An Irrevocable Life Insurance Trust (ILIT) is a great planning tool for high net worth people. An ILIT can allow transfers to heirs free from both estate and income tax. It is a win-win.
But what if you purchased the life insurance policy outside of an ILIT? Can you transfer the policy into the ILIT after the fact? In this post, we are going to show you the steps to transfer an existing policy into an ILIT. Let’s get started.
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What is an Irrevocable Life Insurance Trust (ILIT)?
ILITs are typically established for estate planning purposes. As a general rule, when someone passes away, the insurance proceeds are included in the person’s estate. This of couse means that even though the proceeds may be excluded for income tax purposes, it will be considered for estate tax purposes.
However, if the life insurance is owned by an ILIT, the death benefit proceeds are not included in the insured’s gross estate and will bypass federal estate taxation.
Internal Revenue Code section 2035 provides that a policy transfer by a person within three years of passing away will result in the inclusion of the policy proceeds in your estate. But under Section 2035(d), the three-year inclusion rule will not apply to a sale for adequate and full consideration.
But it’s not that simple. The sale of an insurance policy to a trust has a few issues that need to be addressed like the following:
- namely policy valuation;
- trust funding;
- the transfer for value rule under Code Section 101(a).
ILIT Policy Valuation Issues
We have already stated that the three-year rule will not apply to a sale for adequate and full consideration. As such, the policy must be adequately valued. When you transfer a policy for less than full value, it will potentially receive split treatment – part gift and part sale. If this happened, it could result in including a portion of the transfer in your estate (under the three-year rule) for the amount of the proceeds that exceed the consideration that was received.
An insurance policy should be sold to the trust for its fair value. As a general rule, the fair value of a permanent policy is equal to its terminal reserve in addition to unearned premiums. But in the first policy year, the value is usually the premiums paid. The value of any term policy is typically equivalent to the unearned premium. You would find this data in Form 712 obtained from the insurance company.
The insurance carrier will usually not specify a precise value that can be used for gift tax purposes. The data in Form 712 can generally serve as support of the fair value price. Still, the fair value can differ depending on the type of policy and other factors present.
For example, if the insured’s death is imminent, the policy’s fair market value could be closer to the death benefit face amount. As a result, if you are considering a sale, you should review the policy with your CPA to help determine proper valuation. If the condition warrants it, you should consider obtaining a professional appraisal.
How to Fund the ILIT
To complete the policy sale to the ILIT, the trust must obtain adequate funds to purchase the policy. This is usually done through annual exclusion gifts made to the trust or possibly through a single lifetime applicable exclusion gift.
Another approach could be to use a promissory note with payment terms based on the applicable federal rate. Future annual gifts would then be required to pay for the ongoing insurance premiums and to service the note.
What About the Transfer for Value Rule?
While the sale strategy identified above can prevent applying the three-year rule, it can trigger the transfer for value rule. Under Code Section 101(a)(1), the transfer of a life insurance policy for valuable consideration results in the loss of the tax-free treatment of proceeds upon death. However, this transfer for value rule is only applicable when the policy is transferred to the insured. So more planning is required.
A sale of the policy to a grantor trust (the insured would be the grantor) would fall under this exception to the rule. Rev. Rul. 85-13 contends that a grantor may sell an existing life insurance policy to a grantor trust without transferring value issues. In addition, Rev. Rul. 2007-13 states explicitly that a non-grantor trust’s sale of an existing insurance policy to the insured’s grantor trust also falls within the exception.
What is a grantor trust? It is a trust that explicitly treats the grantor as the trust owner for income tax purposes. The owner is required to include all trust income (including capital gains and losses, deductions, and credits) in the owner’s individual income tax liability.
To create a grantor trust, attorneys will usually grant one or more powers listed in the code to the grantor or another third person. For example, let’s suppose that the grantor (or a third party) can acquire trust assets by substituting assets of equivalent value. In that case, the trust is considered a grantor trust.
It is critical to avoid certain powers that will cause the trust to be a grantor trust and cause the trust to be included in the grantor’s estate for estate tax purposes. As an example, the power to revoke the trust will result in grantor trust status, but it also drives inclusion under IRC §§ 676(a) 2038(a).
In addition to avoiding transfer for value treatment, grantor trust status has the added advantage of eliminating the tax on sales of appreciated property between the grantor and the trust (vital if the policy has built-in gain). Also, taxable interest income is eliminated on notes between the grantor and trust. But the interest should still be paid on any notes to support the debt treatment.
How to Transfer an Existing Life Insurance Policy into an ILIT
- Value the policy
To avoid the “three-year rule” the policy transfer should be for adequate and full value. When you transfer an insurance policy for less than full market value, it could receive split treatment.
- Fund the ILIT
The ILIT must have adequate funds to purchase the policy. This is typically done through annual exclusion gifts or possibly through a single lifetime exclusion gift.
- Avoid transfer for value rule
The transfer of an insurance policy for valuable consideration can result in the loss of the tax-free treatment of proceeds upon death. This should of course be avoided.
- Engage professional help
Make sure to engage a CPA and estate attorney to properly document and value the transaction. If necessary, you may need to hire an appraiser.