Irrevocable Life Trust
An irrevocable trust is a trust in which the grantor completely gives up all rights in the property transferred to the trust, and retains no rights to revoke, terminate or modify the trust in any material way. When such a trust holds a life insurance policy, usually on the grantor's life, it is an irrevocable life insurance trust. If withdrawal powers are given to the beneficiaries, it may also be referred to as a "Crummey trust," so named after the taxpayer in a famous 1968 court case in which the use of such powers was approved. Irrevocable life insurance trusts (ILITs) are used in estate planning to accomplish some or all of the following objectives: - To help meet the liquidity needs of the grantor's estate;
- To help provide for the income needs of survivors after the estate liquidity costs have been met;
- To avoid the estate taxation of the life insurance death proceeds; and
- To shelter property in the trust from creditors at death.
- An irrevocable life insurance trust may be either "funded" or "unfunded."
In a funded life insurance trust, the grantor initially transfers cash or other property to the trust which the trustee uses to pay premiums. The major drawback of the funded life insurance trust is that income earned on the property inside the trust will be taxed to the grantor if it can be used to pay premiums on a policy on the life of the grantor or the grantor's spouse. In an unfunded life insurance trust, the trustee has no other property in the trust with which to pay premiums, and is dependent on annual gifts from the grantor. The unfunded trust is more commonly used, and we will focus upon it here. - The irrevocable life insurance trust is created during the grantor's life.
- The beneficiaries of the trust are often family members of the grantor: spouse, children, grandchildren, spouses of children and grandchildren.
The trust is funded with a life insurance policy on the grantor and/or a spouse. This may be an existing policy which the grantor transfers to the trust, or it may be a new policy that the trustee acquires with cash or other property transferred to the trust by the grantor. In an unfunded ILIT, the grantor makes annual transfers to the trust so that the trustee can pay the premiums. These annual transfers are considered gifts to the trust beneficiaries. If the trust beneficiaries cannot "enjoy" these gifts immediately, the gifts would ordinarily be future interests. That means no annual exclusion ($11,000 in 2003) is available to shelter the annual transfers from the federal gift tax. However, trust beneficiaries can be given special withdrawal powers, called Crummey powers, to convert their interests into present interests that qualify for the annual exclusion. Suppose the grantor-insured dies and the policy proceeds are paid into the trust. How can the proceeds be made available to the executor for liquidity? The trust document often authorizes the trustee to make the proceeds available to the executor. This is usually done in one of two ways: - By authorizing the purchase of illiquid assets from the estate, or
- By authorizing loans to the estate.
Either way, cash flows into the estate at the time it is needed to pay funeral costs, expenses of the decedent's last illness, death taxes, probate expenses, and the claims of creditors. It is critical that the trust document merely authorizes the trustee to purchase estate assets or make loans to the executor. If the trustee is required to do so, the policy proceeds will likely be includible in the grantor-insured's gross estate. If the trustee purchases an asset from the estate, it should be for a fair price. If the trustee "overpays" to pump additional cash into the estate, this could be deemed a taxable distribution of trust income. Similarly, if the trustee makes a loan to the estate on terms much more favorable than prevailing commercial credit conditions, that could be deemed an income distribution by the trust. The trust corpus, including the life insurance, generally avoids being included in the grantor-insured's gross estate for estate tax purposes if: - The trust is irrevocable;
- The grantor is not the trustee;
- The grantor has no incidents of ownership over the insurance policy;
- The insurance proceeds are only used to purchase estate assets or to make loans to the estate in reasonable, arm's-length transactions, not to pay estate costs in a direct manner; and
- The insured lives for at least three years after transferring the policy to the trust.
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