Irrevocable Life Insurance Trust

Irrevocable Life Insurance Trust

The following are the steps that should be followed to set up an irrevocable life insurance trust and to remove all incidents of ownership from an insured.

1. Create an Irrevocable Life Insurance Trust (“ILIT”) to assume outright ownership and all incidents of ownership of all the policies. This is a legal document that needs to be prepared by an attorney.
2. You will need to name a trustee and alternate trustee to administer over the trust. It is not suggested you name people that can benefit from the trust’s assets.
3. The trust will become the sole beneficiary of any life insurance policies owned by the trust.
4. You will need to name beneficiaries to receive any income earned by the trust and/or principal in the trust. An example is for your spouse to be the income beneficiary and your children, principal beneficiaries. The trust can also state how long the income payments will continue and under what circumstances.
5. The trustee should be given the right to invade principal for ascertainable standards of health and welfare of your spouse, children, or other beneficiaries.
6. You can also give the trustee the right to invade principal and distribute funds to the beneficiaries for any reason they feel necessary and appropriate under the then current situations.
7. You can also give the trustee the right to distribute income, or principal, disproportionately based on need, or individual circumstances as they arise.
8. The trust can provide that the children and/or other beneficiaries will receive a pro rata share of the total trust assets when they reach a certain age or stage in their lives. An example is 1/3 upon reaching age 25, 1/2 of the remaining balance upon attaining age 30, and the balance at age 35. Alternatively, the trust can provide that a portion be distributed upon attaining significant events in their lives such as marriage, receiving certain college or university degrees or honorable discharge from the armed forces.
9. The transfer of all incidents of ownership of existing policies to the trust might result in the creation of a taxable gift. To the extent thereof, a gift tax return will have to be filed and either a gift tax paid or the lifetime exemption applied. It can also be arranged for the gifts to be done in stages.
10. To the extent premiums would be due, annual gifts could be made to the trust. If annual gifts are made, then “Crummey Letters” (speak to your accountant or attorney when establishing the trust) should be prepared to permit the allowance of annual gift tax exclusions for the premiums so that those amounts will not be considered as taxable gifts.
11. If grandchildren can become recipients of the life insurance, there will be generation skipping transfer issues which are not covered in here. You are cautioned to seek competent advice in that regard.
12. If the insured dies within three years of moving an existing policy to the trust, the proceeds would still be includible in their estate. This applies to presently existing policies either under direct ownership or a company’s.
13. If new or additional insurance is purchased, it should be acquired directly by the trust. The three-year rule does not apply to policies purchased directly by the trust.
14. Irrevocable life insurance trust assets and insurance proceeds are excluded from estates and estate taxation. Proceeds received after death that include interest or other ordinary income will be subject to income tax by the recipient.
15. If the trust has income (such as interest, dividends or capital gains) during the lifetime of the grantor, the income will be taxed on the grantor’s individual income tax return. This is subject to “grantor trust” rules.
16. The trust is a legal entity under the law. However during the lifetime of the grantor, no separate taxpayer identification number needs to be applied for – the grantor’s Social Security number can be used and no separate tax returns need to be filed by the trust. After the death of the grantor, separate identification numbers have to be obtained and tax returns filed.
17. Note that life insurance owned by an insured where their divorced spouse is a beneficiary will be included in the insured’s estate while the divorced spouse receives all or some of the death benefit (and the insured’s estate will be subject to pay the estate tax on those funds). Irrevocable life insurance trusts owning the policies avoid these types of problems. Also a will’s apportionment clause can possibly reduce some of the taxes paid by the estate.

Reprinted from Getting Your Affairs in Order by Edward Mendlowitz. Available for sale at www.Amazon.com and www.BN.com in print and e-book editions.