Estate Tax Reduction with Irrevocable Life insurance Trusts
Irrevocable life insurance trusts (“ILIT”) are one of the strategies available for estate tax reduction in estates that are near the five million dollar federal tax exemption limit. With the irrevocable life insurance trust, the owner and beneficiary of the life insurance policy is the ILIT. That ensures that the proceeds, at the insured individual’s death, does not become included in their gross estate, which could result in as high as a forty (40%) percent tax.
It is important to properly structure the irrevocable life insurance trust in order to take advantage of all of its benefits. Generally, life insurance proceeds are included in the insured’s gross estate if he or she possessed any “incidents of ownership” in the policy at the time of death (pursuant to IRC §2042(2)). Incidents of ownership is a expansive term that includes not only outright ownership of the life insurance policy but also the right to change the beneficiary of the policy, to borrow against the policy, or to use the life insurance policy as collateral for any loans (Treas. Reg. § 20.2042-1(c)(2)). Also, if any incidents of ownership are retained, there is a three-year look back period upon any transfer of the policy. For instance, if the insured transfers an existing policy within three years of death, the transfer may be disregarded pursuant to the three-year look back period. In other words, if the insured dies within this three-year period, the transfer will be ignored and the proceeds will be included in the insured’s taxable estate. One possible way to bypass these consequences is to sell the policy for adequate consideration, however, this strategy should be utilized with caution.
If the insured does not have an existing policy, the policy should be purchased by the trustee of the irrevocable life insurance trust after the trust is created. As far as payment of premiums, the insured individual has two options. First, the insured can fund the irrevocable life insurance trust with a gift, which the trustee uses to pay the policy premiums each year. Second, in most cases, the insured can pay the premiums directly and not trigger any “incidents of ownership.” Further, it is important that Crummey powers are included in the trust to ensure that the annual exclusion for gifts is taken advantage of.
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