What is an Irrevocable Life Insurance Trust?

You may have heard of an Irrevocable Life Insurance Trust (ILIT). Let’s discuss what it is and the role it can play in someone’s financial plan. An ILIT is simply a trust that is designed to hold an insurance policy. As the name indicates, these trusts are irrevocable, which means that once an asset (usually the life insurance policy) is added to the trust, the grantor may not take it back out. Trust distributions work like any other trust and can be written with specific language that controls how death proceeds are distributed and when various beneficiaries will receive distributions. This can include anything from lump sum distributions at death to milestone distributions that trigger upon certain conditions (such as graduation from college or reaching certain ages) or leaving the funds in trust to be distributed at a trustee’s discretion.

So, let’s look at what makes ILITs attractive from a tax perspective. One of the most attractive tax advantages of having an ILIT is that since the trust owns the policy, the death benefit is not included in the grantor’s gross estate and thus is not subject to estate taxation. Since death benefits can be millions of dollars, this can be a very useful planning tool for clients.

As with any insurance policy, a premium must be paid by someone, and this is true for the policies inside an ILIT as well. The usual way premiums get paid for ILIT-owned insurance is that the grantor makes a gift of cash to the trust—enough money to pay the premium. This contribution to the trust is generally a completed gift for gift tax purposes. There is an Annual Exclusion for Gift Tax purposes which is currently $18,000 per done. But for a gift to qualify for the Annual Exclusion, the gift must be a “present interest.” A gift that goes into trust to fund life insurance for the future benefit of the beneficiaries doesn’t count as a present interest, and so additional steps need to be taken to qualify. Usually this is accomplished by designing the trust to give the beneficiaries a right to withdraw the contribution for a short period of time. These are often called “Crummey” provisions, named after Clifford Crummey. He was involved in a court case in the sixties when the IRS attempted to deny him the annual gift tax exclusion. His trust gave his beneficiaries the right to withdraw contributions for 30 days. Because of this right to withdraw, the court ruled that his contributions to the trusts were, in fact, gifts of present interests that did qualify for the annual exclusion. That was a fascinating case and is well worth a read.

So, for ILITs that have these Crummey powers, when the contribution “gift” is made to pay the insurance premium, trust administrators must allow the beneficiaries the opportunity to make a withdrawal of the contribution (usually within 30 days.) We mail all beneficiaries a Crummey notice explaining their rights of withdrawal. Although they have this right, the beneficiaries often realize that if they withdraw a portion of the gift, the result is a potential lapse of the policy since the full premium payment could not be made. Therefore, it is rare for a beneficiary exercise their withdrawal rights and impair the trustee’s ability make premium payments. While this may seem like a strange requirement, this process is what allows grantors to make ongoing gifts into trust for premium payments and still get the gift tax annual exclusion.

To learn more about the benefits an ILIT, reach out to us. In my role as Trust Administrator, I personally work with ILITs and would be happy to answer any questions.

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