIT of which both you and your wife are grantors. Other than joint-and-survivor policies, you may transfer more than one life insurance policy on your life to a single ILIT.
Once the ILIT has been established and your life insurance policy or policies have been transferred to the ILIT (or purchased by the ILIT) the ILIT will be required to pay the insurance premiums as they come due. You as the grantor of the ILIT should not pay the premiums directly. If you do pay the premiums, this will cause you to have incidents of ownership and the insurance proceeds will be included in your estate which you are trying to avoid by forming an ILIT.
In order to pay the premiums, the trustee will need funds with which to pay them. It is likely that you as grantor will transfer funds to the trust to allow the trustee to pay the premiums. Your transfer of funds will be considered a gift for gift tax purposes. However, you can give up to $13,000 to as many people as you wish each year without being subject to the gift tax. This is called the “annual exclusion”. The annual exemption is currently $13,000 per person per year. For example, you could make a $13,000 gift to each of four persons and your total gift of $52,000 is not taxable. You could give $13,000 to each of 10 persons and your total gift of $130,000 is not taxable. Accordingly, if there are four beneficiaries and the total annual premium is $10,000, you could make a $2,500 gift to each of the beneficiaries by transferring $10,000 to the ILIT. The trustee of the ILIT would use the $10,000 to pay the annual premium.
A gift must be a gift of a “present interest” in order to qualify for the annual exclusion. A present interest gift allows the person to whom you made the gift (the “donee”) to use the gift immediately. If the donee cannot use the gift immediately, the gift is not a present interest and therefore does not qualify for the annual exemption. In such event, you must either use your lifetime exemption or pay a gift tax on the gift amount.
Most gifts to trust are almost by definition, not gifts of present interests because you are transferring property to the trust to be used at a later date by the trust beneficiaries. In order to get around this problem, the trust document can provide the beneficiaries of your irrevocable trust the right to withdraw from the trust any contribution to the trust up to the annual exclusion amount within a month of when the contribution was made. This withdrawal right is called a “Crummey Power” (named after the grantor who first fought the IRS over this issue). There can be adverse consequences to a beneficiary for failing to exercise withdrawal rights. To the extent that the withdrawal right applies to an amount less than or equal to the greater of $5,000 or 5% of the trust property, the failure to exercise the withdrawal right will not have gift or estate tax implications for the beneficiary with the withdrawal right. This safe harbor does not apply, however, if the beneficiary affirmatively states that he or she chooses not to exercise his or her rights; instead, the beneficiary must simply do nothing and let the withdrawal rights lapse on their own terms.
When funds are transferred to the trustee to pay the insurance premiums, the trustee gives notice (a so-called “Crummey notice”) to the beneficiaries that this contribution has been or is about to be made, informs them of their right to withdraw it, and notifies them of the time period during which they may exercise that right. Typically, the terms of the trust itself set forth the details of the withdrawal rights. After the withdrawal period has expired, the trustee can then use any contributed funds not withdrawn by the beneficiaries to pay the insurance premiums.
Most insurance policies do not generate taxable income, but to the extent that the trust assets do earn taxable income during the life of the grantor, this income will almost always be taxed to the grantor and not to the trust. An insurance trust can be drafted so that the income is taxable to the trust and not to the grantor, but since the income of an ILIT tends to be minimal and tax rates are higher for trusts than for individuals anyway, there is usually no reason to do so.
An ILIT may be a useful estate planning for you and may be used for non tax reasons as well as tax reasons.
Contact A.O. Headman, Jr. at firstname.lastname@example.org for more information.
- On November 25, 2012