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Life Insurance Trusts: Why you should consider an Irrevocable Life Insurance Trust

Researcher & Writer
April 01, 2020

Although a life insurance trust is not for everyone, it can be a valuable tool when used correctly. In the following article, we will help shed some light on the process for funding an irrevocable life insurance trust, identify some potential pit falls, and recommend the best type of product. 

Irrevocable Life Insurance Trusts Basics

In general, life insurance will be included in the insured's estate for any of the following: 1) the proceeds are payable to the estate of the insured; 2) the insured maintains "incidents of ownership" in the policy at the time of his or her death; or 3) within a three year period before the insured's death, he or she transferred his or her interest in the insurance policy. The good news is a properly funded ILIT can avoid these potentially catastrophic occurrences.

What is an Irrevocable Life Insurance Trust?

There are two types of trusts: revocable living trusts, also known as inter vivos trusts and irrevocable trusts.

  • Revocable trusts are typically used for estate planning, such as family trusts.
  • Irrevocable trusts are more complex and are typically used for advanced estate planning and business succession.

Four Parties to the Trust

An irrevocable life insurance trust is designed so that the proceeds from a life insurance policy held by the trust can pass to the trust beneficiaries without incurring estate tax.

The insured is typically the creator of the trust.

The creator of the trust is called the Grantor, or the Settlor, or the Trustor.

The trust is administered by the trustee, according to the terms (i.e. instructions) of the trust.

Finally, the beneficiaries are the people or organizations who benefit from the trust.

Why Create an Irrevocable Life Insurance Trust?

Provide for family upon death: One of the quickest and most efficient ways to get money into the hands of your beneficiaries upon death without having to worry about estate tax is through a life insurance trust. The advantage of a life insurance trust is the money will be held separate from your estate for valuation purposes.

For estates in excess of the current 2017 estate tax exemption level of $5,490,000 ($10,980,000 combined), having life insurance available to recoup the 40% estate tax is good planning. And the best part is you control how the money in the trust is distributed through the provisions in the trust.

Provide liquidity to pay debts, taxes, and other expenses: You may have a large estate but often large estates have money tied up in various assets. These assets are not liquid and there may be very little available cash on hand. A life insurance trust provides liquid cash that can be accessed quickly. This can be a huge boon for an estate that has little to no liquidity that would otherwise be forced to sell assets (often at a depressed price due to the urgency) to raise cash.

Business Owners: business owners should consider key man life insurance or buy sell agreements funded with life insurance in order to provide liquidity to a business or provide the necessary funds to allow your business partner(s) to pay your beneficiary for your share of the business. A Business Irrevocable Life Insurance Trust can be used for business continuation purposes. This is typically done where each business owner’s ILIT will own the life insurance policies on the other business owners’ life or lives.

Replace assets gifted to charitable organizations: You may have left a sizable portion of your estate to charitable pursuits. With a life insurance trust you can replace all or a portion of the estate that you gave to charity. Your beneficiaries will be thankful.

How does an Irrevocable Life Insurance Trust work?

The creator of the ILIT, known as the Grantor, may either assign an existing policy to the ILIT or fund the ILIT with cash or property that is used to purchase a new life insurance policy. Which method of funding the trust you choose can be significant due to the three-year rule.

  • Three-year rule: If the Grantor gifts an existing or new policy to the ILIT, then he must live for three years thereafter. Otherwise, if the Grantor dies within the three year period, the funds will be included in his taxable estate.
  • Avoid the three-year rule: Alternatively, if the Grantor transfers property or cash to the trustee of the trust, and the trustee uses the property to purchase a new insurance policy on the life of the Grantor, the three-year rule will typically not apply. This is generally the preferred method.

A trust bank account should be set up. This is especially important in a community property state. The trust bank account should be designated separate property of the Grantor to avoid any problems with commingling of community property funds.

The trustee should be the original applicant and owner of the policy. Therefore, the trustee of the ILIT should be the one to complete the application and acceptance of the policy. The trustee will be the applicant, owner, and beneficiary of the policy. Note: All these steps should be completed AFTER the trust has been created to avoid the three-year rule.

ILIT Mechanics

Once the policy has been approved, future premiums are then paid by the trustee with trust property. Future premium payments are typically made available to the trust by the Grantor. The Grantor typically will gift the necessary funds to the trust, which can then be used by the trustee to pay the premiums.

The most common way a Grantor funds an existing ILIT in order for the trustee to make premium payments is through Crummey Withdrawal Powers.

Crummey Withdrawal Powers:

  • In order to make payments for the life insurance the trust will need to have money available for the premiums. The typical way this is done is through a “Crummey” withdrawal power. A Crummey Power creates an immediate exercisable withdrawal power for the beneficiary.
  • How this looks is the grantor of the trust uses the gift exclusion ($14,000 in 2015) to give a gift to the beneficiary of the trust. The beneficiary will receive written notice (that should be acknowledged in writing by the beneficiary) alerting him or her that they have a withdrawal right, the expiration of the withdrawal right, and how to use the withdrawal right. If the beneficiary does not claim the gift within a certain period of time, typically 30-60 days, the gift will lapse. The trustee of the ILIT will then be able to use the funds in the trust to pay the annual premium on the life insurance policy.
  • Upon the death of the grantor, the insurance carrier pays the trustee the proceeds from the policy. The proceeds are then used by the trustee for the benefit of the trust beneficiaries, in accordance with the terms of the trust.
  • If the deceased-insured’s estate needs more liquidity (i.e. cash) to pay taxes, debts, expenses, etc.…, the trustee may use the life insurance proceeds to either purchase assets from the deceased’s estate or the trustee may loan money from the trust to the estate.

Split-Dollar Life Insurance:

  • One strategy for funding an ILIT is using a private split-dollar life insurance arrangement. The policy premiums are paid by the grantor/insured and the policy is owned by the ILIT. The life insurance in the trust is collaterally assigned to the grantor. As a result of the collateral assignment, the insured/grantor is repaid the premium paid into the policy upon his or her death. There are two specific regimes employed in Split-Dollar insurance: economic benefit regime and loan regime.
  • Under the economic benefit regime, the split dollar life insurance agreement requires the ILIT trustee to make yearly payments equal to an IRS formula that determines the economic benefit. The creator of the ILIT, typically the insured, provides cash to the ILIT each year. After the Crummey withdrawal right timeline for the beneficiaries has passed, the trustee would use the cash from the insured to pay the carrier.
  • Under the loan regime, the annual loan interest is used to determine the amount of gift to the creator of the trust gives to the ILIT. Once again, after the Crummey withdrawal right timeline for the beneficiaries has passed, the trustee would use the cash from the insured to pay the carrier.
  • The key under both regimes is to structure the gift to the ILIT so that it is considered a present gift and not considered a future interest gift. A future interest gift is not excludable from the annual gift tax exclusion.
  • If the policy is taken out by the parents for the benefit of the children, a great way to accomplish this is with survivorship life insurance. Survivorship coverage insures both parents. The policy pays out when the surviving spouse dies. Because it does not pay out until both die it is a less expensive permanent coverage option.
  • Split-Dollar life insurance arrangements are complex. If you are interested in more information please call or email us and we will be happy to answer any questions you might have. You should also consult with an experienced estate planning attorney before proceeding.

Some ILIT pitfalls to avoid

  • Avoid "incidents of ownership": It is imperative that the Grantor of the trust avoid “incidents of ownership”. Some common areas that pose a problem is when the Grantor retains control of the trust or when the Grantor is also trustee of the trust. If there are incidents of ownership then the life insurance will be included in the Grantor’s estate and frustrate the purpose (i.e. to avoid estate tax) of the life insurance trust.
  • Avoid contributing community property: Using community property funds may jeopardize the estate tax results. In community property states it is important that an ILIT that has the grantor’s spouse as a beneficiary not use community property to contribute to the trust. The trust should clarify that contributions are only the Grantor’s separate property in order to avoid the spouse-beneficiary retaining an interest in the trust property.
  • Avoid using just any trustee: Who you choose as the trustee of your ILIT is paramount. You need someone you can trust and you need someone that is responsible. In many instances, the best choice for a trustee of an ILIT is a professional fiduciary.
  • Avoid Making Gifts of a Future Interest: Gifts of a future interest cannot be excluded and count against your lifetime exclusion.

What type of product should be used to fund an Irrevocable Life Insurance Trust?

When considering the type of life insurance to use to fund an ILIT it is important to consider “what is the primary goal of the trust?” Since the primary goal tends to primarily be that the trust has money to pay debts, expenses, and any taxes, it is important to choose a permanent life insurance policy that will last until the inevitable day you die.

There are two main categories of life insurance: term and permanent. You can read about term life versus permanent life insurance to help you make a decision. But in order to save you time we would be remiss not to stress the importance of funding an irrevocable life insurance trust with some type of permanent policy.

The problem with level term life insurance when funding an ILIT is that the policy will come to an end. And while there are some companies that allow the policy to continue after expiration for little to no increase in premium, the face amount of the policy will typically decline year over year. Therefore, if you do not die during the initial term of the policy, you will typically have no life insurance, not have enough life insurance, or pay way too much for the life insurance.

The good news is there is an inexpensive alternative.

Guaranteed Universal Life (GUL)

A guaranteed universal life insurance policy is a permanent policy that is structured to minimize costs in order to provide the lowest priced permanent coverage. There are no bells and whistles with this type of life insurance. Typically, premiums are fixed for the life of the policy, which can go until age 90, 95, 100, or 121. With people living longer than ever, the only “guaranteed” way to make sure your policy lasts as long as you do is to make sure you purchase guaranteed universal life insurance to age 121.

The main advantage to a GUL compared with whole life insurance, indexed universal life, or variable life insurance is that the GUL is less expensive and has a fixed premium. This is typically a relief for those creating ILITs because it takes a lot of the worry out of the process.

If there is a disadvantage to a GUL it is in the fact that a GUL builds little to no cash value. But since borrowing from the policy is not the primary reason for the insurance, this tends to not be a deciding factor when choosing the type of life insurance for the ILIT.

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