April 4, 2008
An “ILIT” is an irrevocable trust which is created for the purpose of owning a life insurance policy. The primary goal of an ILIT is to remove the life insurance proceeds from the insured-grantor’s estate. Because such trusts are irrevocable, they cannot be amended or rescinded in any way after their creation. Accordingly, once the grantor contributes an insurance policy into an ILIT, he or she has effectively released any claim to control the property or to change any of the terms of the trust.
ILITs can be useful tools in creating an effective estate plan. If it is properly constructed, an ILIT can result in payment of a death benefit to a beneficiary which will not be included in the gross estate of the insured. Furthermore, the ILIT can be designed so that the trust can provide benefits to an insured’s surviving spouse without inclusion of the proceeds in the surviving spouse’s gross estate. However, if the ILIT is not constructed or properly created there is a danger that the proceeds will be included in the decedent’s or the insured’s estate. This could result in an effective estate tax rate of nearly 50%.
In crafting an ILIT, it is vital to avoid the “incidents of ownership” which will result in the inclusion of the insurance proceeds in the insured’s estate. See IRC § 2042. In addition, the surviving spouse of the insured may not have any incidents of ownership in the ILIT. The result would be that the proceeds are included in the surviving spouse’s gross estate. Incidents of ownership include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the property. IRC Regs. § 20.2042-1(c)(2). Incidents of ownership also include a reversionary interest in the policy or its proceeds if the value of that interest immediately prior to death exceeds 5% of the value of the policy. IRC Regs. § 20.2042-1(c)(3).
In addition, the life insurance policy must be transferred to the ILIT more than three years prior to the death of the insured. Otherwise, the proceeds of the insurance policy will be included in the insured’s estate. See IRC § 2035. Such transfers are considered taxable gifts based on the insurance policy’s cash surrender value at the time of the transfer. However, the tax cost of transferring a life insurance policy during life could be substantially less than the estate taxes that would otherwise be due upon the individual’s death. Nevertheless, if the insured were to die within three years of the transfer of the insurance policy, the proceeds would be brought back into the insured’s taxable estate.
Another approach is to have the trustee of the ILIT apply for a new life insurance policy on the individual’s life after the ILIT has been created. Proceeds may then be transferred to the ILIT on an annual basis so that the trustee has the funds necessary to make the premium payments for the policy. The annual cash transfers are generally considered taxable gifts. However, because the insured never had any ownership rights in the policy, the policy proceeds would not be included in the insured’s taxable estate even if the individual were to die within three years of the purchase of the policy.
The most common technique for making the cash gifts to an ILIT for the payment of future life insurance premiums is through the annual gift tax exclusion combined with a beneficiary’s unexercised right to withdraw the cash gift. Currently, up to $12,000 per beneficiary of the cash gifts used to pay the premiums can qualify for the annual gift tax exclusion under IRC § 2503(b). The withdrawal right of a beneficiary to use the annual gift includes the unrestricted right for a specified period of time to take the cash before it is contributed to the ILIT and used to pay for the premium. The IRS takes the position that in order to be eligible for the annual gift tax exclusion, holders of the withdrawal rights must (1) have a beneficial interest in the ILIT; and (2) receive an annual notice of the withdrawal right and a reasonable opportunity to exercise the power before it lapses (i.e., thirty (30) days).
If properly constructed and managed, ILITs provide an excellent estate planning tool whereby an insured can channel funds to his or her intended beneficiaries without the inclusion of such proceeds in the insured’s taxable estate.
Written by Jeffrey J. Owens