Irrevocable Life Insurance Trusts
Many individuals are under the misguided belief that life insurance proceeds are not taxable. That belief is only partially correct; it is true that life insurance proceeds are generally not includible in gross income for purposes of computing federal income tax of the policy owner, the estate of the policy owner, or the beneficiary of the policy proceeds. Those same proceeds are general includible, however, in the federal gross estate of a decedent, even though they generally do not pass through the decedent's estate (the proceeds are payable directly to one or more named beneficiaries) and are not includible in the decedent's probate estate. In addition, the gift of a life insurance policy is generally a taxable transfer of the fair market value (not the face value) of the policy at the date of the gift. The kicker is, however, if the donor dies within three years of the date of a life insurance policy gift, the entire proceeds of the policy are brought back into the decedent's gross estate. Properly planned and drafted, an irrevocable life insurance trust (ILIT - pronounced "eye-lit") can mitigate some of these unfavorable consequences.
An ILIT is an estate planning device used to hold life insurance outside of an estate, minimize federal transfer taxes (gift, estate, and generation-skipping), provide liquidity for an estate (to pay taxes on that part of an estate that is taxable such as a closely held business, for example), and to provide control and management of life insurance proceeds. In order to keep proceeds from a trust-owned policy from being included in the estate of the insured, an ILIT must meet certain requirements. The first of these is that the trust must be irrevocable: that is, the trust may not be modified or terminated once it has been created. In addition, neither the grantor nor the grantor's spouse may be trustees of the trust, nor may they hold any "incidents of ownership" in the policy.
While the trust may not be drafted for the specific benefit of the insured or her estate, the independent trustee may be given broad powers over trust proceeds including the authority to purchase assets from the estate of the decedent, thereby providing the estate with cash to pay administrative expenses and federal or state death taxes. The purchased assets may then be retained in the trust, or distributed to the heirs of the decedent as the trust directs (which is frequently the same dispositive scheme as the decedent's will or living trust).
In the optimal case, the ILIT is created and funded with cash sufficient to pay the premium on the policy. The trustee uses the cash to purchase the policy, with the trust being the policy owner and beneficiary. This arrangement avoids the three-year "gift in contemplation of death" issue. If additional premiums must be paid, the grantor may fund the trust with additional cash annually to pay those premiums. Cash (or other property) contributions to the trust constitute taxable gifts of a future interest to the beneficiaries of the trust. These gifts may be considered gifts of a present interest and available for the annual taxable gift exclusion of $12,000 per donee if the trust contains "Crummy" powers and the "Crummy" requirements are properly followed.
In addition to the tax benefits, an ILIT may also simplify an estate plan by having insurance proceeds payable to a trust for the benefit of multiple beneficiaries (several children or grandchildren, for example). This arrangement provides for an independent trustee, if desired, and professional investment and management of life insurance proceeds until distribution to or for the benefit of trust beneficiaries. This arrangement thus provides for multiple beneficiaries of the trust, with the trust being the sole beneficiary of the policy.
We work with our clients to determine the need for an ILIT as part of an overall family and estate tax plan. ILITs are complex legal documents and must be drafted by an experienced estate planning attorney.
©2011 Ronnie C. McClure, PhD, CPA