How Does an Irrevocable Life Insurance Trust Work?

Irrevocable Life Insurance Trusts (ILITs) are a common planning tool. However, buying the policy at the wrong time, leaving out Crummey withdrawal rights and ignoring administrative costs are commonly made mistakes. Being aware of these snares is important to make the ILIT effective, says a recent article titled “Irrevocable Life Insurance Trusts in Estate Planning: Common Pitfalls” from Think Advisor.

Purchasing a new policy outside of the ILIT is a commonly made error. If you purchase a new life insurance policy and then transfer it to the ILIT, the death benefit will be included in your estate for estate tax purposes if you die within three years of the transfer. This undoes any estate tax advantages of the insurance policy and the trust.

IRS Section 2035 causes estate tax inclusion for anyone who transfers or otherwise gives up power over a life insurance policy within three years of death. However, there are ways to address this. If you first establish and fund the ILIT first, so the ILIT is the entity purchasing the policy directly, the death benefit is excluded from your estate regardless of how long you live after the purchase date.

Another error concerns the “Crummy Protocol.” Unless or until the premiums on a life insurance policy are fully paid or are self-sustaining through a draw on the cash surrender value, the insured must make gifts to the ILIT to pay for the premiums. People often like to use their annual gift tax exclusion to make contributions. However, to qualify the gifts for the annual gift tax exclusion, the beneficiaries of the ILIT must have the right to withdraw certain amounts transferred into the ILIT.

Failing to include the required withdrawal rights may eliminate the ability to offset gifts by the annual exclusion right. Even if the ILIT includes Crummey withdrawal rights, you won’t be able to take advantage of the annual gift tax exclusion if the beneficiaries are not informed of their withdrawal rights each time an eligible contribution is made to the ILIT.

Your estate planning attorney will advise you as to how this occurs from a procedural perspective. You’ll want them to review it before it is signed to confirm it includes Crummey withdrawal rights and to help you establish procedures for providing the requisite notice and waiting the required period each time a gift is made.

Lastly, ILITs often have limited assets since they may only be funded with the insurance policy and the amount needed to pay the premiums. Therefore, if the ILIT has any administrative expenses, like accounting, legal or trustee funds, there may be insufficient assets in the ILIT to pay them.

If you pay the expenses directly, they will be considered as making a gift for gift tax purposes, because you will be deemed to have first transferred to the ILIT any amounts paid on its behalf. Avoid this issue by funding your ILIT with the necessary money to pay premiums and administrative costs. If the class of beneficiaries holding Crummey withdrawal rights is broad enough, this may be done solely through annual exclusion gifts.

Reference: Think Advisor (Sep. 29, 2022) “Irrevocable Life Insurance Trusts in Estate Planning: Common Pitfalls”

What is the Purpose of an ILIT?

Life insurance falls into two categories: life insurance and death insurance. Life insurance is used to take advantage of the tax-free returns that qualifying insurance products enjoy under federal income tax laws. There is a death component. However, the main purpose is to serve as a tax-deferred investment vehicle. Death insurance is used to provide financial security for loved ones after the owner passes, with little or no regard for tax and investment benefits.

Using both types of life insurance in estate planning can be a complicated process, but the resulting financial security is well worth the effort, as reported in a recent article “Keeping an Eye on ILITs” from Financial Advisor.

The Irrevocable Life Insurance Trust is a somewhat complex trust structured under state trust law and tax strategies under federal income tax laws. ILITs have been tested in court cases, audits and private letter rulings, so an estate planning attorney can create an ILIT knowing it will serve its intended purpose.

Life insurance in an ILIT is owned outside of the estate and enhances the after-estate tax wealth for the surviving spouse and heirs. Because the trust is irrevocable, the transfer of ownership is permanent.

The annual insurance premium is typically paid by the insured to the ILIT, subject to “Crummey” withdrawal powers, named after a famous case, which gives named people the power to withdraw all or a portion of the contributed premium amounts within specified periods. The time frame depends on the trust—usually it’s 30 or 60 days, but sometimes it’s annually.

There are many nuances and details.  The ILIT lets an insured buy life insurance “outside of their estate” for estate tax purposes, lets the person treat insurance premiums as non-taxable gifts under the annual exclusion provisions and provides safety and security to the beneficiaries.

The ILIT is often used as part of a buy-sell agreement for privately held family businesses to make it possible for the business itself or business partners to buy out the equity of a deceased partner. The payment obligations may be funded by the proceeds from life insurance. In some cases, each partner buys a traditional insurance policy in an ILIT. The estate planning attorney working on a succession plan can provide advice on the most effective way to use the ILIT.

Another use for the ILIT is for wealthy families with illiquid assets, like an art collection or a large real estate portfolio. An ILIT holding a life insurance policy with a death benefit lets the beneficiaries use the proceeds to pay estate tax liabilities, without dipping into their own or the estate’s assets. The investment returns of the ILIT increase the policy owner’s wealth substantially, without increasing their taxable estate.

Reference: Financial Advisor (December 1, 2021) “Keeping an Eye on ILITs”