Irrevocable Life Insurance Trust
1. What is an Irrevocable Life Insurance Trust?
An Irrevocable Life Insurance Trust (“ILIT”) is commonly used to prevent the taxation of life insurance death benefit proceeds after the death of the insured person. Although life insurance proceeds are not subject to income tax, they are included in the taxable estate of the insured. If the estate is large enough, up to 40% of the life insurance death benefit will be lost to the federal estate tax. The solution is to purchase the policy using an ILIT, which is not subject to federal estate tax.
2. Why must the trust be irrevocable?
In order to prevent the death benefit proceeds from being included in the taxable estate of the insured person, the insured person must relinquish control of the insurance policy. If the insured person could revoke the trust and take back ownership of the policy, then it would be treated as a taxable asset when the insured person dies.
3. May the insured person serve as trustee?
No, the insured person must relinquish control of the insurance policy to a third party trustee. However, there is no requirement that the trustee be independent (Note: it's recommended nonetheless). The insured person may even retain the power to remove and replace the trustee, provided the appointed trustee is not related or subordinate to the insured.
4. How are the premiums paid?
Since the insured person must give up control of the insurance policy, the trustee is responsible for payment of premiums. However, the insured person may pay the premiums indirectly by gifting an equivalent amount into the trust when premiums are due. The trustee will then use that money to pay the premiums.
But this runs into another tax problem: the gift tax. When the insured gifts money to the ILIT, this is treated as a taxable gift to the beneficiaries of the trust (usually the children). Fortunately, there is an annual exclusion against the gift tax, which exempts the first $18,000 of taxable gifts each year to any beneficiary. But the annual exclusion is only available if the beneficiary actually has an unrestricted opportunity to take outright ownership of the gift, rather than let it be used for payment of premiums. This is called the “present interest rule.”
Thus, most ILITs are designed to qualify contributions to the trust for the gift tax annual exclusion by requiring the use of Crummey notices. Named after a 1968 Tax Court case approving its use, a Crummey notice is simply an oral or written notice to a named beneficiary, which describes the gift to the ILIT and grants the beneficiary a right to demand his or her share of the contribution. The demand right is usually limited to a number of days, often 30 or less. After the demand right expires, the beneficiary no longer has any present rights to the money. The trustee may proceed to pay the insurance premium and keep the policy in force.
5. Is notice required each time a contribution to the trust is made?
Notice should be given to the beneficiaries at least once per year. This is sufficient even if gifts are made to the trust on a quarterly basis, for example. The notice should include a schedule of dates on which gifts will be made.
6. What if the insured person wants access to the cash value?
One of the major benefits of permanent life insurance is the insured person’s access to the cash value buildup within the policy. Since these policies are often purchased as supplemental retirement plans, the insured may not want to establish an ILIT when it restricts access to the cash value. However, an ILIT can be drafted to permit the trustee to borrow cash from the policy and loan it to the insured person. Although a third party trustee is involved, the cash value remains accessible to the insured.
Another option is to establish an ILIT with a survivorship or second-to-die policy that pays out after both spouses die. If the policy is paid for with separate funds of one spouse, the other spouse may remain a lifetime beneficiary. This is referred to as a Spousal Lifetime Access Trust ("SLAT").
7. Are there alternatives to the Irrevocable Life Insurance Trust?
Many people attempt to avoid estate taxation of life insurance by granting ownership of the policy to adult children. Although commonly used, this alternative is problematic:
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
An Irrevocable Life Insurance Trust (“ILIT”) is commonly used to prevent the taxation of life insurance death benefit proceeds after the death of the insured person. Although life insurance proceeds are not subject to income tax, they are included in the taxable estate of the insured. If the estate is large enough, up to 40% of the life insurance death benefit will be lost to the federal estate tax. The solution is to purchase the policy using an ILIT, which is not subject to federal estate tax.
2. Why must the trust be irrevocable?
In order to prevent the death benefit proceeds from being included in the taxable estate of the insured person, the insured person must relinquish control of the insurance policy. If the insured person could revoke the trust and take back ownership of the policy, then it would be treated as a taxable asset when the insured person dies.
3. May the insured person serve as trustee?
No, the insured person must relinquish control of the insurance policy to a third party trustee. However, there is no requirement that the trustee be independent (Note: it's recommended nonetheless). The insured person may even retain the power to remove and replace the trustee, provided the appointed trustee is not related or subordinate to the insured.
4. How are the premiums paid?
Since the insured person must give up control of the insurance policy, the trustee is responsible for payment of premiums. However, the insured person may pay the premiums indirectly by gifting an equivalent amount into the trust when premiums are due. The trustee will then use that money to pay the premiums.
But this runs into another tax problem: the gift tax. When the insured gifts money to the ILIT, this is treated as a taxable gift to the beneficiaries of the trust (usually the children). Fortunately, there is an annual exclusion against the gift tax, which exempts the first $18,000 of taxable gifts each year to any beneficiary. But the annual exclusion is only available if the beneficiary actually has an unrestricted opportunity to take outright ownership of the gift, rather than let it be used for payment of premiums. This is called the “present interest rule.”
Thus, most ILITs are designed to qualify contributions to the trust for the gift tax annual exclusion by requiring the use of Crummey notices. Named after a 1968 Tax Court case approving its use, a Crummey notice is simply an oral or written notice to a named beneficiary, which describes the gift to the ILIT and grants the beneficiary a right to demand his or her share of the contribution. The demand right is usually limited to a number of days, often 30 or less. After the demand right expires, the beneficiary no longer has any present rights to the money. The trustee may proceed to pay the insurance premium and keep the policy in force.
5. Is notice required each time a contribution to the trust is made?
Notice should be given to the beneficiaries at least once per year. This is sufficient even if gifts are made to the trust on a quarterly basis, for example. The notice should include a schedule of dates on which gifts will be made.
6. What if the insured person wants access to the cash value?
One of the major benefits of permanent life insurance is the insured person’s access to the cash value buildup within the policy. Since these policies are often purchased as supplemental retirement plans, the insured may not want to establish an ILIT when it restricts access to the cash value. However, an ILIT can be drafted to permit the trustee to borrow cash from the policy and loan it to the insured person. Although a third party trustee is involved, the cash value remains accessible to the insured.
Another option is to establish an ILIT with a survivorship or second-to-die policy that pays out after both spouses die. If the policy is paid for with separate funds of one spouse, the other spouse may remain a lifetime beneficiary. This is referred to as a Spousal Lifetime Access Trust ("SLAT").
7. Are there alternatives to the Irrevocable Life Insurance Trust?
Many people attempt to avoid estate taxation of life insurance by granting ownership of the policy to adult children. Although commonly used, this alternative is problematic:
- Child might die before Parent. If the child dies before the insured parent, the parent has no control over the persons to whom ownership of the policy will pass.
- Complications of multi-party ownership. If the insured parent has multiple beneficiaries, all of them should be named as owners of the policy. Even if permitted by the insurance company, administration of the policy is plagued by potential complications.
- Potential loss to creditors. In some states the policy is subject to potential seizure by a creditor of the insured’s child (although not if the child lives in Arizona).
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.