An Irrevocable Life Insurance Trust (ILIT) is an irrevocable trust established in order to own life insurance on the life of the settlor of the ILIT. Normally, the proceeds of the life insurance policies on an individual’s life are includable in that person’s gross estate when a person dies. If the ILIT owns the policy and the settlor holds no incidents of ownership, the proceeds of the life insurance policy are not includable in the settlor’s estate. The reason for this is because the ILIT is a separate entity from the settlor.
The two most common ways for the ILIT to become the owner of a life insurance policy is for the ILIT to purchase a policy on the settlor’s life or for the settlor to gift a policy to the ILIT. The preferred method is for the ILIT to purchase the policy because if the settlor dies within three years of making a gift of the policy to the ILIT, the insurance proceeds are includable in the settlor’s estate. One common solution is to obtain a three year term policy to protect against this contingency.
An ILIT is an irrevocable trust and the settlor must be careful to not retain any incidents of ownership. This means that the settlor cannot change the beneficiaries of the trust nor change the beneficiary of the policy, borrow against cash value or participate in any decision affecting the policy. All decisions regarding the administration of the ILIT are to be made by the trustee without the settlor’s input. However, the ILIT is set up as a grantor trust which means that any income earned by the trust during the settlor’s lifetime is taxable to the settlor and must be included on the settlor’s income tax return.
The settlor should make a cash donation to the trust along with the gift of the life insurance policy. I recommend that this gift be an amount in excess of the first year’s premium payment. The trustee will need to continue to make future contributions in order for the trust to have funds sufficient to pay the premiums on the policy. These future contributions should not be in the exact amount of the premium payments and not made only when the premium payments are due. Additionally, the settlor must be careful that the payments due not include directions or notations that could be interpreted as a direction to the trustee to use these funds to pay the insurance premiums. It is important to follow these rules to avoid the IRS claiming that the trustee was merely the settlor’s agent which may lead to the proceeds of the policy being included in the settlor’s estate.
The contributions from the settlor to the ILIT are taxable gifts. Every person is allowed to make annual gifts up to the annual exclusion amount which will not count against the gift tax exemption ($11.2 million in 2018). The annual exclusion is set at $15,000 for 2018 and is per donee. However, in order for the gift to qualify for the annual exclusion it must be presently available to the beneficiary. The trustee must advise the beneficiaries of each contribution from the settlor to the ILIT and allow the beneficiary the opportunity to withdraw the contribution. The power of withdrawal is known as a Crummey power and is necessary for the contribution to qualify for the annual exclusion.
A quick listing of additional instructions to serve as the trustee of an ILIT follows below:
- All decisions and actions regarding the ILIT must be made by the trustee, not the settlor;
- When acting as trustee, make sure you make it clear you are acting in the role by identifying yourself as trustee and adding “as trustee” to your signature;
- Do not commingle funds of the ILIT account and your personal funds;
- Do not make payments for ILIT expenses from your personal funds;
- Keep records of all ILIT transactions and copies of all ILIT bank accounts;
- Use the EIN number, not your social security number, when acting on behalf of the ILIT;
- Maintain sufficient funds in the ILIT to pay the beneficiaries in the event they exercise their right to withdrawal; and
- Give notice to the beneficiaries when contributions are made to the ILIT.
The above is only a partial listing of guidelines for the trustee to follow. It is imperative that the trustee seek and receive assistance from an estate planning attorney if any questions arise.