What is an Irrevocable Life Insurance Trust?
An irrevocable life insurance trust, or ILIT, is an estate planning tool used to shelter life insurance policies from estate taxes. ILITs are irrevocable, meaning their core provisions cannot be changed or amended. An ILIT, like every trust, involves a grantor, a trustee, and beneficiaries. The grantor is the individual that establishes and funds the trust. The trustee is the person who controls the trust. They pay the life insurance premiums, issue Crummey letters, and distribute trust assets to the beneficiaries. Moreover, the Trustee should not be a related or subordinate party as defined by 26 U.S. Code §672 as to ensure that they do not have any incidents of ownership over the policy. Finally, the beneficiaries are the individuals who the grantor chooses to receive the trust assets.
How Does an ILIT Work?
An ILIT is a trust designed to own life insurance policies. Typically, life insurance policies owned by an individual would be subject to estate taxes upon their death. However, life insurance policies owned by an ILIT pass to the beneficiaries without the death benefit being includable in the grantor’s taxable estate.
The Trustee is in charge of paying the insurance policy premiums. As such, the grantor will have to transfer their own assets into the trust to cover the premium payments. This transfer qualifies as a gift to the beneficiaries. In order for this transfer to avoid triggering a gift tax filing requirement, two things must be true. First, the annual transfer must be less than the annual gift tax exclusion. Second, the transfer must qualify as a “present” gift to the beneficiary.
Crummey Letters
The beneficiaries must have an immediate and unrestricted right to withdraw the transfer to the ILIT in order for it to qualify as a present gift. Furthermore, the Trustee must communicate this right to them in writing. This communication is referred to as a Crummey Letter, named after the case from which it was derived. The letter states that a transfer has been made to the trust and the beneficiary has a certain period of time in which they can withdraw the contribution. Thereby changing the classification of the transfer from a “future” gift to a “present” gift thus allowing it to qualify for the annual exclusion.
When to Use an ILIT?
An ILIT is a good estate planning tool for anyone whose estate may be subject to the Massachusetts or Federal estate tax. While it is possible to transfer existing term life policies to an ILIT, it is not advisable to transfer existing whole life policies. The tax benefits would be nullified because the whole life policy will be subject to the federal gift tax upon being transferred to the trust. Furthermore, it is far more advisable to allow the Trustee to purchase the policy on the life of the grantor after the Trust has been established. This method ensures that there will be no gift tax filing triggered at the inception of the Trust.
Picking a Trustee
It is advisable to use a professional trustee due to the complexities and requirements of an ILIT. Indeed, the timely payment of premiums and the issuance of properly drafted Crummey Letters is vital to the Trust. Furthermore, if the professional trustee were to make an instrumental mistake that led to the improper dissolution of the ILIT, they should have malpractice insurance that will help cover your damages.
Potential Pitfalls of the ILIT
There are a few potential downsides to having an ILIT. First, any beneficiary could go “rogue” and exercise their Crummey Letter right of withdrawing the premium payment. This would effectively terminate the trust, as every transfer made to the ILIT with the purpose of paying the premium could be negated by the beneficiary exercising their right to withdraw.
Another potential downside is its irrevocability. The grantor needs to be sure that they are committed to the beneficiaries that they list in the Trust. Indeed, there is no easy way to change the beneficiaries after the ILIT has been executed. Finally, the ILIT uses any utility if the grantor would have died without a taxable estate anyway. The ILIT is a tool for wealthy individuals who need to find ways to shield their assets from estate taxes. It should not be done in situations where a grantor is below or near the estate tax exemption amount.
