Federal Gift and Estate Tax Planning- Part 3 of 7: Advanced Planning with ILITs

Creating and Irrevocable Life Insurance Trust aka ILIT

The first advance planning technique I will discuss in this series of blogs and one of the simplest strategies is to have a life insurance policy held by an Irrevocable Life Insurance Trust aka an “ILIT.”  While this strategy does not reduce the size of an individual’s taxable estate or estate taxes per se, it creates untaxed liquidity outside of their taxable estate to pay the taxes which may be due on the individual’s taxable estate. One question clients may have is why holding life insurance individually does not serve this same purpose?  While there are many great reasons to hold life insurance, including providing a benefit to the beneficiaries which is generally not subject to income taxes, estate tax planning is not one. Section 2042(2) of the Internal Revenue Code provides that an individual’s gross taxable estate includes life insurance payable to beneficiaries if the decedent possessed incidents of ownership in such policy. Therefore, life insurance in and of itself increases one’s taxable estate and the death benefit itself is subject to estate tax.  However, with an ILIT, one establishes a trust to own a life insurance policy with themself as the insured.  The trust is typically the beneficiary of the policy and the trustee, who is different from the insured, holds legal title to the policy and pays the premium.  Essentially, the individual releases any incidents of ownership in the policy which would cause the death benefit to be included in their gross taxable estate. Accordingly, the death benefit does not increase the value of the individual’s taxable estate and is thus not subject to estate tax and, therefore, the full value of the death benefit can be used to purchase assets from the estate to create liquidity, loan money to the estate, or make distributions to the beneficiaries undiminished by estate tax.     

Once an ILIT has been established an individual can either transfer an existing policy to the trust or the individual can fund the trust with enough cash to pay the premiums and the trust itself can purchase the policy.  In the latter, an individual can use their annual gift tax exclusion to fund the trust with enough cash to pay the premiums and avoid using any of their basic exclusion. While the annual gift tax exclusion is generally not available for transfers to a trust, a “Crummey” limited withdrawal power can be written into the trust.  If the proper formalities are taken to legitimize the Crummey power for the beneficiaries of the trust, the transfers to the ILIT can be eligible for the annual gift tax exclusion. 

When transferring an existing life insurance policy to an ILIT, the taxpayer must live for 3 years thereafter to avoid the death benefit being included in their gross taxable estate due to the three-year rule in Section 2035 of the Internal Revenue Code. Therefore, in most situations, creating an ILIT and having the trustee purchase the policy is preferred to transferring an existing policy to an ILIT.

An ILIT is an easy to establish mechanism to reduce the burden of unavoidable estate taxes. An ILIT can be especially useful in cases where an individual’s estate is anticipated to consist of valuable but illiquid or difficult to sell assets such as qualified retirement accounts, real estate, or business interests, because selling assets of this kind to pay estate taxes potentially creates additional tax consequences. For traditional IRAs or 401(k)s, income tax is due on top of estate taxation if the retirement account funds must be withdrawn immediately to pay estate taxes.  For real estate and business interests, capital gains taxation may be due upon sale if the assets have appreciated since date of death or were not eligible for a step-up in basis at death. Additionally, closely-held business interest are often unmarketable or difficult to sell.

To learn more about estate tax planning, contact our office.

Estate Planning & Admin