Life insurance plays a unique role in estate planning. It can help provide liquidity to pay estate taxes and expenses of administration, replace earnings in the event of death, equalize inheritances among heirs, and fund the transfer of a family business. When life insurance is needed, an Irrevocable Life Insurance Trust (ILIT) offers both tax and non-tax advantages that are not available with outright policy ownership by an individual.
1. What is an ILIT?
An ILIT is an irrevocable trust that contains provisions specifically designed to facilitate the ownership of one or more life insurance policies. Typically, the ILIT is created by the insured (known as the grantor of the ILIT) and is both the owner and beneficiary of the life insurance policies. If the trust is structured and managed properly, the life insurance death benefit received by the ILIT will not be subject to income tax or estate tax upon the death of the insured or the insured’s spouse. [1] During the grantor’s life, the trustee will hold certain powers, often including the ability to make distributions to the trust beneficiaries. Upon the grantor’s death, distributions from the trust to the beneficiaries will be made according to the trust terms.
2. Who can serve as an ILIT trustee?
The trustee of an ILIT can generally be anyone other than the insured, although naming an "independent trustee" may offer greater flexibility for estate planning. If a trust beneficiary is also a trustee, distributions should generally be subject to an "ascertainable standard," such as health, education, maintenance, and support.
3. How is an ILIT typically funded?
After an ILIT is drafted and executed, it must be funded to have the ability
to purchase life insurance. ILIT funding is typically done through one of the following:
basic gifting;
financing techniques and/or loan arrangements; or
sophisticated estate planning techniques.
Financing arrangements and sophisticated estate planning techniques are beyond the scope of this piece. Gifting cash or other assets to an ILIT is a common and a simple funding method.
Each person subject to US federal gift and estate taxation has the ability to give away a certain amount of property, during life or at death, without incurring any gift, estate, or generation skipping transfer (GST) taxes. These amounts are commonly referred to as the exemption amounts — one for gift and estate taxes (the "lifetime" exemption) and another for GST taxes. Only gifts made in excess of these exemptions are taxable. Under current law, the lifetime exemption is $10 million, indexed for inflation each year ($12.92 million in 2023) [2]; this amount is scheduled to revert to $5 million (indexed for inflation) after 2025.
In addition to lifetime exemption gifts, every individual has the ability to gift up to $17,000 (in 2023; indexed for inflation annually) to another individual each year without incurring any gift taxes, known as the annual exclusion. This gift is neither taxed nor subtracted from their lifetime exemption. The annual exclusion represents a very valuable opportunity to gift property to a trust, because the donor can make annual gifts to each beneficiary of a trust.
4. What is a "present interest gift" and how do Crummey withdrawal powers work?
For a gift to qualify as an annual exclusion gift, there must be a transfer of a "present interest" in the property. A transfer is of a present interest if there is an unrestricted right to the immediate use, possession, and enjoyment of property, or the income from property. [3] Contributions to an ILIT typically can qualify as a present interest gift (and thus avoid or partially avoid gift tax) if the beneficiaries possess a power to withdraw the contributions for a limited period of time. These withdrawal powers, called "Crummey" powers, cause the contributions to be present interests and thus qualify for the annual exclusion from gift tax. [4] ILITs almost always include Crummey powers for the primary beneficiaries of the trust, such as the grantor’s children, and may sometimes be referred to as "Crummey Trusts."
5. Can a contingent beneficiary be a Crummey beneficiary?
Possibly. A "Cristofani Trust" is the name for an ILIT that gives Crummey powers to the primary beneficiaries of the trust as well as the contingent or secondary beneficiaries of the trust (the grantor’s grandchildren or other relatives such as nephews/nieces or children’s spouses). A Cristofani Trust can be used in some cases when a trust is purchasing a large life insurance policy and the grantor needs additional annual exclusions to fund the trust. [5] However, trust beneficiaries who receive withdrawal powers should have at least a contingent interest in the ILIT and all Crummey beneficiaries should receive actual notice of their withdrawal powers. [6]
6. What special provisions can be added to an ILIT?
There are several different types of drafting provisions and language that may be added to an ILIT depending on the planning needs and preferences of the grantor and their family. A given ILIT may contain special language, also making it one or more of the following:
Spousal Lifetime Access Trust (SLAT)
A SLAT is an irrevocable trust that gives the trustee the ability to make distributions to the grantor’s spouse at any time during the lifetime of the spouse. A SLAT can provide the non-grantor spouse and children with access to trust assets without subjecting them to estate taxation in the estate of either spouse. ILITs with SLAT provisions provide an enhanced level of control and flexibility over the assets because the trustee can make distributions to the spouse should the spouse need access to the trust funds.
Dynasty Trust
A dynasty trust is a long-term trust created to maximize the transfer of wealth from generation to generation while minimizing (or eliminating) the impact of the GST and estate taxes. When an ILIT contains dynasty trust provisions, it may last for many generations, rather than terminating after the death of the grantor or the grantor’s children, like a traditional ILIT. Dynasty trust language can give each generation access to trust assets (such as for health, education, maintenance, and support), while keeping the remaining trust assets outside of the beneficiaries’ taxable estates and exempt from GST tax for as long as state law permits. [7]
Grantor Trust
Every trust has a "grantor," but not every trust is a grantor trust. A specific type of grantor trust – commonly referred to as an "intentionally defective grantor trust" (IDGT) – is an irrevocable trust that contains certain provisions or powers that cause the grantor of the trust to be treated as the owner of the trust assets, but only for income tax purposes. [8] For estate tax purposes, assets held inside the trust remain outside of the grantor’s taxable estate. Consequently, the trust is referred to as being "defective" because the grantor must pay all income taxes associated with trust assets despite the fact that the grantor does not actually own or control these assets. A grantor trust can be an attractive vehicle to fund with income producing assets such as stock or real estate, in addition to a life insurance policy, because the income generated by the assets will be taxed at the grantor’s income tax rate. Moreover, because the trust income is attributed to the grantor individually, rather than to the trust, no trust assets need to be spent to pay income taxes, which can allow them to grow more rapidly inside of the trust.
7. What is a credit shelter trust and can a credit shelter trust own life insurance?
A credit shelter trust, also known as a bypass or family trust, receives a decedent’s remaining applicable exclusion amount at death. The trust is outside of the taxable estate and will typically pass to the grantor’s children and grandchildren free from estate and gift taxes.
The assets inside the credit shelter trust can often be used to purchase life insurance on the surviving spouse (as an alternative to an ILIT), or the credit shelter trust assets can be leveraged by making a loan to an ILIT to fund life insurance premiums. If the credit shelter trust owns insurance on the surviving spouse, caution must be taken to ensure the insurance will not be includible in the spouse’s estate. For example, the insured/surviving spouse may not serve as trustee and must not hold a limited power of appointment. [9]
8. What are some of the key benefits of an ILIT?
Liquidity for estate taxes and other expenses — ILITs provide liquidity outside the insured’s taxable estate for the payment of estate taxes, debts, and expenses of administration.
Equalization of inheritances/transfer of a family business — ILITs create a pool of assets to enable an insured to equalize inheritances when the insured would like to pass a single asset (such as a family business or farm) to one child yet leave equal value to other children.
Creditor protection — Life insurance proceeds received by an ILIT are typically protected from creditors of the ILIT beneficiaries until the ILIT beneficiaries actually receive the trust proceeds.
Asset management vehicle — An ILIT can provide for the effective management of insurance proceeds after the insured’s death. By using a trusted professional, bank, trust company, or appointed family member as trustee (or co-trustee) of the ILIT, the insured will know that the insurance proceeds will be properly managed.
Enhanced control — The trust structure allows the grantor to maintain some level of control "beyond the grave" by giving them the ability to determine how and when the death benefit and other trust assets will be distributed among beneficiaries.
This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.
1. Whether the proceeds of a life insurance contract are included in the gross estate of the insured depends upon whether, at the time of death (or within the three-year period prior to death), the insured held any “incidents of ownership” with respect to the policy. IRC §§2042 and 2035(d)(2).
2. The maximum estate tax rate is 40%. Under the Tax Cuts and Jobs Act of 2017, the $10 million lifetime exemption (indexed for inflation) is scheduled to revert to a $5 million exemption (indexed for inflation) after December 31, 2025. The IRS clarified in 2018 that there will be no "clawback" of unified credit used before 2026. In addition, if an individual passes away with an unused amount of exemption remaining, that individual’s surviving spouse can use the unused amount to shelter a transfer from either gift or estate taxes.
3. §25.2503-3(b).
4. These powers are known as "Crummey" powers, named after the taxpayer in the case of Crummey v. Commissioner. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968) and Internal Revenue Code Section 2503(b). For a Spousal Lifetime Access Trust, the beneficiary spouse should not be given Crummey rights of withdrawal. In addition, in
a community property state, the grantor spouse should create a separate property agreement and the premium gifts to the ILIT should be funded from separate property. See Treas. Reg. §20.2042-1(b)(2).
5. See Cristofani v. Commissioner, 97 T.C. 74 (1991) and Kohlsaat v. Commissioner, T.C. Memo 1997-212. In Cristofani, the court stated that the Crummey beneficiaries did not have to have a vested present interest or vested remainder interest in the trust to qualify for the annual exclusion.
6. It is customary for the Crummey withdrawal period to last 30 days. There should never be an explicit understanding among family members that a withdrawal power will not be exercised, otherwise the IRS may disallow the use of the annual exclusion.
7. Over 20 states have abolished the common law "rule against perpetuities," which traditionally limited the duration of trusts. Consult your attorney to determine the law for your state.
8. The grantor trust takes advantage of the differences between the estate tax rules of IRC §§2036-2042 and the grantor trust income tax rules of IRC §§671-678.
9. Clients should work with legal counsel to determine if an existing credit shelter trust is suitable to own life insurance on a surviving spouse.