The Importance of Proper Trust Maintenance
The trustee of an irrevocable life insurance trust (ILIT) must follow numerous rules and regulations laid out by the IRS in order to exclude the ILIT’s policy proceeds from federal and state estate tax.
The insured and the trustee should check to see that these rules and regulations are in compliance annually because any significant mistake — even an honest one — may lead the IRS to challenge the trust and tax the life insurance proceeds.
Life Insurance Trust Basics
An ILIT holds one or more life insurance policies on your life. Each year, in order to pay the premiums on the life insurance policy, you must gift money to the ILIT and then your trustee uses this money to pay the premiums. After your death, your trustee will distribute the insurance proceeds according to your instructions.
If established properly, you will not have any control over the life insurance policy itself or any of the assets in the ILIT.
Normally, if you do not have control over an asset, it is not taxable for estate tax purposes. The IRS is not happy about the ability of people to pass on vast sums of money without paying tax and they may scrutinize your ILIT for mistakes so it can collect the estate tax.
Accordingly, even though you have no control over the assets in your ILIT, it is still important that it is properly maintained.
Funding the ILIT
After the trust document is drafted, the trustee will either purchase an insurance policy on your life or transfer an existing policy into the trust. In either case, the trustee must be the policy’s owner and beneficiary. For policy that is not paid in full, the trustee must open up a bank account for the trust and you must deposit money into the ILIT’s account to cover the premium.
Your gift to the ILIT — whether cash or an existing insurance policy — qualifies for the annual gift-tax exclusion of up to $12,000 per beneficiary (for calendar year 2007). If you decide to transfer an insurance policy to the trust via gift, you must figure out the value of the policy.
A good rule of them is the value of a term policy is approximately the current year’s premium or the cash surrender value for a whole life policy. (This is not exact however and there are exceptions, so you must get an official valuation from the insurance company – this is known as the interpolated terminal reserve plus a portion of that year’s premiums paid by the owner.)
If you transfer an existing policy to your ILIT and you die within three years of that transfer, the proceeds will be included in your estate for estate tax purposes. If you are insurable, the three-year rule can be avoided by gifting cash to the trust and having the trustee purchase a new policy. You can then surrender the old policy and use the cash value, if any, to pay the premiums on the new policy.
Premiums and Crummey Notices
Each year you make a gift to the ILIT, whether to pay the annual premiums or otherwise. The gift will qualify for the annual gift-tax exclusion as long as the IRS considers the gift a gift of a “present interest.”
In order for the gift to be deemed a gift of a “present interest”, your trustee must give the beneficiaries a right to withdraw the gift. This is known as a demand right or a Crummey power. (If a beneficiary is a minor, your trustee should send a Crummey notice to their parents or guardians of that minor.)
This notice requirement applies to the first year’s gift as well as every subsequent year’s. If your trustee forgets to send the Crummey notices, the IRS may say that the beneficiaries did not have a “present interest” and include the gifts as part of your taxable estate.
As soon as the withdrawal period lapses — typically after 30 days and assuming the beneficiaries don’t exercise their withdrawal rights – the trustee can use the money to pay the premium. Due to this time constraint, money should be put into the trust account at least 45 days prior to the premium being due.
There is always a danger that the beneficiary will actually take the money, so you should explain to your beneficiaries that allowing the right to lapse each year without withdrawing the cash is in their long-term best interest.
It should be noted that if the trust owns a second-to-die policy on your and your spouse’s lives, the survivor should continue to make gifts to the ILIT so that the premiums can continue to be paid.
Records and Tax Returns
If the ILIT has gross income in excess of $600 for the year, your trustee is responsible for filing annual income tax return. The trustee should also maintain certain records in the event that the IRS chooses to audit the ILIT’s operation. These records include:
- Copies of all Crummey notices sent to the beneficiaries along with any related correspondence;
- Canceled checks from your individual (or joint checking account for a 2nd to die insurance trust) showing the gifts you made to the ILIT; and
- The trust’s checking account records, showing gift deposits and premium disbursements.
Avoid Incidents of Ownership
To maintain your ILIT’s tax-advantaged status, avoid exercising any control over the trust. In IRS terms, the insured party must not have any “incidents of ownership” during the trust’s life. If you violate this rule, the IRS will include the insurance policy in your estate and tax the proceeds. Incidents of ownership include the ability to:
- Change or add a beneficiary,
- Surrender or cancel the policy,
- Assign the policy or revoke a policy assignment,
- Borrow against the policy or pay premiums with policy loans; or
- Pledge the policy as collateral for a loan.
Mistakes Can Be Costly
Any significant mistake — even an honest one — may prompt the IRS to challenge the trust and tax the insurance policy’s proceeds. If you or your trustee has any questions about the proper way to handle your ILIT, please call before you act.