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Irrevocable Life Insurance Trusts
Most clients are shocked to learn that the death proceeds of insurance on their life are includible in their taxable estate. They believe that life insurance escapes estate taxes and passes to their loved ones without possible subjection to estate taxation.
This confusion probably began when a client was told that life insurance is income tax-free. For married clients, the confusion is compounded by the belief that the unlimited marital deduction somehow magically insulates the insurance death proceeds from ever being taxed. Often the marital deduction merely postpones the heavy tax burden on such the death proceeds.
Regardless of the source of confusion, a great many clients' families will have far less life insurance proceeds than anticipated as a result of a failure to properly plan for this potential tax liability.
An Irrevocable Life Insurance Trust (or "ILIT" as it is frequently called) has proven to be a highly effective method of preventing the inclusion of life insurance proceeds in an insured policy owner's taxable estate. The ILIT has been tested extensively in court and an experienced estate planning attorney should have no trouble in properly drafting this highly technical document.
Although highly technical, because this specialized trust document which is controlled not only by trust law, but also by the Internal Revenue Code and various regulations, rulings and court cases; if all legal requirements are followed, a properly drafted and maintained ILIT can save estate taxpayers who own life insurance thousands of tax dollars.
Before deciding whether an ILIT can be beneficial in a specific client's overall estate plan, a client must understand the technical requirements for the proper establishment and ongoing maintenance of an ILIT. After fully comprehending these requirements, some clients, notwithstanding the potential estate tax savings, decide that an ILIT is not for them. A qualified estate planning attorney can explain the nature and reason for these technical requirements.
The purpose of the balance of this memo, then, is to provide you with an overview of the nature of the Irrevocable Life Insurance Trust and the tax and personal benefits it can provide.
The proceeds of a life insurance policy are generally includible in the one's taxable estate if the deceased insured either owned the policy or held sufficient "incidents of ownership" of the policy. This is true for term insurance, cash value insurance, and even insurance provided by your employer. If includible in the deceased's taxable estate, the policy proceeds will be included in the determination of the deceased's estate's value and be subjected to Estate Taxation (along with the deceased's other assets) at a marginal rate 45%. While many believe that the estate tax has been repealed, such is not the case. Further in and after the year 2011 estate taxation is imposed on gross estates of a size larger than 1 million dollars.
"Incidents of Ownership" which will cause life insurance death proceeds to be taxed as part of in the insured's taxable estate include not just policy ownership, but also the right to borrow the cash value, the right to change beneficiaries, and/or the right to change how the proceeds are ultimately distributed to the beneficiaries.
An Irrevocable Life Insurance Trust (or ILIT) is created to own or control one or more policies insuring your life. The ILIT is irrevocable, meaning you cannot change the terms once it has been signed, although some flexibility can be written into the document.
For instance, you can allow others, such as your spouse to exercise control over the timing of when the proceeds upon her death will be distributed to your children
(a limited power of appointment).
Although it is technically possible, the insured should not serve as trustee of the ILIT. This only invites additional scrutiny by the IRS. The trustee can be almost anyone else, such as a parent, a sibling, an adult child, or even a bank. Even though the insured "loses" control of the policy after the trust is created, this should not be a cause for substantial concern. A well drafted ILIT should anticipate most contingencies which might occur in the future; so that by proper drafting, the trustee will have binding instructions as to how to deal with future contingencies, should they arise.
The insured cannot be a beneficiary of the trust or be entitled to receive principal or income from the underlying policy; but the insured's spouse and children can be (and usually are) entitled to enjoy the benefits of the policy, and, if properly drafted, such enjoyment will not necessarily cause inclusion of the value of the proceeds in such person's taxable estate.
Similarly, the ILIT should not provide distribution to the insured's estate or revocable living trust, as the insured's ability during lifetime to redirect the beneficial enjoyment of the policy proceeds through such estate planning vehicles will cause inclusion of the policy proceeds in the insured's taxable estate.
Once the trust is properly drafted, the next step is funding the trust through the purchase or transfer of life insurance into the name of the trust.
Note that if an existing policy is transferred from the insured to the trust, there will be a three year delay in tax benefit arising from the trust's creation. However, if the trust is created and thereafter a new policy is purchased by the trust, the tax savings benefits are immediate.
Note, too, that if an existing policy is transferred to the trust and that policy has cash value greater than $11,000, care must be had to properly structure the transfer of the policy, in order to avoid the possible creation of a gift tax consequence from the transfer of the policy to the trust. Remember, such transfers are in the nature of a gift.
Likewise, the continued funding of the trust, in order to allow the trust to pay the ongoing policy premium, must be carefully structured.
Until the time that a policy becomes self funding ( which often happens with whole or universal life insurance products, but not with straight term insurance, in order to allow the trust to keep the policy in force, transfers of value to the trust must be made. These transfers to the ILIT usually constitute gifts which cannot subsequently be returned.
Likewise, because the insured cannot directly receive any benefit from the trust or underlying policies without triggering unwanted estate tax consequences, an ILIT is an inappropriate planning tool for life insurance which is purchased in order to create a source of tax free benefit the insured plans to use in the future (as a quasi-retirement plan, for example).
The annual transfers of value to the trust to allow continued payment of policy premiums will usually constitute a gift. As you probably already know, gifts up to a value of $11,000 per year per donee can be made without incurring gift tax on the gift. However, what you probably don't know is that the so-called annual gift exclusion only applies to gifts of a present interest, and gifts to a trust generally do not qualify as a present interest. Don't worry about trying to understand the legal concept of what's known as a future interest (many lawyers don't really understand the concept). What you do have to understand, however, is that to avoid possible imposition of gift taxation upon the contribution of the value of the premium to the trust, a somewhat convoluted procedure must be followed. This is the so-called CRUMMEY (the name of the taxpayer whose case established the procedure, not a description of the process) Notice Procedure. This procedure requires that whenever a gift is made to the trust, a notice of the fact that a gift was made must be delivered to each trust beneficiary along with notice that for a limited period of time (usually 15 days) each beneficiary has a right to demand immediate distribution of his or her proportionate share of the gift just made. This right to presently enjoy the gift transforms the gift from a future interest to a present interest and thereby allows application of the annual gift exclusion to the gift to the trust.
Usually the trust agreement provides that the trustee provide this CRUMMEY NOTICE, after each contribution is made to the trust. After the expiration of the withdrawal period, the trustee uses the contribution to pay the life insurance premium then due. If the beneficiaries sign a waiver of their withdrawal rights immediately after the contribution and notification, the trustee can pay the insurance premiums immediately. The IRS places great importance upon the adherence to the CRUMMEY process, usually requesting to see the annual notices and proof of receipt by the trust beneficiaries as part of any estate tax audit.
IT WORKS IF: The IRS has approved the ILIT concept when all the technical requirements are met, but the IRS is notorious for challenging ILIT when these requirements are not met. Even the order in which the documents are signed on the same day can be critical. With a substantial portion of your life insurance proceeds at tax risk, it is not worth taking shortcuts or having a novice prepare your documents.
Procedure upon the death of the insured: The trustee receives the death benefit upon your death. These proceeds can be distributed to your family, held in trust, or used to purchase assets from your estate or from your revocable living trust. This last option would be important if your estate or revocable trust has insufficient liquid assets to pay estate taxes. The tax on your estate is due nine months after the date of death. Those with large taxable estates often do not have sufficient liquidity to pay the estate tax due. The need to pay estate taxes has caused many a farm, family business, or major real estate holding to be sold at discounted prices to pay the estate tax.
Life insurance can provide the money needed to pay the estate tax, and by having the policy purchased and held in an ILIT, the proceeds can be used to provide the needed liquidity for your estate and yet not inflate the value of your estate (and corresponding estate tax bill) by the value of the policy at death.
Married couples may wish to consider using a "second to die" policy which pays the death benefit only after both spouses are deceased. That is usually the exact time, of course, that the proceeds are needed to pay the estate taxes due to the estate tax deferral inherent in the marital deduction.
Because no death benefit is paid on the first death, the premium is usually much lower than that of a policy which insures a single life. An ILIT can be drafted to hold such a policy.
DIRECT OWNERSHIP: Often clients try to accomplish similar results to the ILIT by having, say, their children own the policy equally.
Many problems can arise under such an arrangement. A child can die; the policy can be attached and liquidated by a child's creditors; the policy could be considered as the child's property in the event of a divorce; one child may refuse to pay the premiums, or may wish to borrow the cash value.
The outright gift of a policy makes no provisions for young children or grandchildren. These and other issues can be addressed in a properly drafted Irrevocable Life Insurance Trust.
Before paying legal fees to have your ILIT drafted by an attorney, you may wish to submit a trial application to the insurance company to ascertain that you are insurable at acceptable rates. Once insurability is established and the ILIT drafted and signed, the trustee can submit a new application with the trust as the owner, applicant and beneficiary. An experienced life insurance agent can help you prepare the proper type of application.
SUMMARY: The ILIT is an IRS-approved means of removing your life insurance proceeds from your taxable estate, and yet still have the proceeds available to provide for your spouse and children according to your desires. Gifts made each year to the ILIT can be exempt from gift tax. For those with taxable estates, the savings in estate taxes can range from 45% to 49% of the death proceeds. The ILIT can also protect your family after you are gone. Trust provisions can be included to protect beneficiaries from lawsuits, divorce, or their own indiscretion. If you have a taxable estate and own a large insurance policy, or are contemplating purchasing one, see your estate planning attorney today to discuss how an ILIT might benefit your family.
This summary of the Irrevocable Life Insurance Trust was prepared by Joseph R. Burcke and is intended to provide general information about Irrevocable Life Insurance Trusts, and not specific legal advice applicable to any individual's particular legal situation. For more information on the Irrevocable Life Insurance Trust, or other estate tax saving or probate avoidance techniques, consult with an estate planning professional.
Mr. Burcke's law practice focuses upon Estate Planning and estate administration and litigation. He is a well known lecturer on estate planning topics.
To arrange a free one hour consultation to discuss your particular estate planning concerns, call (314) 795-4273 or write Mr. Burcke at 7777 Bonhomme, Ste. 1501, Clayton, Missouri 63105. He can also be contacted on the internet at MoProbate@ yahoo.com.
Copyright©2004 by Joseph R. Burcke, Attorney at Law,
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