1. What is an Irrevocable Life Insurance Trust?
  2. Why use life insurance to pay estate taxes?
  3. How is life insurance “structured” to avoid taxes?
  4. Do you have to use an Irrevocable Trust to own life insurance?
  5. Why use an Irrevocable Trust?
  6. How does an Irrevocable Life Insurance Trust work?
  7. Are there any limits to the gifts made each year?
  8. What does the Trustee do with the gifts received?
  9. What happens when the Grantor (Insured) dies?
  10. What if Congress changes the exemption amounts?

An Overview of Irrevocable Life Insurance Trust (ILIT)

An Irrevocable Life Insurance Trust (ILIT) can be used to good advantage whenever an individual (or a couple) faces a death tax (aka Inheritance or Estate Tax) in his or her generation, and wishes to provide liquidity for payment of those taxes with existing life insurance, or insurance to be purchased, without subjecting the proceeds themselves to depletion by death taxes.

What is an Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust (ILIT) can be used to good advantage whenever an individual (or a couple) faces a death tax (aka Inheritance or Estate Tax) in his or her generation, and wishes to provide liquidity for payment of those taxes with existing life insurance, or insurance to be purchased, without subjecting the proceeds themselves to depletion by death taxes.

Why use life insurance to pay estate taxes?

For persons who die leaving an estate subject to the estate tax, without the use of life insurance, estate assets would have to be liquidated in order to pay estate taxes. This can cause undue hardship on the family, as important assets such as a family business, retirement property or other retirement assets are sold to pay the taxes due. The loss of important assets is coupled with the cost of actually liquidating those assets, leading to significant estate shrinkage. The potential costs include the cost of selling at fire-sale prices to generate cash quickly as the family business is sold for book value, the real estate or securities have to be sold before the market rebounds, or the IRA needs to be liquidated thus also triggering separate income taxes. Add to that the transaction costs of 3% to 10% for liquidation including realtor, escrow and broker fees.

Using life insurance, properly structured to avoid tax on the policy proceeds, will cost on average less than 10% of the amount needed to pay the tax. Just as important, the death benefit makes the cash available as soon as it is needed, avoiding the need to liquidate the important estate assets.

How is life insurance "structured" to avoid taxes?

For purposes of this discussion, life insurance paid for with after-tax premium dollars are always income tax free to the beneficiary. The problem is that if the person named as the insured owns or otherwise maintains control over the policy, the death benefit, while income tax free, will be included in the insured’s estate for calculation of estate taxes. It can cause a person’s estate otherwise subject to the estate tax to pay additional unnecessary taxes of up to 50% of the death benefit amount. It can also cause a person’s estate, which otherwise would not be subject to the estate tax, to unnecessarily become subject to the estate tax. Don’t forget that there are also several states that impose a separate Inheritance Tax, including IA, IN, KY, TN and PA.

Do you have to use an Irrevocable Trust to own life insurance?

The alternative to using an Irrevocable Life Insurance Trust is to give policies, or cash to purchase policies outright to the children or successor generation, who would then individually own a policy or policies on the life of the Grantor.

The advantage is that you can save the cost of using an attorney to create your Life Insurance Trust.

There are also disadvantages for the Grantor to consider:

  • Will the recipients maintain the policies or liquidate them to access the cash values?
  • Will the recipients use the policy proceeds for the intended purpose of providing liquidity for payment of taxes?
  • Will the recipient lose the policy through a divorce or judgment of a creditor?

Why use an Irrevocable Trust?

After considering the alternative, an Irrevocable Life Insurance Trust is indicated where the donor does not have confidence that the recipients of the gifts will cooperate in retaining the policies or their proceeds and making them available to the donor's estate for payment of taxes, or where the gifts are made to minor or other beneficiaries, who do not have the capacity or judgment to manage the policies proceeds.

Therefore, a benefit of using an Insurance Trust is that a Trustee can be chosen who understands the goal of providing liquidity for payment of taxes, and in that way there is more certainty that the proceeds will be used for the intended purpose, at the insured's death.

How does an Irrevocable Life Insurance Trust Work?

The Grantor with the expected estate tax problem sets up the Trust naming a third party to act as Trustee and the Grantor establishes the beneficiaries of the Trust. The Grantor then makes gifts to the trust, enabling the Trustee to apply for and pay premiums on a Life Insurance Policy on the life of the Grantor.

You may also transfer (gift) one or more existing life insurance policies to the Trust. If transferring existing policies to the Trust, keep in mind that there are special rules for valuing these policies for gift tax purposes. These types of gifts in particular should be thoroughly reviewed by your attorney and/or tax advisor in advance of any such transfer.

Once the Trust is established, the Grantor will have no rights to or control over the Trust or the Life Insurance Policy, thus fulfilling the irrevocable requirement.

Are there any limits to the gifts made each year?

The gifts are usually intended to qualify as tax-free gifts under the annual exclusion for gifts of $13,000 or less per donee per year. For example, if Rich Smith creates a trust naming his two children as beneficiaries, he can gift up to $26,000 per year to the trust. If Rich is married and his spouse consents to gift splitting, they can both contribute a total of $52,000 per year as gifts to the trust without anyone incurring any gift, estate or income tax liability.

What does the Trustee do with the gifts received?

Upon receipt of any gift, the Trustee must notify each beneficiary of his or her “Crummey” withdrawal right. With a Crummey withdrawal power, each time a contribution is made to the trust, the beneficiary has a temporary right to demand withdrawal from the trust. If the demand right is not exercised, the annual transfer for that year remains in the trust for management by the trustee. If the demand is made, the Trustee must deliver the funds to the beneficiary. However, the beneficiary generally will recognize that such a withdrawal may affect the grantor's decision as to future transfers to that Trust and the beneficiary may therefore not make a demand. Once the withdrawal right lapses, the Trustee is then free to use the monies, which were contributed to pay the premiums on the life insurance policies.

The name "Crummey trust" comes from the name of a party to a lawsuit, Crummey v. Comm., 397 F.2d 82 (9th Cir. 1968).

What happens when the Grantor (Insured) dies?

Upon the death of the insured person(s), usually the Grantor(s) of the Trust, the Trust will be beneficiary of the Life Insurance Policy and receive the policy death benefit free from tax. The Trustee may then distribute the trust assets to your named beneficiaries in accordance with your wishes or use trust assets to buy assets from your estate, thereby providing liquidity to pay estate taxes without having to sell estate assets such as real estate, securities or business interests.

What if Congress changes the exemption amounts?

Congress has established, and from time to time has changed the amount of a decedent’s estate which may be excluded from Federal Estate Taxes. In 2008, the first $2 million in assets are excluded from Estate Taxes. In 2009, the excluded amount is $3.5 million. In 2010, a decedent may leave an unlimited amount of assets free from Estate Taxation. Ind 2011 and 2012, the first $5,000,000 are excluded from estate tax. However, the current law is set to expire in 2013, reducing the excluded amount of assets down to only $1 million.

With the uncertainty over permanent estate tax repeal, clients are looking for more flexibility in their Irrevocable Life Insurance Trusts. If the Estate Tax is repealed for good, clients want to have the ability to get some or all of their contributions back. Married couples can now enjoy the flexibility they desire with a properly drafted Spousal Access ILIT.