Continuing with my previous posting, this post will cover the general requirements of an irrevocable life insurance trust ("ILIT.")
What is an ILIT?
An ILIT is a trust primarily set up to hold one or more life insurance policies. The ILIT is a taxable entity that must file its own separate tax returns each year. However, the returns are generally simple and can be handled easily by an accountant. The main purpose of an ILIT is to avoid federal estate tax on life insurance proceeds / death benefits paid on a life insurance policy. If the trust is drafted and funded properly, your loved ones should receive all of your life insurance proceeds, undiminished by estate tax. Caution: Because an ILIT must be irrevocable, once you sign the trust agreement, you can't change your mind; you can't end the trust or change its terms.
How an ILIT works
Because an ILIT is an irrevocable trust, it is considered a separate entity. If your life insurance policy is held by the ILIT, you don't own the policy--the trust does. You name the ILIT as the beneficiary of your life insurance policy. (Your family will ultimately receive the proceeds because they will be the named beneficiaries of the ILIT.) This way, there is no danger that the proceeds will end up in your estate. This could happen, for example, if the named beneficiary of your policy was an individual who dies, and then you die before you have a chance to name another beneficiary. Because you don't own the policy and your estate will not be the beneficiary of the proceeds, your life insurance will escape estate taxation.
Creating an ILIT
Your first step is to have an attorney draft and execute an ILIT agreement. Because precise drafting is essential, you should hire an experienced attorney in these matters. Although you'll have to pay the attorney's fee, the potential estate tax savings should more than outweigh this cost.
Naming the Trustee
The trustee is the person who is responsible for administering the trust. You should select the trustee carefully. Neither you nor your spouse should act as trustee, as this might result in the life insurance proceeds being drawn back into your estate. None of the beneficiaries of the ILIT should be trustees either, due to potential conflicts of interest and related issues. Select someone who can understand the purpose of the trust, and who is willing and able to perform the trustee's duties. A professional trustee, such as a bank or trust company, may be a good choice.
Funding an ILIT
An ILIT can be funded in one of two ways:
1. Transfer an existing policy --You can transfer your existing policy to the trust, but be forewarned that under federal tax rules, you'll have to wait three years for the ILIT to be effective. This means that if you die within three years of the transfer, the proceeds will be subject to estate tax. Your age and health should be considered when deciding whether to take this risk.
2. Buy a new policy --To avoid the three-year rule explained above, you can have the trustee, on behalf of the trust, buy a new policy on your life. You can't make this purchase yourself; you must transfer money to the trust and let the trustee pay the initial premium. Then, as future annual premiums come due, you continue to make transfers to the trust, and the trustee continues to make the payments to the insurance company to keep the policy in force.
Gift Tax Consequences
Because an ILIT is irrevocable, any cash transfers you make to the trust are considered taxable gifts. However, if the trust is created and administered appropriately, transfers of $13,000 per person per year (2011 figure) or less per trust beneficiary will be free from federal gift tax under the annual gift tax exclusion. Additionally, just as each of us has a lifetime estate tax exemption, we also have a lifetime gift tax exemption, so transfers that do not fall under the annual gift tax exclusion will be free from gift tax to the extent of your available exemption.
Crummey Withdrawal Rights
Generally, a gift must be a present interest gift in order to qualify for the $13,000 annual gift tax exclusion. Gifts made to an irrevocable trust, like an ILIT, are usually considered gifts of future interests and do not qualify for the exclusion unless they fall within an exception. One such exception is when the trust beneficiaries are given the right to demand, for a limited period of time, any amounts transferred to the trust. This is referred to as Crummey withdrawal rights or powers. To qualify your cash transfers to the ILIT for the annual gift tax exclusion, you must give the trust beneficiaries this right. The trust beneficiaries must also be given actual written notice of their rights to withdraw whenever you transfer funds to the ILIT, and they must be given reasonable time to exercise their rights (30 to 60 days is typical.) It is the duty of the trustee to provide notice to each beneficiary. Assuming the beneficiaries do not elect to take the funds, and the policies stay in effect, the ILIT works as intended. This is a big assumption, so it is important to have all beneficiaries "on board" when doing this type of planning and understand the ramifications.
Every person’s estate planning – especially with the use of an ILIT – is different. Accordingly, it is imperative to talk with an expert in these matters when using an ILIT. It is also imperative to follow the rules specific to your situation, using the proper professionals. Moreover, it is important to check your state rules as well: in some states life insurance proceeds is also subject to state estate tax in addition to federal estate tax.
ILITs are great tools, but also have definite requirements and associated responsibilities.
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Required Disclosure Pursuant to IRS Circular 230: Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code; or (2) promoting, marketing or recommending to another party any transaction or matter addressed in this communication.