What Is the Irrevocable Life Insurance Trust?

An irrevocable trust is one 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 Crummey powers are granted to the beneficiaries, it may also be referred to as a "Crummey trust" after a famous 1968 court case of the same name (397 F.2d 82).

These trusts are used in estate planning to accomplish four primary objectives:

to help meet the liquidity needs of the grantor's estate,

to avoid the estate taxation of the death proceeds,

to provide for the income needs of survivors after liquidity costs have been satisfied, and

to shelter property from creditors at death.

Funding Alternatives

An irrevocable life insurance trust may be either "funded" or "unfunded."

In a funded life insurance trust, the grantor not only transfers the life insurance policy to the trust, but also transfers other property to the trust from which the premium payments may be made. The property may be in the form of cash, securities or some other asset. The major drawback of the funded life insurance trust is that the trust income may be taxed to the grantor if it can be used to pay premiums on a policy on the life of the grantor or the 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 cash gifts from the grantor. The "unfunded" trust is more commonly used, and we will focus upon it in the remainder of this section.

Features of the Irrevocable Life Insurance Trust

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. This may be an existing policy which the grantor gifts to the trust, or it may be a new policy that the trustee acquires with cash transferred to the trust from the grantor.

Unless the policy is paid up, the trustee will have to pay the annual premiums. The trustee could do so with the cash income earned by securities in the trust (if any), but this would make the trust income taxable to the grantor. This result also occurs if the policy is on the grantor's spouse.

To avoid this problem, the grantor usually makes annual transfers of cash to the trust so that the trustee can pay the premiums. Of course, these annual transfers are gifts. Where the trust beneficiaries cannot begin to "enjoy" the policy as soon as the grantor-insured dies, the gifts would ordinarily be future interests. That means no gift tax annual exclusion is available to shelter the annual cash transfers from the federal gift tax.

If the trust beneficiary can get a distribution of the insurance proceeds immediately after the insured dies and the proceeds are paid into the trust, the gift of the policy is a gift of a present interest [Rev. Rul. 76-420, G.C.M. 37451]. Most trusts defer the beneficiary's enjoyment of the proceeds, and thus the gift is of a future interest (unless a Crummey power is used).

The Crummey Power

The Crummey power is meant to secure the gift tax annual exclusion for annual gifts to the trust that enable the trustee to pay premiums. The trust beneficiaries are given the power, exercisable annually for a limited period of time, to withdraw the annual cash transfers to the trust. The beneficiaries are notified when a transfer is made to the trust that is subject to their Crummey powers.

Naturally, one hopes they won't exercise their powers. But the mere fact that they could is sufficient to convert what might otherwise be future-interest gifts into present interests that qualify for the gift tax annual exclusion. So, if there are four beneficiaries with Crummey powers, up to $40,000 of cash transfers could be sheltered annually from the gift tax ($80,000 with gift-splitting, as indexed for inflation after 1998). These withdrawal powers do not accumulate if unexercised; they lapse after the specified period expires.

Notwithstanding the gift tax annual exclusion amount ($10,000 in 1997 and 1998, indexed for later years), the Crummey power for each holder should generally be limited to the greater of

$5,000, or

5% of principal if that turns out to be less than $10,000.

This is the maximum amount that will not be considered a taxable gift to the other trust beneficiaries if the holder of the power allows it to lapse unexercised each year.

If the beneficiary's annual right of withdrawal does not exceed the five-and-five limits, the amounts the beneficiary could have withdrawn but did not are excludable from the beneficiary's gross estate--except for the amount which could have been withdrawn in the year of death, which must be included. If the beneficiary's right of withdrawal exceeds the five-and-five limits, the aggregate excess amounts which could have been withdrawn will be includable in the beneficiary's gross estate up to a maximum of the full amount of the proceeds.

When the premium payment is substantial, there may not be enough beneficiaries to shelter the annual cash transfers to the trust. Grantors have tried to get around this by "creating beneficiaries" who have no rights in the trust except Crummey powers. The IRS has attacked this practice in letter rulings.

But the IRS received something of a setback in the Tax Court in the Cristofani case in 1991 (97 T.C. 74), where theTax Court ruled that the unexercised rights of withdrawal by several beneficiaries allowed additions to the trust to qualify for the $10,000 annual exclusion. The IRS later acquiesced in the result in Cristofani (Actions on Decision 1992-09 and 1996-10), but has indicated that it will continue to press the issue outside the Ninth Circuit. Two 1996 IRS releases, Technical Advice Memorandum 9628004 and an Action on Decision (on Cristofani), indicate that the IRS will seek to deny exclusions for Crummey powers when the powerholders have no other interests in the trust, when there is a prearranged understanding that the powers will not be exercised, or when the withdrawal rights are not in substance what they purport to be in form. At a minimum, the beneficiaries should have some other interest in the trust besides Crummey powers.

The trust should give the beneficiaries a reasonable period of time in which to exercise their powers, say, 30 days. If the trust says they have until December 31 to exercise their powers, and the grantor makes the cash transfer on December 30, the IRS would almost certainly view this as a sham. The gift tax annual exclusion (multiplied by the number of beneficiaries with present interests) would be lost.

Also, the trustee must give the beneficiaries formal notice that the trust has received a cash transfer subject to their Crummey withdrawal powers.

Liquidity Planning

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 must authorize 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.

However, it is critical that the trust document merely authorizes the trustee to do this. If the trustee is required to do so, the policy proceeds would likely be includible in the grantor-insured's gross estate. This would undo a chief advantage of using the irrevocable life insurance trust.

So long as the trustee has discretionary power only, and the estate is not a direct or indirect beneficiary of the proceeds, the proceeds will not be includible in the gross estate unless and to the extent actually used to pay estate obligations (i.e., without any bona fide loan or asset purchase taking place).

The danger doesn't end there. 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. So, any loan should

bear a reasonable rate of interest,

provide a repayment schedule, and

be secured by estate assets as collateral.

A "sweetheart deal" on the purchase or loan could be considered a use of the life insurance proceeds to benefit the estate and thereby jeopardize the estate tax exclusion as well.

Tax Aspects of Irrevocable Life Insurance Trusts

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.

The IRS has ruled that a grantor's power to remove a trustee and appoint an individual or corporate successor trustee that is not related to or subordinate to the grantor is not a reservation of the trustee's power by the grantor. Thus, such a reserved power will not cause the trust property to be included in the grantor's gross estate [Rev. Rul. 95-58, 1995-1 C.B. 191].

If the trust produces any income, the income will be taxed to the grantor if the trust is a grantor trust as defined in tax law. The trustee's ability to use trust income to pay premiums on a policy on the life of the grantor or the grantor's spouse is one of the factors that would make the ILIT a grantor trust.

The gift tax can be avoided on annual cash transfers to the trust if the beneficiaries have properly drafted Crummey powers.

After estate settlement costs have been provided for, the remaining trust assets can be held for the benefit of trust beneficiaries.

When several generations are covered by the trust, the generation-skipping tax becomes a planning consideration. There is a liberal exemption from this tax, so it will only be a factor in rather large trusts.

Nontax Advantages of Irrevocable Life Insurance Trusts

Besides tax avoidance, irrevocable life insurance trusts offer the following practical advantages:

Cash can be made available to help pay estate settlement costs.

Financial security can be provided for the grantor's survivors.

Probate costs can be avoided on the life insurance proceeds and any other assets passing via the trust.

The trust provisions are private and confidential, not a matter of public record as in the case of a will.