THE ESTATE PLANNING BENEFITS OF AN

IRREVOCABLE LIFE INSURANCE TRUST (ILIT)

By: Bradford B. Gornto, JD, LL.M.

Gornto & Gornto, P.A.

444 Seabreeze Boulevard, Suite 200

Daytona Beach, Florida 32118

Telephone (386) 257-1899

Estate Taxation of Life Insurance Proceeds

      The use of life insurance to provide funds for the continuing financial needs and support of one's surviving family and to pay debts and estate taxes is a common and accepted estate planning practice.  However, what is not commonly known or understood by clients (and some advisors) is that the death benefit paid on a life insurance policy that is owned by the insured is included in the insured's taxable estate for federal estate tax purposes.  Section 2042 of the Internal Revenue Code (I.R.C.) provides that the death benefit paid under a life insurance policy in which the insured held any "incidents of ownership" at death shall be included in the taxable estate.  Therefore, depending on the size of the estate and other applicable facts, 45% (which is the top federal estate tax rate) of the life insurance death benefit intended for the care and support of one's surviving family could be consumed by additional estate taxes.  In other words, if a person owns a life insurance policy that insures his or her life, then that person may be placing the financial security of their surviving family at risk by unnecessarily exposing their life insurance proceeds to estate taxes.  Due to the fact that the maximum estate tax rate is currently 45%, the estate tax liability can be staggering in certain situations.  Of course, any portion of your life insurance death benefit that is needlessly consumed by estate taxes will reduce the proceeds that will ultimately be available for the benefit of one’s family and the prompt payment for the estate taxes assessed on the other assets owned by the decedent.  Such a scenario would jeopardize the common “estate tax liquidity purpose” for purchasing such life insurance in the first place

Purpose & Administration of an Irrevocable Life Insurance Trust (ILIT)

       Often, the most effective solution to this dilemma is the establishment of an irrevocable life insurance trust ("ILIT") to own the life insurance policy.  A properly designed and drafted ILIT is one of the most effective and common estate planning strategies available today.  Not only can an ILIT eliminate all estate taxation of your life insurance at your death and provide liquidity to your estate, but it will also allow you to shield the life insurance proceeds from unintended recipients, such as in-laws, and ensure that your life insurance proceeds are administered in strict accordance with your wishes after your death.  Further, an ILIT, when utilized in conjunction with other types of trusts, such as a Charitable Remainder Trust, will facilitate significant other estate planning benefits.

      An ILIT is a trust (a legal arrangement under state law) whereby one irrevocably transfers the ownership of his or her life insurance policies to a trustee, or establishes the ownership of a new life insurance policy on his or her life, to be held and administered, pursuant to the terms of the trust agreement.  As with other trusts, an ILIT has a grantor, a trustee, and beneficiaries.  Typically, the insured is the grantor of an ILIT.  The trustee of an ILIT must be a person other than the insured, or the “incidents of ownership” in the life insurance policy will be deemed to be held by the insured and, therefore, included in the insured's taxable estate. 

     Once the ILIT is established, the insured will then need to gift the necessary cash for the initial life insurance premium to be paid by the trustee.  Thereafter, the insured will need to make additional gifts to the ILIT each year in order for the trustee to pay all the future premiums due under the policy.

     At the death of the insured, the trustee of the ILIT is responsible for collecting the life insurance proceeds and investing and distributing the principal and/or income to the beneficiaries of the ILIT, all in accordance with the wishes of the grantor as expressed in the trust agreement.  Typically, the beneficiaries of the ILIT are the members of the insured's surviving family (i.e., spouse, children, etc.).  The dispositive provisions of a ILIT may be as simple as providing for the outright distribution of the life insurance proceeds to the surviving family of the insured, or the life insurance proceeds may be held and managed by the trustee of the ILIT for their long-term care, support and welfare.  In other words, the dispositive provisions of the ILIT are specifically drafted to carry out the wishes of the insured after his or her death.  Careful selection of the trustee of the ILIT will help provide for the proper management and investment of the life insurance proceeds following the insured’s death.

Three Year “Look-Back” Rule for Estate Tax Inclusion – IRC Section 2035

     When transferring an existing life insurance policy (owned by the insured) to an ILIT, it is critically important to understand the so-called “three year rule” under I.R.C. Section 2035.  In general terms, the three year rule provides that if the insured dies within three years after transferring a life insurance policy on his her life to an ILIT (or any other third party, for that matter), then the life insurance proceeds will be included in the insured's taxable estate.  In other words, one must survive at least three years after the date of the transfer of an existing life insurance policy to an ILIT in order for the proceeds to be excluded from one's taxable estate.  As a precaution, the trustee can protect the ILIT from this estate tax exposure by purchasing an inexpensive three-year term policy on the insured’s life equal to the potential estate tax.  However, this three year look-back rule of I.R.C. Section 2035 does not apply to a new life insurance policy acquired by the trustee of the ILIT on the insured’s life.  In such an arrangement, the trustee is simply named as the original applicant, owner and beneficiary of the new life insurance policy on the insured’s life. 

Qualifying Annual “Premium” Gifts to ILIT for the Gift Tax Annual Exclusion

     As previously discussed, the primary purpose for creating an ILIT is to remove the life insurance death benefit from the insured’s taxable estate at the lowest possible gift tax cost, and, if possible, without reducing the insured's available federal unified credit (against estate and gift taxes).  This is accomplished by drafting the ILIT in such a way to qualify the cash gifts to the ILIT for the annual exclusion from gift tax, which is currently $13,000 per donee.  First, it is important to understand that the annual exclusion is only available for transfers that are "present interest gifts.”  For example, if you give your child a check for $13,000, that is a “present interest” gift which will qualify for the $13,000 annual exclusion and will not be applied against your lifetime unified credit exemption amount.  However, the same gift of $13,000 to an ILIT is not a gift of a "present interest” because the beneficiary of the ILIT does not have a “present” right to receive or enjoy the benefit from the $13,000 cash gift to the ILIT.  This type of gift is referred to as a “future interest gift” and will not qualify for the annual exclusion.  As a result, such a gift would require the donor to allocate $13,000 of their unified credit applicable exemption amount to the gift on a U.S. Gift Tax Return (Form 709), which will result in additional costs and administrative burdens.

     For the above reasons, ILITs typically are drafted to provide limited withdrawal rights to the beneficiaries, which are intended to make the cash gifts to the ILIT “present interest gifts” to the extent of the donor’s $13,000 per donee annual exclusion amount.   Such limited withdrawal rights are commonly referred to as “Crummey withdrawal rights,” which derive their name from the court case of Crummey v. Commissioner, 397 F2d. 82 (9th Cir. 1968).  In the Crummey case, the 9^th Circuit Court of Appeals for the Ninth Circuit held that a trust beneficiary's limited demand power or right of withdrawal from a trust did create a valid "present interest" in the gifted property subject to the power for purposes of qualifying the gift into the trust for the annual exclusion.  A Crummey withdrawal right creates in one or more of the beneficiaries of the ILIT the legal right to withdraw from the trust a certain amount of property that has been gifted to the trust for a limited period of time (30 days is the minimum recommended period of withdrawal).

     By granting Crummey withdrawal rights to a sufficient number of beneficiaries the ILIT will prevent the grantor from making taxable gifts when he or she makes cash gifts to the ILIT to pay for the annual life insurance premiums.  While the use of Crummey withdrawal rights may appear to be a game in which the IRS would not participate or tolerate, the IRS acquiesced to the validity of Crummey withdrawal rights as a means of creating "present interest" gifts in 1973.  However, the IRS has imposed additional technical requirements, which must be properly respected during the ongoing administration of the ILIT.

     There are many factors which must be carefully evaluated before establishing a ILIT, such as: (i) the projected financial needs of the insured (and his or her spouse) during his or her lifetime; (ii) the financial needs of the insured’s family after his or her death; (iii) the projected size of the insured’s taxable estate; (iv) the insured’s health condition and insurability; (v) the type of assets likely to be included in the insured’s estate (e.g., real estate, closely held business, etc.) to determine the likely liquidity to pay for any estate taxes; (vi) the special needs of the insured’s family members; and (vii) the insured’s wishes regarding the disposition of his or her property after his or her death.

     The example below illustrates the estate tax savings for a single person whose death occurs in 2013 with an ILIT that owns a $1,500,000 life policy on his life, in comparison to the estate tax liability that would result if the same person died as the owner of the life insurance policy.