Tansey Estate Planning

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Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust (“ILIT”) is an Irrevocable Trust, which owns and is the Beneficiary of a life insurance policy. The ILIT’s purpose is to create properly structured life insurance that is a Non-Taxable Asset. The insured must not have any “incidents of ownership” in the life insurance policy life insurance in order for the life insurance proceeds to be a Non-Taxable Asset. Furthermore, a Settlor may not have “incidents of ownership” in an existing life a life insurance policy within three years contributed to an ILIT. Some of these “incidents of ownership” are: owing the policy; changing the beneficiary of the policy; borrowing against the policy; and pledging the policy as collateral for a loan. It is best the Settlor to create the ILIT and then have the ILIT’s Trustee apply for the life insurance.

The Settlor cannot directly pay the life insurance premiums. There are three Gift Tax efficient methods to transfer assets (“fund”) the ILIT: (1) use a combination of the Annual Exclusion and Withdrawal Rights; (2) Use some or all of the Lifetime Gift Tax Exclusion; and (3) Loan money to the ILIT.

Up until 2011, the most common method of funding an ILIT was to use the Annual Exclusion and give the Beneficiaries a Withdrawal Right. The Settlor would gift an amount that was slightly larger than the insurance premium to the ILIT. (Note that the Settlor is allowed to give the Annual Exclusion amount to each Beneficiary of the ILIT. If there were five Beneficiaries, the Settlor could gift five times the current Annual Exclusion Amount of $13,000 or $65,000.) The Trustee would receive the gift, and would notify the ILIT’s Beneficiaries that each one has the right to withdraw his or her portion within the next 30 days. The Withdrawal Right makes the gift to the ILIT a gift of a Present Interest and eligible for the Annual Exclusion. Without the Withdrawal Right, normally Beneficiaries of an ILIT would not have use of the gifted money until well into the future. That means that the gift to the ILIT would not qualify for the Annual Exclusion. After the 30 days have expired and the Beneficiary has not exercised his or her Withdrawal Right, the gifted funds remain in the ILIT and available to purchase life insurance. The IRS looks carefully whether or not the Withdrawal Right is real or illusory. The Trustee should keep careful records and demonstrate that the Withdrawal Rights were sent to the Beneficiaries and the Beneficiaries received notice of the Withdrawal Rights.

For at least in 2011 and 2012, it becomes more practical for the Settlor to use some or all of the Lifetime Gift Tax Exclusion. The Lifetime Gift Tax Exclusion increased from $1 million per person to $5 million per person. The Settlor could donate up to $ 5 million (or his her remaining Lifetime Gift Tax Exclusion). The ILIT’s Income or a combination of Income and Principal could be used to pay for the life insurance. For example, the Settlor contributes $4 million to the ILIT and assume that the ILIT could make a 5% return on investing that $4 million. That means that $200,000 per year would be available to purchase life insurance. If the Settlor wishes to have a shorter pay period for the life insurance, the ILIT could use some of the ILIT’s Principal to pay for the life insurance. However, the Settlor would not want to make a single payment for the life insurance, because that would create a Modified Endowment Contract. A Modified Endowment Contract has income tax consequences, such that the Trustee of the ILIT could not borrow against the life insurance policy income tax free. If the Settlor were to use a large portion of the Lifetime Gift Tax Exclusion, there would be no need to use Withdrawal Rights.

The final method to fund the ILIT is to loan funds to the ILIT to pay for the life insurance. Again, there is no need to give Beneficiaries Withdrawal Rights. However, the loan and the interest would reduce the amount of the life insurance proceeds available for the Beneficiaries, unless the ILIT had other methods to pay back the loan.

In many cases ILITs were created to pay Estate Taxes. This helped non-liquid estates from a panic sale, because Estate Taxes have to be paid nine months after death. However the ILIT cannot directly pay the Estate Taxes. Instead, the Trustee could lend funds to the estate to pay the Estate Taxes.

ILIT planning can be combined with other Advanced Estate Planning Techniques. An ILIT could be used to replace wealth donated to a Charitable Remainder Trust or tide family members during the Income Period of a Charitable Lead Trust. When an ILIT is used in this manner, the ILIT is called a “Wealth Replacement Trust.”