Basic Rules for Life Insurance Trusts
One of the most efficient and tax-leveraged estate planning tool is the Irrevocable Life Insurance Trust (also known as an “ILIT”). However, certain rules and formalities must be observed in order for the ILIT to serve its intended purpose.
Incidents of Ownership
Critical to the tax benefits of the ILIT is that the assets of the trust must be excluded from the insured’s (Grantor’s) estate. In order for the assets of the ILIT to be excluded from the Grantor’s estate, the Grantor cannot and must not retain any “incidents of ownership” over the life insurance policies that are owned by the ILIT at the time of the Grantor’s death. If the Grantor does retain any incidents of ownership, the death benefits payable to the trust by reason of the Grantor’s death will be included in the Grantor’s estate, thereby subjecting the proceeds of insurance to the estate tax.
Incidents of ownership are the following powers:
- The right to change the beneficiary of the insurance policy.
- The right to assign the insurance policy.
- The right to revoke an assignment of the insurance policy made by the insurance policy’s owner.
- The right to borrow against the insurance policy.
- The power to surrender or cancel the policy.
- The right to use the policy as collateral for a loan by the grantor.
- The right to receive a revisionary interest under certain circumstances from the life insurance policy.
- Any other rights of ownership in the policy, and
- The grantor cannot be the applicant for the life insurance policy.
The powers and rights enumerated above are held by the Trustee of the ILIT since the owner of the insurance policy is the ILIT. This is why the Grantor/Insured should never be a trustee of the ILIT. However, structured properly, the insured’s spouse CAN be a trustee so long as the spouse is not considered to be a Grantor of the trust and so long as the spouse is not an insured. Where the ILIT owns “second-to-die” insurance, neither spouse should be a trustee of the ILIT.
Creation of the ILIT:
The ILIT will acquire insurance on the Grantor by either gift of the existing policy or by purchasing a new policy. When acquiring an existing policy by gift, there will be a three year waiting period in order for the proceeds to be excluded from the Grantor’s estate. This is the infamous “3 year rule” and means that if the Grantor transfers a policy of insurance on his or her life into an ILIT and then dies within 3 years of that gift to the trust, then the death benefits payable to the ILIT will be included in the insured’s estate. With proper structuring this result can usually be avoided.
The usual process is to create the ILIT first and then have the Trustee of the ILIT sign the application for insurance. It is alright for the insured to be medically underwritten before the trust is established, so long as the insured does not “apply” for the insurance by signing the application. The sequence of events should be as follows:
- Have an estate planning attorney draft the irrevocable life insurance trust.
- Have the irrevocable life insurance trust executed by the grantor and witnesses or notarized as needed.
- The trustee (or attorney) obtains a tax identification number for the ILIT and files income tax returns as appropriate.
- The ILIT trustee applies for a new life insurance policy on the life of the grantor.
- The grantor makes a gift of money to the ILIT in a manner that takes advantage of the annual gift tax exclusion.
- The trustee of the ILIT opens a checking account in the name of the ILIT and deposits the gift from the grantor into that account.
- The trustee of the ILIT provides the written notification to the beneficiaries of the ILIT of the gift that has been made by the grantor. (In that letter, the right of the beneficiary to withdraw that gift must also be expressed.)
- After the time allowed for the withdrawal has expired (or a signed statement from the beneficiary has been received declining to make the withdrawal), the trustee of the ILIT makes the premium payment for the insurance policy from the ILIT’s account.
Annual Administration of Premium Payments:
Each year, or on other periodical basis for which the premiums are due on the life insurance policy, a similar process as set forth above must be performed by the trustee of the ILIT. That sequence is as follows:
- The grantor makes a financial gift to the ILIT in an amount that is sufficient to pay the insurance premium. If desired, more can actually be donated to the ILIT.
- The trustee of the ILIT deposits that gift into the ILIT’s checking account.
- The trustee of the ILIT then provides the letter advising each beneficiary of the gift and their right to demand payout of their proportionate share of that gift.
- After the time has elapsed for the beneficiaries to demand their proportionate share, or the beneficiaries have issued a written statement declining to exercise that demand, the trustee of the ILIT then uses the funds in the account to pay the insurance premium.
This is a complex area of the tax law, as is most estate planning. Be sure to consult competent tax and legal professionals.
A great deal of responsibility lies with the trustee. If he or she is not thoroughly familiar with these requirements, professional assistance should be obtained!
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