Many of you know that life insurance proceeds generally pass to the designated beneficiaries free from any income tax. However, it might come as a surprise that the proceeds from a life insurance policy are includable in the taxable estate of the policy owner for estate tax purposes. This could lead to all or a portion of the life insurance proceeds being subject to estate taxes depending on the amount of insurance and the size of the policy owner’s taxable estate.
What are the rules?
An irrevocable life insurance trust (“ILIT”) is a trust designed to remove life insurance proceeds from a grantor’s taxable estate, usually by taking advantage of the grantor’s available annual gift tax exclusions.
The grantor creates an ILIT by entering into an agreement with a trustee who must be someone other than the grantor. The grantor cannot serve as trustee as the trustee will have specific incidents of ownership over the life insurance policy that could result in the policy proceeds being included in the grantor’s estate, the very thing the ILIT is designed to do avoid. The beneficiaries of the ILIT are typically the grantor’s spouse and children.
Once the ILIT has been executed, the grantor will transfer cash to the ILIT. The trustee will apply for and purchase life insurance on the grantor’s life, or the grantor may transfer the ownership of an existing policy to the ILIT. Three years must pass if the grantor transfers an existing policy to the ILIT before the policy proceeds will be excluded from the grantor’s taxable estate. If the grantor dies within three years of the transfer of the policy, the proceeds will be includable in the grantor’s taxable estate.
Once the ILIT owns the life insurance policy, the ILIT itself should be designated as the beneficiary of the life insurance policy. The grantor will typically continue to make gifts to the ILIT, intended to be used by the trustee to pay the required insurance premiums as they become due.
Gift tax issues?
Initially, gifts to an irrevocable trust do not qualify for the annual gift tax exclusions. They are called a gift of a future interest instead of gifts of a qualifying present interest. For the gifts to the ILIT to qualify for the annual exclusions, the ILIT is drafted to allow the beneficiaries of the trust, typically the grantor’s children, a window of time during which they can withdraw a portion of the contributions to the trust up to the amount of the annual exclusion (currently $12,000 per donee). It is not intended that the beneficiaries withdraw the contributions to the trust, as this would leave the trustee without funds to pay the premiums on the insurance policy.
Still, the withdrawal rights are necessary to convert a future interest gift to a present interest gift which qualifies for the annual gift tax exclusion. The trustee of the ILIT should notify the beneficiaries of their right to withdraw contributions to the trust by sending them notices of their right to withdraw contributions on at least an annual basis. These annual notices are sometimes referred to as “Crummey Letters” named after the case which favored using this technique.
By its nature of having premiums paid overtime, life insurance lends itself to this technique of utilizing annual exclusions to remove the policy proceeds from the grantor’s taxable estate. Gifts to an ILIT by the grantor are typically within the amount of the available annual exclusions. Therefore, in most cases, the insurance proceeds can be excluded from the grantor’s taxable estate without using up any of the grantor’s applicable exclusion amount.
Anyone who has life insurance that they intend to keep in place for more than a temporary period and who has an estate large enough where the life insurance proceeds will be subject to estate taxes should seriously consider creating an ILIT.