"ILIT - A Valuable Planning Technique" by Tracy Christen Reimann, Esq.

Originally published in the Westchester County Business Journal, October 8, 2007 (Download PDF)

As the 2008 elections loom closer, the question of where the political hot potato known as the Federal Estate and Gift Tax will land is sure to attract its share of rhetoric. There are many opinions about where it should land, but only speculation about where it will land. We must all “hope for the best but plan for the worst”. It seems clear, however, that whatever happens, Life Insurance will continue to be a valuable planning technique.

Typically, individuals will purchase a single life policy insuring her life, or spouses may purchase a second-to-die policy insuring both lives, payable upon the death of the second spouse. A trust, called an irrevocable life insurance trust (“ILIT”) is created and the insurance policy is placed in the trust. The individual annually transfers the dollar amount for the premiums to the designated trustee who in turns deposits the funds in the ILIT bank account and pays the premiums. At the death of the insured the proceeds are paid to the ILIT so that the proceeds are available to the beneficiaries to pay taxes, purchase assets or provide for their support. If the ILIT is structured properly, the policy proceeds are not subject to the federal estate tax.

The ILIT can be customized for specific needs. For example, in the case of spouses, when one of them dies, the ILIT can divide into two trusts: one trust to provide income to the surviving spouse for life; and the other to pay for the needs of surviving children to pay for their needs during their minority.

The annual premiums are treated as a gift. However, gift tax ramifications can be avoided by use of the “annual exclusion” which allows each of us to gift up to $12,000 (in 2007 with an inflation adjustment for future years) to any number of individuals. Never an easy horse to ride, the law requires that to utilize the annual exclusion amount, a present interest must be gifted. This means that the donee must actually have the rights to take the cash rather than allow the trustee to use it to pay the premiums. Therefore, annual premium gifts, in order to qualify for the annual exclusion, must be subject to a right of withdrawal. Accordingly, most trust agreements contain what are known as “Crummey” Powers1 (named after a famous United States Supreme Court case, not the rule) which authorize the beneficiaries to withdraw for a certain time period the annual additions to the trust. Naturally, the person creating the ILIT must be confident that his beneficiaries will not exercise their Crummey Powers. This confidence often flows from the beneficiaries’ knowing that exercising their Crummey Powers is likely to impact the way the grantor of the trust distributes other assets.

What happens if the annual insurance premiums exceed the annual exclusion amount for a particular year. If the excess is relatively small, the Grantor can simply loan the needed funds to the ILIT. Such a loan must be evidenced by a promissory note that provides for the payment of the principal and interest at a time certain.

Risks arise, however, when the annual insurance premiums far exceed the annual exclusion amount. One such risk is that the I.R.S. may attempt to invalidate the gift transactions and bring the insurance proceeds back into the taxable estate. The solution to this dilemma may be to when forming the ILIT to transfer to it an asset that can generate sufficient income to pay the life insurance premiums. Income producing real estate is often well suited for this purpose. The grantor obtains an appraisal for the property and then transfers the property into the ILIT using some of her lifetime exemption from gift tax. A married individual can possibly split the gift with her spouse thusly utilizing a smaller portion of her lifetime gift exemption. As a result, the ILIT has sufficient income to pay the annual insurance premiums. Moreover, additional estate tax savings will arise if as is often the case, the realty appreciates after it is transferred into the ILIT. Additionally, the ILIT can be drafted as a Grantor Trust for income tax purposes. This means that the Grantor will be responsible for all income taxes on the trust’s income.

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