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In general, the federal estate tax is applied to all assets that transfer upon the decedent's death. This includes property owned by the decedent, including life insurance policies on the decedent's life. Therefore, upon the decedent's death, the entire face value of the policy is included in the decedent's taxable estate. If the decedent owns a multi-million dollar policy, the policy coupled with the value of the decedent's other assets could present an estate tax problem for the decedent's heirs.
An Irrevocable Life Insurance Trust or ILIT ("eye-lit") is a trust that owns a life insurance policy for the benefit of the beneficiaries. Since the trust owns the policy and not the decedent, the proceeds of the policy are not included in the decedent's taxable estate. In order for the policy to be excluded from the decedent's estate, the decedent may not have any of the "incidents of ownership" of the policy. The general incidents of ownership include the right to change the beneficiary, transfer ownership of the policy, use the policy value as collateral for a loan, or any other traditional rights of ownership. If the policy is irrevocably given to the trust, then it is off the table for estate tax purposes.
In order to establish an ILIT, the person establishing the trust, called the grantor, typically retains an attorney to draft the trust document. The grantor has the power to name the initial and successor Trustees who will manage the trust once it is established. The grantor can also retain the power to remove the trustee and appoint a successor, so long as the grantor does not appoint a successor that is related to or subordinate to the grantor. Neither the grantor, nor his or her spouse, can be the trustee of the trust.
The grantor also has the power to name the beneficiaries of the trust. The beneficiaries of the trust are those persons that will receive the proceeds of the trust upon the death of the grantor. The beneficiaries of the trust are typically the grantor's children. The beneficiaries of the trust may also be the grantor's grandchildren, however, care must be taken with regards to the generation skipping tax.
The grantor's estate should not be the beneficiary of the trust. If the grantor wants to provide some liquidity to the estate, the trust may authorize (not force) the trustee to make the proceeds available to the executor by authorizing the purchase of illiquid assets from the estate, or by authorizing loans to the estate. The funds received by the executor can then be used to pay funeral costs, expenses of last illness, death taxes, probate expenses, and creditor's claims.
Once the legal document establishing the trust is executed, then the trust is ready to receive a new or existing life insurance policy. If the policy is a new policy, then the trustee should be the applicant for the new policy. The trust should also be the original owner of the policy and the beneficiary of the policy.
If the policy is an existing policy, then the grantor must irrevocably assign or transfer the policy to the trust. The trustee should participate in arranging the transfer. Once the policy is assigned, the grantor can no longer exercise those incidents of ownership over the policy. Finally, if an existing policy is transferred to the trust, then the grantor must survive another three years or else the proceeds will be included in his or her taxable estate. Do not wait until you are sick before attempting to transfer an existing policy into the trust!
Once the policy is in the trust, the premiums must be paid, but how? If the grantor were to directly pay the premiums, this would be treated as a gift of a future interest and would be taxable. The same would be true if the grantor were to transfer money into the trust for the payment of premiums. Something more is needed. In a now famous court case, Crummey v. Commissioner, the Court decided that if the grantor were to transfer money into the trust and the beneficiaries had the power to immediately withdraw the funds, then it would not be a gift of a future interest. Instead it would be a gift of a present interest which can then qualify for the annual exclusion. In 2014 and 2015 the annual exclusion is $14,000 per person. Thus, the grantor can indirectly pay the premiums by transferring funds for the premiums to the trust. The trustee then gives the beneficiaries ample opportunity to withdraw the money if they wish. Hopefully the beneficiaries will think strategically and choose to leave the money in the trust. After an appropriate period of time (typically a month), the trustee can then use the funds to pay the insurance premiums of the policy.
A carefully drafted and managed ILIT can allow you to pass millions to your beneficiaries tax free. Contact the Duran Firm today to start work on your ILIT.