The primary role of life insurance in estate planning is to provide cash at the death of the insured in order to provide for survivor lost income, to provide for a cash inheritance and to provide for the payment of expenses of the estate of the deceased insured, including the payment of taxes at death. The Irrevocable Life Insurance Trust (“ILIT”) is a legal entity which created inter vivos which allows the insured to set aside assets, usually insurance policies, which are potentially shielded from estate taxes while making the assets available to family members immediately after the death of the insured. The benefit of having the ILIT is the payment of estate settlement expenses and inheritance estate tax free. In exchange for this benefit, the insured must surrender control over the insurance and any other assets held in the trust.
- Irrevocability – The ILIT must be irrevocable when created. Retaining the right to exercise any control over the assets held in the trust will cause the trust property to be included in your estate and subject to estate tax. Furthermore, the terms of the trust and the beneficiary designations must also be irrevocable. This is an important distinction in contrast to the Revocable Living Trust where a grantor always has the right to terminate, change or revoke any or all provisions of the trust.
- Payments of Premium; Crummy Powers – The trustee, in order to make the required premium payment to the insurance company in order to keep the policy in force, will usually receive gifts from the insured or the insured’s spouse. The whole concept of the “gifts” to the trust is to qualify the payments for the gift tax annual exclusion. Normally, a premium payment from the insured or the insured’s spouse is deemed to be a gift of a “future interest” because the trust beneficiaries do not possess a present right to receive benefits during the lifetime of the insured. The gift tax annual exclusion is only permitted for “present interest” gifts. However, if the beneficiaries are given “Crummy Powers”, that is, the right of a beneficiary to request the trustee to distribute premium payment gifts of a “present interest” to them currently, the premium gifts made to the trust are considered gifts of a present interest, qualify for the gift tax annual exclusion of $14,000 for each trust beneficiary or $28,000 per beneficiary with the consent of the insured and his or her spouse.
- Limiting Right of Withdrawal – Under Section 2514(e) of the Internal Revenue Code (“IRC”), the right of withdrawal for each beneficiary must be limited to the greater of $5,000 or 5% of the trust corpus. This limit is necessary so that the withdrawal beneficiaries will not be deemed to have made a gift to the other trust beneficiaries when the power of the withdrawal beneficiary lapses. In the case of only one trust beneficiary, the limitation is not a concern since a failure to exercise the withdrawal power will not result in a transfer to anyone other than the beneficiary who failed to exercise the withdrawal right. Accordingly, the sole beneficiary can be given a withdrawal right equal to $14,000.
- Trustees – A major objective of the trust is to avoid having the trust assets included in the estate of the Grantor or the Grantor’s spouse. Accordingly, the Grantor cannot act as the trustee since the Grantor would retain rights over the transferred property which would cause inclusion in the Grantor’s estate. However, to ensure some limited control over administration of the trust assets, the Grantor’s spouse can be appointed as the trustee. However, a trust must be drafted in order to having the Grantor’s spouse as the owner of the trust. Consequently, the trust must restrict the spouse-trustee’s powers by eliminating any general power of appointment as defined under IRC Section 2041. In doing so, the trust also eliminates the powers under IRC Section 678 that would cause income inclusion to the Grantor’s spouse. Consequently, a Co-Trustee must be named to exercise discretionary powers not available to the Grantor’s spouse. There is no limitation on how many trustees may be appointed.
- Administration of the Trust; Taxes; Fees – Once the trust is set up, the trustee can purchase additional life insurance for the insured without having the insurance subject to the 3-year transfer rule. The trustee accounts to the beneficiaries, usually at quarterly internals, distributes income (and any principal) at least quarterly to the named beneficiary, usually the surviving spouse and prepares or causes to prepare Fiduciary Income Tax Returns on Form 1041 if the trust has taxable income in any year. The trust has its own Employer Identification Number issued to it by the Internal Revenue Service. The trustee has broad powers to administer the trust and has the ability to do whatever it takes to carry out its duties as a fiduciary. A trustee has the right to statutory fees based on income and corpus.
- Spendthrift Provisions – The assets of the trust are usually insulated from attack by creditors. A “Spendthrift Clause” in the trust is incorporated to protect a beneficiary from his or her own acts or indiscretions. This includes the sale or assignment of an interest in the trust to be established for his or her benefit. The clause will usually protect beneficiaries from creditors in the event of a business failure or an aggrieved spouse in a divorce proceeding.
- Execution of Trust – There are no set rules which govern the execution of an irrevocable trust agreement under state law. Accordingly, once the agreement is drafted and is ready for execution, an attorney may want, but is not required, to have it witnessed in the same formality as one would have a will executed.
- Post-Execution – The attorney must advise the client to execute change of ownership forms with the insurance company who has issued the policy if existing policies are to be transferred into the trust. An attorney must review with the client which policies are in force, how to set up the checking account for the trustee, the mechanics of paying the premium and providing advice on how to give notice to beneficiaries each year with respect to the “Crummy Powers.” Merely setting up a trust for a client and not advising with respect to the mechanics of transferring existing policies or instructions on what the trustee should do in purchasing new insurance for the client could lead to a malpractice action against the attorney.