How Does an Irrevocable Life Insurance Trust Work?

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The steps to successfully establishing an ILIT include the following:

  1. Your advisors, including your attorney, help to design and create the ILIT.
  2. The trustee of the ILIT applies for an insurance policy on your life, or the lives of you and your spouse.
  3. You make a gift of the premium amount to the ILIT.
  4. The trustee notifies the beneficiaries of their “demand right.”
  5. The trustee pays the premium for the insurance.

It’s important that you and your advisors follow the steps slowly and carefully to prevent mistakes. If any of these steps are skipped or rushed, you run the risk of having the insurance proceeds brought back into the estate for tax purposes.

The design of the ILIT will depend upon its purpose. An ILIT doesn’t exist until it is drafted and signed, and the ILIT must be in existence before the life insurance application is submitted to the insurance company. If you apply for the insurance personally, and then immediately move the policy to the ILIT after it’s purchased, it will be 3 years before that policy is considered out of your estate. The same result occurs if you transfer the ownership of an already existing policy on your life to the trust. Many times it is more advantageous to have the trustee of the ILIT buy a new policy on your life.

Once the trustee has applied for the insurance policy, underwriting has been completed, and you are approved as the person to be insured, it’s time for the Trustee to pay for that policy.

The next step is for you to make a gift of cash to the Trustee of the ILIT to pay for the policy premiums. Whether your gift to the ILIT will be considered a taxable gift will depend upon the terms of the ILIT, including the right of your beneficiaries to access (withdraw) the gift. As a general rule, if no beneficiary has a right to withdraw your gift, then you have made a taxable gift that will reduce your lifetime federal gift tax exemption. If the gift exceeds this amount, then you will owe federal gift tax. Your gift may also be subject to state gift tax. However, if your beneficiaries have the right to withdraw the gift, then it will not be considered a taxable gift for federal gift tax purposes if it meets the requirements discussed below.

A beneficiary’s right of withdrawal is necessary to avoid the taxation of the contribution to the ILIT as a taxable gift .As discussed in Chapter 4, each person can give a present interest gift of an annual gift tax exclusion each year to any number of beneficiaries without the gifts being subject to gift tax. But to qualify, the gift must be a “present interest” (as opposed to a future interest) gift.

Only gifts where the recipient has the immediate right to the use and enjoyment are “present interest” gifts. The problem is that gifts to a trust are normally future interest gifts, and thus do not qualify for the annual gift tax exclusion. That is, the beneficiaries do not normally have the immediate right to the contributions to the trust. They will only receive the trust proceeds sometime in the future.

However, if the ILIT gives the beneficiaries the right to withdraw those funds for a limited period of time (usually 30 days), they are then entitled to the present use and enjoyment for that period of time. That right is enough to cause what is otherwise a future interest gift to be considered a present interest gift. This right of withdrawal technique is sometimes called a “Crummey demand right,” or “demand right” and this type of trust is often referred to as a “Crummey Trust.” That name is not a commentary on the quality of the trust.

The term “Crummey trust” originated with the 1968 case, D. Clifford Crummey v.   Commissioner of Internal Revenue.   In that case, Mr. Crummey had established an irrevocable trust for the benefit of his four children. He and his wife funded the trust with cash transfers each year, allowing the children to withdraw the amount of the contribution (not to exceed $4,000) any time prior to December 31 of the year of the contribution. The Ninth Circuit Court of Appeals ruled that the withdrawal right made the transfers gifts of a “present interest,” and therefore eligible for the annual exclusion from the Federal gift tax. The decision paved the way for establishment of similar trusts, which became known as “Crummey trusts” or “demand trusts.”

This right of withdrawal qualifies the gift for the annual exclusion from gift tax, whether or not the beneficiaries actually withdraw anything.  If the beneficiaries do not exercise their right of withdrawal within the time limit provided in the trust, that right expires and the trustee is then free to pay the life insurance premium. When the beneficiaries understand why you have established the ILIT, they will not normally exercise their demand right.

The annual gift tax exclusion limit applies to each beneficiary of the trust. So if you have an insurance policy premium of $50,000 per year, and you have five beneficiaries, the maximum gift ($14,000 per beneficiary in 2015) to each beneficiary would more than cover the premium cost.