Basics of Life Insurance Trusts

Basics of Life Insurance Trusts | The Pollock Firm LLC

Trusts can be a wonderful tool for tax planning. If your death is likely to cause an estate tax or an inheritance tax, you should understand the basics of life insurance trusts. An irrevocable life insurance trust (ILIT) is one the most common form of trusts and is the base for many other trusts such as third party special needs trusts, third party asset protection trusts, spousal lifetime access trusts (SLATs), and dynasty trusts.

Because an ILIT is the foundation for so many other types of trusts, I created a brochure that you can download to understand the basics of life insurance trusts. (Click here to download brochure about the basics of life insurance trusts.) Additionally, please read on if you really want to take a deep dive into this topic.

Planning Considerations

  1. The Grantor should NEVER be trustee of his or her own ILIT. An ILIT will generally lose the tax benefits if you are trustee and the trust owns a policy on your life.
  2. Typically people transfer cash into an ILIT and then the trustee turns around and purchases life insurance on the life of the Grantor. However, an ILIT can own almost any asset, not just life insurance.
  3. It may sound obvious, but once money goes into an irrevocable trust, the money no longer belongs to you. This may be a problem if you wish to take out the cash value of whole life policy in the future.
  4. If the Trustee is the Grantor’s spouse, care must be taken when making contributions to the trust to ensure that the Trustee spouse is not making any contributions. (i.e. Never contribute joint or community property to the trust or write a check to the trust from a joint account or a business account). Some people may need to open up new, separate bank accounts.
  5. ILITs can be somewhat expensive to establish and maintain.
  6. Generally it is better to fund the trust on an annual basis and have the trust pay for any life insurance owned by the ILIT. Paying annually into the trust minimizes the maintenance fees. If multiple insurance policies are in one trust, try to convince the insurance carriers to have the same due date for the premiums.
  7. The life insurance trusts is a particularly useful planning tool for non-citizen spouses and unmarried couples because it provides a means to give the decedent’s significant other a large sum of money tax free, yet control the money’s ultimate destination.
  8. Setting up an ILIT as a Crummey Trust can be tricky if the beneficiaries are disabled or if the beneficiaries are minors and the Grantor is divorced.

It most tax efficient to establish an ILIT as a Crummey Trust.

It is impossible to understand the basics of life insurance trusts without knowing what a Crummey Trust is.

  1. A Crummey trust is designed to provided a limited withdrawal right to certain beneficiaries of an irrevocable trust so that transfers to the trust are eligible for the annual gift tax exclusion.
  2. The more Crummey beneficiaries there are, the greater the gift that may be made to the trust without having to pay a gift tax. Crummey beneficiaries may not just be named at random, because they do have a real right to withdraw the money that is put into the trust.
  3. Generally, a 30 day withdrawal right is considered adequate, but there is no clear minimum.
  4. Particular care must be taken when drafting the Crummey power to ensure that the power lapses only the extent of the greater of $5000 or 5%. Any greater lapse will be considered a gift by that withdrawal beneficiary to the other beneficiaries of the trust.
  5. The trustee should have broad powers to satisfy any withdrawal rights. All Crummey withdrawal rights should be satisfied either against the contribution or the property of the trust, including any insurance policy or fractional interests in the insurance policy. This will provide substance to a Crummey withdrawal right.
  6. A Crummey Trust is named after Clifford Crummey, the first taxpayer to use this type of trust successfully.
  7. If an ILIT is not set up as a Crummey Trust, then it actually makes maintenance much easier. However, it does eat into the lifetime gift and estate tax exclusion of the Grantor each time a contribution is made to the trust.

Types of Life Insurance

If the value of your life insurance policy and your other assets are in excess of the federal estate tax threshold (currently $11.7m per person), it is advisable to discuss the benefits of an ILIT with a tax and estate planning attorney. This is true regardless of what type of life insurance policy you own. The most common types of life insurance to put into a trust are term, whole life, universal insurance policy, or a second-to-die life insurance policies.

  1. Term Life Insurance – Term life insurance policies are designed to last for short period of time. Typically they last for 20 years and cover specific risks, such as covering college costs for your children. The premiums on these policies are typically low. It is relatively easy to contribute an existing policy to an ILIT because of the low value of the policy.
  2. Whole Life Insurance – Whole life insurance policies are designed to build up a cash value. They typically produce a guaranteed return that will ultimately pay for the insurance premium. Ideally they are structured to last your entire lifetime. Be careful that you don’t buy a policy that will expire early! The premiums can be quite substantial. It is important for your estate planning attorney to know the premium amount because it can affect the design of the trust. Specifically, the higher the premium, the more Crummey beneficiaries are needed. A contribution of a large whole life policy to an ILIT may result in the need to file a gift tax return.
  3. Universal Life Insurance – A universal life insurance policy is also designed to be a “permanent” policy if structured correctly. However, a universal life insurance policy does not build up a cash value for the most part. Accordingly, unlike the whole life policy which should eventually pay for itself, this is designed so that you likely have to make premium payments for your entire life. Again, make sure you ensure that it does expire early!
  4. Second to Die Insurance – A Second to Die Insurance Trust is different from a typical ILIT in one substantial and obvious way – the insurance payout is not made until the second to die. Practitioners should ensure that neither spouse is ever eligible to serve as trustee nor made a Crummey beneficiary. Since this trust is not for the benefit of the surviving spouse, the clients should be sure that the surviving spouse has enough funds to live on absent the trust funds. These trusts are particularly beneficial for clients interested in special needs trusts and dynasty trusts as more insurance can purchased for a lower premium amount.

Insurance Trusts Established Pursuant to Divorce or Separation

Frequently, divorce attorneys draft provisions in a separation agreement that requires one spouse to maintain life insurance for the benefit of children. We also see situations in which life insurance is required to cover alimony payments. Sometimes, they even require the money be sent to a trust.

Divorce attorneys rarely spell out the terms of the trust with any specificity. Accordingly, a savvy client will use that lack of specificity to ensure that the trust is designed the way that you want it to be handled. For example, maybe you wish to name a sibling to manage the money for your children rather than having your ex manage the money. Maybe you wish for the money to be primarily used for your children’s education, and not frivolous ventures. You can use this type of trust to take control.

The trust can also allow one spouse to have better access to information. For example, perhaps Spouse 1 is requiring Spouse 2 to have life insurance coverage for the benefit of their joint children. If Spouse 2 simply buys a policy, Spouse 1 constantly has to ask Spouse 2 if it is still in force and who the beneficiaries are. If Spouse 1 requires Spouse 2 to set up an ILIT in which Spouse 1 is trustee of such trust, Spouse 1 will always have access to that information.

Funding an ILIT

After the trust agreement is executed, you must make arrangements to fund the trust. You must know what the tax identification number is before any assets are placed into the trust. Many practitioners like to get a separate tax identification number (TIN) for the ILIT. If the trust is an Intentionally Defective Grantor Trust, the Grantor’s social security number can be used as the tax ID. However, I believe it is generally a good idea to get a separate TIN.

After the trust agreement is signed, an account must be created in the name of the trust. (If the Grantor does not have an individual checking account, the Grantor may also have to create a checking account to fund the trust.)

Insurance must either be purchased by the trust or transferred into the trust. This requires completing insurance forms that designate the trust as the owner AND beneficiary of the policy. (One the the biggest mistakes people make is only changing the beneficiary of a policy to the trust. You will not receive any estate tax benefits unless you also make the ILIT the owner of the policy.)

Immediately after the trust is funded, a letter must be sent to the designated Crummey beneficiaries to advise them of their withdrawal rights. These letters should be acknowledged by the beneficiaries (or their guardians) and maintained by the attorney (or trustee). After 30 days (or whatever the relevant Crummey time period is) the Trustee may use the gift from the Grantor to pay the insurance proceeds.

Be careful of accidentally funding the trust! This often happens when a trust owns a life insurance policy and the Grantor directly pays the premium rather than making payments to the trust. The danger to accidentally funding a trust is that the trustee may forget to send out the Crummey notices and payments on the policy won’t be considered tax free gifts. The Grantor may make direct payments on a policy owned by the trust, but the Crummey notices must be sent and the trust must be otherwise properly funded.

Buying a Policy or Transferring an Existing Policy to an ILIT

When creating a life insurance trust, it is important to know whether the client will be buying the insurance through the insurance trust or if they will be transferring in an existing insurance policy.

It is generally safer for a person to transfer cash into the trust and have the trust buy the insurance because:

  1. It avoids I.R.C. §2035 which states that a person’s gross estate for estate tax purposes includes certain assets that have been transferred out of the person’s estate within three years of death. Accordingly, if a person transfers an insurance policy to an insurance trust and dies within three years of when the gift to the trust was made, the full amount of the proceeds will be subject to Federal Estate Taxes.
  2. It avoids having to determine the value of the existing policy at the time of the transfer. This value is known as the interpolated terminal reserve and is frequently a bit of a pain in the neck to obtain from the insurance company.

However, if you gift an existing insurance policy to a trust:

  1. The value of the insurance at the time of the transfer is a gift to the Crummey beneficiaries of the trust.
  2. Care must be taken when selecting the beneficiaries of the trust to ensure that there are enough beneficiaries to shelter the value of the gift.
  3. The trust must be funded with enough liquid assets in the event someone does wish to exercise their withdrawal rights.

If you have a large policy that must be transferred to an ILIT, and you are worried about the 3 year lookback rule applying, you can transfer other assets to the trust and then have the trust buy the policy. This technique works particularly well if the ILIT is constructed as an intentionally defective grantor trust.

Income Taxation of an ILIT

While the Grantor of an ILIT is alive, you have the choice of having the trust pay taxes on any income, or you can arrange for the Grantor to pay the tax on any income earned.

The trust should generally be created as an Intentionally Defective Grantor Trust (IDGT). An IDGT is a trust that is out of the grantor’s estate for estate tax purposes, but includible in the grantor’s estate for income tax purpose. This allows for tax free sales between the trust and the Grantor. It also, in effect, allows for additional tax free contributions to the trust if the Grantor picks up the tax burden. The IRS hates these techniques, and it is constantly under attack. Even now, one of the items up for discussion as part of the latest COVID-19 relief package is the disallowance of this technique. An irrevocable trust is most frequently converted to an IDGT by allowing the grantor a power to substitute trust assets, other than the insurance, with assets of an equivalent value to the trust in a non fiduciary manner. (See I.R.C. § 675(4).)

Upon the death of the grantor, the trust can no longer be taxed as an IDGT. Accordingly, following the death of a grantor, an ILIT will either be taxed as a simple or complex trust depending upon the terms of the trust. A simple trust is when all the net income is required to be distributed to the beneficiaries. A complex trust is anything besides that. With a simple trust, the beneficiary picks up all the income and it is taxed at the beneficiary rate. With a complex trust, any net income not distributed is paid by the trust. Trust tax rates are more onerous than individual tax rates.

Generation Skipping Tax Considerations

The practitioner must consider whether the Grantor’s Generation Skipping Tax Exemption should be allocated to the ILIT. The Internal Revenue Code was revised under EGTRRA to provide an automatic allocation of the Grantor’s GST exemption to certain trusts. In many cases and this is not always the most desirable result. A grantor may opt in or opt out of having the automatic allocation on a timely filed gift tax return.

7 thoughts on “Basics of Life Insurance Trusts

  1. Hi Kevin – you say that the IDGT does not have to file a 1041 because it is a grantor trust, what about the NJ-1041? Isnt it true that under NJ law ALL grantor trusts have to file a NJ-1041 with a k-1 going to the grantor?

    Thank you

  2. Joseph,

    Good point. The Trust may have to file a NJ-1041. Admittedly, while the Grantor is alive, I almost never have to because there is never any income. At most, we send in a letter saying that no return is due because we are under the income threshhold. For NJ, this is $10,000. If the only assets of the trust are the insurance and a small bank account, it will not throw off income.

    On further note, if there is enough income, the trust may have to file a 1041 depending on which tax ID is used. Many practitioners like to play it safe and get a new tax ID for the trust, thereby requiring the filing of a 1041.

  3. Thank you for a great blog post. Question about the Crummey letters: if the beneficiaries are just the spouse for life and then siblings afterwards, do you typically still include the withdrawal rights language and Crummey letter formalities? I've always been curious about that.

  4. Diane,

    Whether to include withdrawal rights usually has more to do with the net worth of the Grantor. As you know, each contribution to a trust uses up part of the Grantor's $1,000,000 lifetime exemption if there are no withdrawal rights. So, if there is any danger whatsoever that contributions to the trust would use up too much of the Grantor's lifetime exemption, I add the withdrawal rights.

    Prior to the increase in the estate tax exemption amount, I always added the withdrawal rights. Now I am trying to do it on more of a case by case basis.

    On a side note – when a spouse is the beneficiary of a trust, and the amount of the premium is less than the annual exclusion amount, it always makes sense to add the withdrawal rights. You can have the spouse acting as trustee and include a provision in the trust that if the trustee is the withdrawal beneficiary, she does not have to send a notice to herself.

  5. Kevin, thanks for a VERY helpful response. I'm a 4th year associate at a boutique TE firm and I feel like there is always so much to learn. I appreciate clear and concise blogs such as yours! Thanks again! Diane

  6. Thanks for the excellent post! I am curious how you would draft the Crummey letters when the ILIT holds an employer-paid life insurance policy that pays premiums twice monthly. Does one annual Crummey letter suffice for all of the premium payments? Thank you very much.

  7. Marie,

    I'm a bit confused – I have never run into a situation where the employer is paying for an employee's policy that is owned by a life insurance trust.

    I guess this would technically be income to the employee and then a gift by the employee to the trust. I would rather have a cleaner transaction where the employer pays the employee and the employee puts the money in directly.

    I still think Crummeys would have to be done ever two weeks and the trustee should switch the policy to a different payment term (ideally yearly) to avoid all the hassle.

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