04.06.2015

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Updates

Creating an Irrevocable Life Insurance Trust (ILIT) can dramatically increase the liquidity of an individual’s estate and effectively leverage the value of the annual $14,000 per donee gift tax exclusion and the $5,430,000 generation-skipping transfer tax (GSTT) exemption for U.S. persons. (The annual exclusion is $14,000 in 2015. The GSTT exemption is $5,430,000 in 2015) In short, ILITs often provide an outstanding way for U.S. persons to achieve multiple estate planning goals – including substantial estate tax and GSTT savings. The following discussion provides an introduction to ILITs and the ways in which they can help preserve the estates of clients in a wide range of situations.

In simplest terms, an ILIT is an irrevocable trust, the trustee of which will own and be the beneficiary of policies on the life of the creator of the trust (the "grantor"). Married couples often create ILITs to hold "second-to-die" policies, the proceeds of which are payable on the death of the survivor. In order to succeed in passing the insurance proceeds free of estate tax, the grantor cannot serve as trustee and cannot retain any power to revoke or amend the trust or otherwise affect the policy. The grantor usually makes annual gifts of cash to the trust that the trustee uses to pay the premiums on the policy. An ILIT is usually structured so those gifts qualify for the annual $14,000 per donee gift tax exclusion. Note that an ILIT can hold any type of life insurance, including employer-provided term insurance if the insurance plan permits assignment of the policy.

Who Should Consider an ILIT?

ILITs are most often suitable for individuals or couples whose estates are likely to be subject to a heavy estate tax hit. In 2015, a U.S. person can pass up to $5,430,000 free of the U.S. estate tax. ILITs may be appropriate for those whose assets, including life insurance, will be significantly larger than the exempt amounts. An ILIT is useful primarily for two reasons. First, the proceeds of policies acquired by an ILIT are not included in the grantor's estate. Second, an ILIT can provide liquidity for those who wish to make it possible for their survivors to preserve a closely held business or other unique asset that might otherwise have to be liquidated to pay estate taxes and expenses. Another advantage is that the proceeds of life insurance are generally not subject to the federal income tax. ILITs are appropriate for individuals and couples who will not need to have access to the cash value of insurance policies to meet lifetime needs.

How an ILIT Is Created and How an ILIT Operates

Most ILITs are created by a parent (or parents) in order to provide for children and grandchildren. The grantor initially funds the ILIT with cash that the trustee uses to pay the first annual premium on a new policy on the life of the grantor. As indicated above, ILITs are usually drafted so that gifts to the trust qualify for the annual $14,000 gift tax exclusion that is allowable for each beneficiary of the trust. The policy is applied for and acquired by the trustee, who is both the owner of the policy and its designated beneficiary. In each subsequent year, the grantor transfers additional funds to the trustee to pay the annual premium. The later transfers can also qualify for the annual gift tax exclusions.

Under a slightly different approach, an existing life insurance policy may be transferred to an ILIT. However, the estate tax saving is lost if the grantor-insured does not live for more than three years following the transfer. The proceeds of a policy owned by an ILIT are included in the grantor-insured's estate if he or she retained any incident of ownership in the policy (e.g., the right to borrow against the policy, recover its cash reserves or change the beneficiary). If the grantor-insured did not retain any incident of ownership in the policy, the insurance proceeds are received by the trustee free of estate and income taxes. (As noted above, if the insured dies within three years of transferring a policy to an ILIT, the proceeds are includible in the insured’s estate for tax purposes.)

Insured Cannot Serve as Trustee of an ILIT

The estate tax benefit of an ILIT is lost if the grantor-insured serves as its trustee. If the trust owns a policy on both a husband and wife (so-called "joint" or "second-to-die" insurance), neither spouse can serve as trustee. Subject to other planning considerations, any other individual or a corporate fiduciary may serve as trustee.

Payment of Insurance Premiums

In most cases, the grantor each year transfers enough cash to the trust to pay the annual premium. As indicated above, an ILIT can be drafted so that the annual contributions to the trust qualify for the annual gift tax exclusion. The annual exclusion is allowed if the beneficiaries (typically the children) are given the noncumulative right to withdraw the annual contribution to the trust during a limited period of time (usually 30 days) after they receive notice of the contribution. The power of withdrawal lapses if not exercised during the withdrawal period. Such a power, known as a "Crummey Power," after the name of the tax case that upheld the tax benefit, qualifies contributions to the trust for the annual gift tax exclusion. Although the grantor cannot legally prevent the beneficiaries from exercising the power, the power is almost never exercised by a beneficiary because of the greater benefits to be achieved from the policy.

Estate Tax Advantages of an ILIT

The proceeds of life insurance policies owned by an ILIT are generally not included in the estate of the insured grantor. The potential of the exclusion is illustrated by the following example:

An unmarried person (A) owns property worth about $7,000,000. Even allowing for A’s right to transfer $5,430,000 free of U.S. estate tax, if A were to die in 2015, A’s estate would owe about $630,000 in U.S. estate tax. If A buys a $1,000,000 policy in order to fund the payment of the tax, his estate will be increased to $8,000,000, on which about $400,000 in additional tax would be due (a total of $1,030,000). A's family would receive a net of about $6,970,000.

If A instead creates an ILIT that buys a $1,000,000 policy on A’s life which has an annual premium of $28,000, the proceeds of the policy will not be includible in A’s estate. If two or more beneficiaries of the ILIT hold Crummey Powers of withdrawal, A’s annual contribution of $28,000 to the trust will not generate any gift tax liability or result in the loss of any gift exemption.

By establishing the ILIT, A can create the liquidity necessary to pay the estate tax without having to pay any gift tax. Under this scenario, A's family would receive a net of about $7,370,000 ($400,000 more than if the insurance proceeds are included in A's gross estate).

Life Insurance Held by an ILIT Also Has an Income Tax Advantage

The buildup of cash value within a policy owned by the trustee of an ILIT is wholly free from income tax. Even more important, the life insurance proceeds ultimately received by the trustee of the ILIT are not subject to the federal income tax.

ILITs Can Hold a Policy Insuring the Joint Lives of a Married Couple

Because of the unlimited marital deduction, the estates of most couples are planned so that no estate tax is payable on the death of the first to die. Instead, the obligation to pay any estate tax is deferred until the death of the surviving spouse. The annual premium on a joint or second-to-die insurance policy is much lower than it would be if the life of each spouse were separately insured. In short, an ILIT can provide an economical way to provide tax-free funds to pay the estate tax due on the death of the surviving spouse.

ILITs Can Also Leverage the Generation-Skipping Transfer Tax Exemption

Outright gifts from a grandparent to a grandchild can be subject to a combined GSTT and gift tax cost of up to 58 percent. Fortunately, however, each grandparent has a substantial GSTT exemption ($5,430,000 in 2015) that can be applied to insulate the transfer to grandchildren from the tax. Importantly, the benefit of the exemption is amplified if gifts to grandchildren are funneled through an ILIT. The possibility of sheltering far more than $5,430,000 in insurance proceeds from the GSTT exists because the exemption need only be applied against the annual transfers that are made to pay the premiums and not to the far greater value of the ultimate insurance proceeds.

© 2015 Perkins Coie LLP