The Irrevocable Life Insurance Trust

Life insurance is a very useful tool in estate tax planning. Life insurance proceeds create needed liquidity to pay taxes and expenses, as well as providing cash dollars for beneficiaries. Yet, if life insurance is not owned correctly and the premiums are not paid in the most efficient manner, its benefits are greatly reduced.

The Irrevocable Life Insurance Trust (“ILIT”):

1. Avoids a 47 percent federal tax on life insurance proceeds on the death of insured – and can shelter those proceeds from federal estate tax for a number of generations.

2. Allows premium payments to qualify for the $11,000 annual gift tax exclusion.

3. Permits a trustmaker to make “gifts with strings attached.”

4. Shelter the life insurance proceeds from the claims of the beneficiaries’ creditors.

A Brief Description of the Strategy

Many people believe that life insurance is exempt from federal estate tax. Nothing could be further from the truth. If you own life insurance, the death proceeds will be subject to federal estate tax. There is no escaping this fact of federal estate tax life.

For the most part, life insurance proceeds are free from federal income tax. Under the Internal Revenue Code, a person who receives life insurance proceeds generally does not have to pay any income tax on the proceeds. There are exceptions, but this is the general rule.

Life insurance can avoid probate when paid to a designated beneficiary other than the insured’s estate. However, as long as the insured has any rights or powers over the policy (called incidents of ownership), the proceeds will be included in his or her estate for tax purposes.

To avoid this problem, the life insurance policy can be purchased by, or contributed to, an irrevocable trust and generally not be included in the insured’s estate. Of course, the insured cannot be a trustee or beneficiary of that trust because this would represent an incident of ownership.

Here is a summary of how an ILIT works:

1. The need for life insurance is established by analyzing the liquidity and estate planning goals of a family.

2. The family’s life insurance expert gathers preliminary medical information and schedules physicals in order to determine insurability.

3. After determining insurability, the ILIT is prepared; the trustmaker, or trustmakers – if a joint ILIT is to be created by a husband and wife – signs the ILIT.

4. The trustee signs applications for the life insurance.

5. The trustee applies for taxpayer identification number for the trust and opens bank account in name of trust.

6. The trustmaker(s) makes a gift to the ILIT which the trustee deposits in the trust’s bank account.

7. The trustee notifies the beneficiaries of their limited right to withdraw their share of the gift from the ILIT

8. The beneficiaries waive their right to withdraw, or the time for exercising withdrawal lapses.

The Specifics of This Strategy

Irrevocable trusts are used extensively in estate planning because they remove assets from an individual’s estate and allow a certain degree of control by their maker. Properly designed and implemented, they allow a surprisingly high degree of flexibility coupled with significant estate planning benefits.

Individual and Joint ILITs

An ILIT with one trustmaker is called an individual trust. An ILIT with two or more trustmakers is called a joint trust.

Individual trusts are used by unmarried trustmakers who want to avoid federal estate tax on their life insurance proceeds. Because unmarried trustmakers do not have the benefit of the marital deduction, ILITs are extremely important if their estates exceed $1,500.000.

Individual ILITs are also used by married trustmakers who want to make sure that the proceeds from insurance policies are not included in their estates upon death.

In some cases, an individual ILIT is created for the husband and another ILIT is created for the wife. Each ILIT owns and is the beneficiary of policies on the life of the respective trustmaker. No matter which trustmaker dies first, the proceeds can be used to care for the surviving spouse, children, and other beneficiaries. When the other spouse dies, the proceeds will be available to pay federal estate tax and care for the other beneficiaries. Both policies’ proceeds will be free from federal estate taxation.

Individual ILITs are also used when the trustmaker has existing life insurance policies that he or she would like to transfer to an ILIT. Prudent planning dictates the use of new policies of life insurance when an ILIT is being created.

A joint ILIT generally owns a second-to-die (last survivor) policy on the lives of both spouses. This policy pays when the second spouse dies, so it is the perfect arrangement when the purpose of the life insurance is pay estate taxes upon the death of the second spouse to die.

The advantages of a second-to-die policy are:

• The premium payments on this type of policy are generally significantly lower than those for two individual policies, since premiums are based on the joint age of both insureds.

• The proceeds will be available to pay federal estate tax regardless of which spouse dies first.

Determining whether an individual ILIT or a joint ILIT should be used for a married couple is based on the circumstances of each situation. However, if a married couple’s motive is to use life insurance purely for the payment of estate taxes, a joint ILIT is the better planning method. If the life insurance is to be used not only for the payment of federal estate tax but also for the benefit of the surviving spouse and other beneficiaries, then an individual trust is preferred.

Gifts to an ILIT and the Annual Exclusion

Contributions to an irrevocable trust are considered gifts to the beneficiaries to the trust, and are therefore taxable. Ideally, the maker would use the $11,000 annual estate and gift tax exclusion (or the unified credit for larger gifts) to help offset any gift taxes that may arise. If there is more than one beneficiary to the trust, the maker could give up to $11,000 per beneficiary. Under ordinary circumstances, however, the gift is not eligible for the $11,000 annual gift tax exclusion because the beneficiaries do not actually have the free use of the gift presently. The amount of the gifts would instead reduce the maker’s $1,500,000 exemption equivalent amount, or if that is insufficient, they would then be subject to gift tax.

In order to qualify a gift to an ILIT for the annual gift tax exclusion, the beneficiaries must have a “present interest” in the amount given to the trust. A present interest can be created by giving the beneficiaries the right to withdraw the asset from the trust under a provision known as a withdrawal right, sometimes call a Crummey power.

In a famous court case, Crummey v Commissioner, the courts decided that if an irrevocable trust’s beneficiaries are given the right to withdraw a gift made to the trust for a reasonable period of time after the gift is made, the gift will qualify for the annual exclusion. The number of annual exclusions that are allowed for a gift to an ILIT is equal to the number of beneficiaries who have a demand right. A demand right can give to children and grandchildren; if there are two trustmakers, then $22,000 per beneficiary can be given to the ILIT and still qualify for the annual exclusion.

The “5 and 5” Conundrum

The right to withdraw assets means that the demand right beneficiary has a power of appointment during the time in which he or she can withdraw the assets. The Internal Revenue Code stipulates that the release or lapse of the power of appointment results in a gift of a “future interest to the other trust beneficiaries” to the extent that the release amount exceeds the greater of $5,000 or 5 percent of the sums subject to the release. This provision is commonly called the “5 and 5” limit. This means that if a beneficiary does not exercise his or her right to withdraw, that beneficiary is making gifts to the other beneficiaries equal to the value of the amount that was given up. If this amount exceeds the greater of $5,000 or 5% of the total assets in the trust, then the beneficiary is considered to have made a gift of a future interest to the other beneficiaries. The amount of this gift reduces the beneficiary’s $1,500,000 exemption equivalent amount. Consequently, many people have wanted to fund irrevocable living trust up to the new $11,000 annual limit but found that it would create tax problems for the beneficiaries.

There are solutions to this 5 and 5 conundrum. One of them, which is used by most sophisticated practitioners, involves using "hanging" Crummey powers to make full use of the $11,000 annual gift exclusion for each donee. Under the terms of the ILIT, the amount that lapses is limited to the 5 and 5 safe harbor amount each year. The amount contributed to the donee in excess of the safe harbor amount remains available to be withdrawn by the beneficiary or "hangs," until it lapses at some future date.

Selecting Who Can or Should be Trustees

The candidates for trustee of an ILIT are relatively self-evident in many situations. First, those candidates who would not make good ILIT trustees should be eliminated. The trustmaker cannot act as a trustee of an ILIT. Doing so would give the trustmaker too much control, and the value of the life insurance proceeds would be includable in his or her estate.

Similarly, the trustmaker’s spouse would not make a good ILIT trustee. While technically a spouse may act as a trustee, the risk of the IRS finding that too much control is being exercised is high. The trend by the IRS has been to attack almost every trust arrangement in which a spouse is a trustee when the principal of the trust is not designed to be included in the spouse’s estate. Since this is the case in an ILIT, naming a spouse as a trustee should be avoided.

Even though the trustmaker and the trustmaker’s spouse have been eliminated, there are still many attractive candidates. One of the best is your CPA or public accountant. Accountants are extremely good choices as trustees who serve while the trustmaker is alive. An ILIT requires detail, accounting, notifications to beneficiaries, and follow-up. No other advisor is as equipped as the accountant to handle these items. Since administration of an ILIT, at least while the trustmaker is alive, is mostly ministerial, the accountant can be relied upon to meticulously follow the correct procedures. After death the trustmaker, other trustees can either replace the accountant or be added. This will make the ILITs trustees consistent with those found in the trustmaker’s revocable living trust.

A bank trust department is another extremely good candidate for the position of the initial ILIT trustee. Like accountants, bank trust departments can be riled upon to proceed meticulously with the business of administering the ILIT. They are specifically structured to deal with trust; they are reliable and experienced professional trustees. Generally, if the ILIT holds only life insurance policies and a nominal amount of cash, the fee charged by most bank trust departments is reasonable for the tasks performed and the liability assumed.

Other advisors can make good trustees too. However, it is important that an advisor be detail-oriented and equipped to administer the ILIT. Desire is not enough. Attention to detail, good bookkeeping practices, good follow-up, and existing systems and procedures are absolute requirements for an advisor who takes on the job of ILIT trustee.

Family members can certainly be used, as can friends of the trustmaker. However, they must be capable of meeting the criteria set forth above. If a trustmaker feels uncomfortable with naming a bank or an accountant as sole trustee, or insists on naming a friend, a relative, or an inexperienced advisor, it is almost always better to add an accountant or a bank trust department as a co-trustee. Two heads are better than one, and that is especially true in trusteeships.

The watchword for ILIT trustees is “detail.” An ILIT trustee must be able to effectively and accurately administer a technical trust. Much depends on having a trustee who is aware that procedures reigns supreme in effectively maintaining an ILIT.

Using Life Insurance Proceeds to Pay Death Taxes

One of the more confusing aspects of an ILIT is how the ILITs life insurance proceeds can be used to pay the death taxes of the insured. An ILIT cannot pay the death taxes created by the insured’s estate directly. If the ILIT does so, the payment is considered a gift. The ILIT must use an alternative method for paying the taxes.

The ILIT should have special language in it that allows the trustee to make loans to the maker’s living trust or probate estate. If the loan method is used, the transaction must be at arms length to avoid any gift problems. Interest must be paid, and the indebtedness should be evidenced by a promissory note. The loan must be repaid or extinguished in some manner.

An alternative to making a loan is to have the ILIT buy property from the maker’s revocable living trust or probate estate. Under current law, all of the property included in the maker’s estate receives a step-up in basis at death. If the ILIT purchases property that has a step-up in basis for a purchase price equal to the stepped-up value, there will be no taxable gain. There is taxable gain only to the extent that the purchase price of the property is greater than the step-up in basis. The net effect is that the estate has cash and the ILIT now owns property. Since the beneficiaries of the revocable living trust and the ILIT are almost always identical, in essence there has been no real change in the economic position of the beneficiaries.

The Use of Existing Life Insurance Policies

The proceeds from an insurance policy are included in the estate of a decedent if the decedent possessed “incidents” of ownership either at death or within three years of death. This means that if a maker transfers a life insurance policy into an ILIT that he or she currently owns, and if the maker dies within three years, the life insurance proceeds will be subject to estate tax. This is the primary reason that new policies should be purchased by the trustee of the ILIT; the three year rule of inclusion is eliminated.

Another potential problem arises when using existing life insurance to fund and ILIT. Many times, the life insurance has a substantial cash value. If it does, then the value of the policy is treated as a gift to the ILIT. If the value exceeds $11,000 ($22,000 for a second-to-die policy) multiplied by the number of demand right beneficiaries, then the excess will reduce the $1,500,000 exemption equivalent. If the exemption equivalent has been used, then a gift tax will be due.

While there are some methods that can reduce the adverse impact of using existing life insurance policies, none of them are particularly effective in most cases. If it is economically viable and if the maker is insurable, it is almost always better to purchase new life insurance.

Dispositive Provisions

An ILIT can be drafted to leave property to children, grandchildren, and others in literally thousands of ways. Generally, the provisions that are created to leave property to beneficiaries are tailored to meet the individual needs of each beneficiary. There is no legal reason to leave trust property to each beneficiary in the same way. In fact, it is quite common for a maker to divide the life insurance proceeds equally, but have different conditions for making distributions of income and principal of each beneficiary’s share.

Generation-Skipping Considerations

The federal gift and estate tax system is structured so that property will be taxed at each generation of a family as that property is transmitted from generation to generation. Gifts made by an individual to children during life, and bequests at death, are normally subject to tax before receipt by the children. Similarly, property received by children from their parents, which they do not consume during their lifetimes, will again be subject to tax when it is transmitted to their own children. Thus, in the normal course of events, and ignoring certain exemptions under the gift and estate tax laws, property will be taxed twice on its way down from an individual to his or her grandchildren, and again repeatedly as it is passed down to each subsequent generation.

In the past, wealthy people often could avoid paying more than one gift or estate tax by placing property in a trust for the benefit of their children, grandchildren, and even great grandchildren. To eliminate this planning loophole, Congress in 1986 passed a new federal generation-skipping transfer tax (“GST tax”). Thus, any property which escapes the gift or estate tax at a given generation level may be subject to the GST tax, which is imposed on the transferred property at a flat 47% rate.

There is a very important exemption for the GST tax called the “GST exemption.” The GST exemption allows every individual to shelter up to $1,500,000 of property from the GST tax. An ILIT that is created for the benefit of the trustmaker’s children and grandchildren can be used to leverage this exemption. This leverage occurs because the amount of the premiums given to the ILIT qualify for the GST exemption. If, for example, $1,500,000 of life insurance premiums buys $7,000,000 worth of life insurance protection, then the $1,500,000 premium is the standard that is used to determine the amount of GST exemption used. The additional $6,000,000 of life insurance proceeds do not reduce the GST exemption and are not subject to federal estate tax or GST tax!

A generation-skipping ILIT is ordinarily structured to continue in existence for the maximum period of time permitted under applicable state law. Under the laws of most states, this legal maximum is limited by a doctrine known as the “Rule Against Perpetuities.” This doctrine provides that a trust may not postpone the “vesting of interests” beyond a period defined with reference to the lives of an ascertainable class of persons who were living at the time the trust assets, and requires termination of the trust, either immediately or at some specified future time. A corollary of vesting is that the vested beneficiary will be treated as owner of the trust assets for federal transfer tax purposes, so that the assets again will be subject to tax when the pass from the beneficiary to the next generation. The maximum period of that vesting may be postponed under the Rule Against Perpetuities is usually described as 21 years after the death of the last to die of certain identified lives, called “lives in being.” This period averages about 90 years, depending on the age of the maker, the maker’s children, and whether or not grandchildren are living at the time the ILIT is signed.

During the term of the generation-skipping ILIT, children, grandchildren, and even great grandchildren can be the beneficiaries of the trust. There is no federal estate tax on any of the proceeds until such time as the Rule Against Perpetuities forces the trust to end. The proceeds will be subject to estate taxation upon the death of the final beneficiaries.

If a generation-skipping ILIT has as its only beneficiary grandchildren or great-grandchildren and the only gifts made to it are $11,000 annual exclusion gifts, then each gift to the ILIT does not reduce the $1,500,000 GST exemption. This important exception to the GST tax rules allows an even more efficient way to pass life insurance proceeds free from GST tax.

An ILIT can be extended past the Rule Against Perpetuities. This type of trust is called a Dynasty Trust. For those people who wish to never have their assets subject to federal estate tax, a Dynasty Trust should be considered.

Planning Risks and Detriments

There are some potential detriments in using ILITs. The biggest risk is that the trustee of the ILIT will not follow the administrative procedures that are necessary to insure that the gifts to the ILIT will qualify for the $11,000 gift tax annual exclusion. The trustee must take great care to follow all of these rules.

The trustee must also be diligent in the choice of life insurance products and companies that are used to fund the trust. These decisions should be reviewed annually to insure that the ILITs funding is always meeting the objectives of the maker’s planning.

Finally, because an ILIT is irrevocable, considerable time and effort should be expended in the planning stage so that the terms of the ILIT fully satisfy the maker’s planning goals. The trust should be drafted by an estate planning attorney to absolutely insure that the ILIT is as flexible as it can be without endangering its estate tax-free status.

Previous Page