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Irrevocable Life Insurance Trusts: Administration Checklist

 |  By: Susan Goddard, CPA/PFS, Senior Manager, Tax, Brittney Cooper, CPA, Manager, Tax

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Executive Summary: An Irrevocable Life Insurance Trust (“ILIT”) is a trust that can be used to minimize estate taxes by moving the proceeds of life insurance policies outside of your taxable estate. This article provides a general overview of ILIT funding and administration requirements.

The primary reason we buy life insurance is to provide our loved ones with financial support and the ability to pay our remaining debts - including any estate taxes. Did you know that the proceeds from life insurance policies that you own at death could be subject to federal estate tax? If you are able to withdraw or borrow the cash value, pledge the policy for a loan, surrender, cancel or assign the policy, or change the policy beneficiary, you are deemed to have “incidents of ownership” which will subject the policy and its proceeds at your death to the estate tax system. Fortunately, proper planning can help shield these assets from estate taxation and preserve the benefits of your planning.

One way to eliminate any “incidents of ownership” and keep life insurance policies and proceeds outside of your taxable estate is to establish an Irrevocable Life Insurance Trust (ILIT) for your policies. An ILIT is a unique trust established to be both the owner and beneficiary of one or more life insurance policies. When properly established and administered, the policies held by the ILIT and their proceeds pass outside of your estate and are not subjected to the estate tax system. Additionally, using an ILIT can enable you to provide management help for your heirs, protect them from creditors, and facilitate the coordination of life insurance with your overall estate plan. Depending on how it is structured, it can also provide your family with a quick source of cash to fund the payment of estate taxes and other expenses after your death.

Once an ILIT has been created, it must be properly administered. Failure to properly administer an ILIT can result in unintended taxable gifts to the ILIT, loss of the gift tax annual exclusion, and possible income and estate taxation of the insurance death benefits.

The below is a general overview regarding the administration and funding of an ILIT:

Administration Overview

  • Obtain a Federal Taxpayer Identification Number - After the ILIT agreement is created, the trustee should obtain a tax identification number (TIN) for the ILIT. The TIN will allow the ILIT to apply for new life insurance policies, transfer existing policies, open accounts, and file fiduciary income tax returns (if required).
  • Fund the ILIT – An ILT can be funded in one of two ways:
    • Transfer Existing Policy: You can transfer an existing policy to the trust and name the trust as the beneficiary of the policy. The disadvantage to transferring a policy is that if death should occur within three years after the transfer, the policy proceeds will be included in your estate for estate tax purposes. For that reason, before transferring an existing policy to an ILIT you should discuss planning options with your tax advisor which may avoid the three year rule.
    • Buy New Policy: To avoid the three-year rule as explained above, the trustee can purchase a new life insurance policy on your life. When taking this route, everything to do with the ownership of the policy should be signed by the Trustee including the initial application for the policy. Additionally, the ILIT should be designated as the original owner and beneficiary of the policy.
  • Keep Records of all Trust Activity - The trustee should hold the original contract for each insurance policy owned by the ILIT and keep accurate records of the trust’s receipts and disbursements. It is extremely important that you select a responsible party as trustee of your ILIT.
  • Premium Notices – Insurance premium notices should be sent to you and the ILIT trustee.
  • File Timely Gift Tax Return, if Necessary – You should provide your accountant with annual gift information to determine whether you must file a gift tax return due to your contributions to the ILIT which are used to fund insurance premiums. Additionally, you should discuss with your tax advisor whether or not you should be allocating a portion of your generation-skipping tax (GST) exemption to the trust to avoid the potential imposition of a generation-skipping tax at a later date.

Funding Overview

  • Open a Bank Account - The trustee should open a checking account for the ILIT.
  • Gift Premium Payments to ILIT - Instead of paying the insurance premium directly, you should “gift” a check payable to the ILIT trustee to enable the payment of the policy premium. The trustee should immediately deposit the check in the ILIT’s checking account. If you are the sole grantor of the ILIT and your spouse is a beneficiary of the ILIT, checks to the ILIT should not be made from a joint account.
  • Notify Beneficiaries of their “Crummey” Withdrawal Rights – In order to minimize the gift tax implications of gifts to the ILIT, most ILITs provide the beneficiaries with “withdrawal rights” in the trust (known as “Crummey” powers). The ILIT will specifically describe these rights and tell the trustee what needs to be done. Generally, after receiving the check, the trustee will immediately notify the trust beneficiaries of the gift and their withdrawal rights. A beneficiary should not waive his or her withdrawal right, but simply allow for the withdrawal right to lapse each year. Once the withdrawal power lapses, the gift remains in the trust and is used to pay the policy premium. Look to the attorney that drafted the ILIT to prepare model withdrawal letters for use each year.
  • Issue Check to Pay Policy Premium from ILIT Account – The ILIT trustee should pay the policy premium with a check from the ILIT’s checking account.

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