CA Estate Planning Blog

Tuesday, April 5, 2011

Irrevocable Life Insurance Trust [ILIT]

WHAT IS IT?

An Irrevocable Life Insurance Trust (ILIT) is an irrevocable trust that provides a means of avoiding estate taxes on life insurance proceeds, while providing a benefit for your spouse and/or children. 

WHO NEEDS IT?

Any individual whose estate may or will have an estate tax liability should consider an ILIT to avoid having life insurance proceeds included in the estate and causing or increasing estate tax liability.
 
WHAT DOES IT DO?
 
An ILIT avoids estate taxes on life insurance proceeds by taking life insurance out of the taxable estate. Life insurance is considered part of the taxable estate when the following occurs: (1) Upon your death, the life insurance proceeds are paid directly or indirectly to your estate; or (2) When you were alive, you held any ownership interest in the life insurance proceeds. Ownership interest includes the right to change a beneficiary, surrender or cancel the policy, or borrow against the policy. If you leave the proceeds to anyone other than a spouse, such as a child, parent, or friends, then your estate will be taxed. If you leave the proceeds to a spouse, then your estate will not be taxed, but your spouse's will be.
 
An ILIT takes the life insurance out of the taxable estate by placing the life insurance into an irrevocable trust, then naming another individual (not yourself) as the trustee. A life insurance policy placed into an ILIT is considered to have no owner, therefore it is not considered part of your estate. The ILIT is also considered the beneficiary of the life insurance proceeds, which keeps the proceeds out of your, your spouse's and your children's estates.  After the insured dies, the Trustee will invest the proceeds of the trust and administer the trust for its beneficiaries. 
 

WHAT ARE THE BENEFITS?

Utilizing an ILIT can: (1) help avoid estate tax liability; (2) increase the size of your estate without increasing your estate tax liability; (3) provide liquidity to pay off liabilities or tax obligations without selling other assets; (4) allow for transfers out of the estate with minimal or no gift tax consequences; (5) protect beneficiaries from creditors; and (6) provide an ongoing management of assets under the terms of the trust.
 

HOW DO I SET IT UP?

There are two ways to set up an ILIT: (1) You can purchase a life insurance policy in the name of the trust; or (2) You can transfer an existing life insurance policy into the trust. 
 
It is preferrable to purchase a life insurance policy in the name of the trust rather than transferring an existing life insurance policy into the trust.  Transferring an existing policy into a trust triggers a three-year survival rule, whereby the original policy owner must survive the date of transfer by three years or the life insurance proceeds will be included in the decedent's estate for estate tax purposes as if the transfer never occurred. 
 
If the insured has a spouse, the ILIT should contain a fail-safe clause, providing that if the insured/transferor dies within three years of the transfer of any policy to the ILIT, then the proceeds of such a policy will be held separately under the ILIT and administered for the surviving spouse in a way that will qualify for the estate tax marital deduction.  This arrangement will render those proceeds tax free if the insured dies within three years of the transfer and is survived by is spouse. The trade-off is that whatever is left of these proceeds will then be included in the estate of the surviving spouse.
 
HOW DO I FUND IT SO THAT THE PREMIUMS ARE NOT SUBJECT TO FEDERAL GIFT TAX?
 
It is important to fund the life insurance policy in a manner that will render the policy premium payments exempt from the federal gift tax.   
 
If you transfer securities or cash to the trust so that the trustee will have income to pay the premiums, the full value of the securities or cash payments would be considered a taxable gift and you would be liable for the gift tax if the value of either exceed the annual $13,000 exemption per trust beneficiary. 
 
However, you may be able to exclude these premium payments from counting towards the gift tax exemption by setting the life insurance trust up as a Crummey Trust.  This trust focuses on the requirement that the $13,000 annual gift tax exemption applies only to gifts in which the beneficiary has a "present interest," or the right to immediately access and spend the gift (although some restrictions on access are permissible).  The Crummey Trust gives the beneficiaries a present interest in the premium payments by providing the beneficiaries with the opportunity to withdraw the amount of the premium payment for up to thirty (30) days after it is made.  
 
Parents wishing to set up this type of trust for the benefit of their children have some assurances that the children will not empty the trust and run away with the funds. The beneficiaries can only withdraw the most recent gift payment, leaving the remainder of the trust intact.  And if a parent cannot convince a child to give up his right to withdraw funds, the parent could stop making payments to the trust, leaving the remaining funds in the trust to grow until the final dispersion. 
  
TAKING ADVANTAGE OF THE GENERATIONAL TRANSFER TAX EXEMPTION
 
The Generational Skipping Transfer Tax (or GSTT) is a federal tax that is imposed on outright gifts and transfers in trust to beneficiaries who are either (a) related to and one generation younger than the donor (i.e. grandchildren), or unrelated to and more than 37.5 years younger than the donor.  The GSTT is imposed on the beneficiaries of these gifts or transfers (also referred to as 'skip persons') to ensure that taxes are paid at each generational level, even when a donor establishes a trust to allocate his assets to future generations.  The GSTT takes effect when a skip person receives an amount that exceeds the $1 million tax credit (in 2011); the overage is then taxed at a flat rate of 55%. 
 
An ILIT can be used to leverage the insured’s GSTT exemption, since the exemption will be based on the premiums, not on the death benefit or the cash value of the insurance. Total premiums cannot exceed the grantors' available GSTT exemptions. As long as the GSTT exemption covers all of the lifetime gifts made to the trust, all trust assets, including the death benefit from the life insurance, will be exempt from generation-skipping transfer taxes. If the ILIT is properly drafted and administered, the death benefit proceeds should also be free from income and estate taxes.

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