For some agents, the irrevocable life insurance trust (ILIT) is part of their everyday vocabulary and standard operating procedure. For others, it’s the mythical unicorn they’ve heard of but never seen. And yet for others, it’s a mystery, if they’ve heard of it at all. Following are basics to help the estate planning newcomer understand ILITs, and some suggestions for more experienced agents.
The basics
We all know life insurance is income tax-free if properly structured. If life insurance is owned by an individual, it is part of their estate. This can present problems if, for example, the owner and their beneficiary (such as their spouse) die at the same time or if the owner dies with a substantial estate.
These problems can be mitigated, however, by either starting a new policy inside of an ILIT or transferring an existing policy into the trust.
If the policy was individually owned by the insured and then transferred into a trust, it was “polluted,” meaning the grantor/policyowner had an incident of ownership. As a result, it will be pulled back into their estate if they die within three years of the transfer (the so-called “three-year-rule”).
A better practice is to apply via a preliminary inquiry or apply in the name of the insured but then withdraw the application after the carrier’s ratings of the client. Then, a new application can be filed with the trust named as owner and beneficiary. If the policy was never owned by the insured (and, therefore, never tainted) it will then sidestep the three-year-rule.
Crummey powers
A Crummey Notice, or Demand Right Notification, essentially makes the gift of the premiums a “present interest gift.” Essentially, the government doesn’t know how to tax the gift of the insurance policy, so they can only tax the portion that is a gift today. By letting the beneficiaries know a gift is being made, then, we’re giving them the chance to say, “Forget the insurance — just gift me the premiums today.” In a nutshell, we put an expiration period in the notice (most practitioners choose 30 days; the undersigned and others often use until the end of the calendar year). After the expiration period, the beneficiary can no longer claim the gift as it expired, but they did have that 30-day (or longer) window, thus making the gift a present interest which then lapsed.
Avoiding gift taxes
Individuals can gift up to $12,000 per year (inflation adjusted) to each individual they choose, and a married couple can “gift split” and gift up to $24,000 per year to each individual. (An individual can only gift $5,000 to their spouse, however.) So, if your clients are a married couple with three children and a second-to-die policy, they can gift $72,000 per year into the ILIT. If all the gifting to the children goes into the premiums, they can not gift any larger amounts. Similarly, what if they have grandchildren and a large estate with equally large premiums? The solution is Cristofani beneficiaries.
In the Cristofani case, the court allowed an increase in the class of Crummey beneficiaries. The mere fact that someone is offered a 30-day window for a portion of the premium and rejects it is not enough; they have to have a real chance, however slight, of receiving a viable portion of the ILIT proceeds. Accordingly, a well-drafted ILIT can allow the grantors to make gifts to secondary or tertiary beneficiaries within the trust and still retain their ability to otherwise gift to their children or engage in other estate planning techniques without using up their exclusions on particular children or grandchildren. The legal requirement again is in the trust; the Crummey beneficiary must be a real beneficiary if the other beneficiaries predecease. The functional requirement is that the Crummey beneficiary (like any other beneficiary) must be cooperative.
For example: Stacey creates an ILIT for Gary, Shayna, and Caylee. Gary is Stacey’s spouse. So, Stacey can contribute $12,000 each for Shayna and Caylee, but only $5,000 for Gary, totaling $29,000 in premium. If Stacey required a policy with a $100,000 annual premium, she could not make those premium payments without dipping into her lifetime gift tax exemption. However, if additional secondary beneficiaries were named to the trust, such as Stacey’s brother, sister-in-law, cousins, etc., and they received Crummey notices and were cooperative, the amount of premium could be increased by $12,000 per head. With roughly nine other family members, Stacey could fully fund the ILIT each year without applying a penny toward Gary, Shayna, or Caylee, thus retaining her ability to otherwise gift without exhausting her gift tax exemptions on policy premiums.
The irrevocable life insurance trust should be the linchpin of any estate tax-related insurance sale — and with some of the larger estates, the benefits to the client and the agent simply cannot be overlooked.
Gary B. Garland is an attorney who practices in Manalapan, NJ and New York, NY and is the lead author of “CPA’s Guide to Life Insurance” and “CPA’s Guide to Federal and Estate Gift Taxation.” He can be reached at 732-972-6700 or gary@estateattorney.info.