ESTATE PLANNING, WILLS & TRUSTS

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IRREVOCABLE LIFE INSURANCE TRUSTS

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Income and Estate Taxation of Life Insurance Proceeds

 

Typically a life insurance policy is owned by an individual who designates a beneficiary of the policy to receive the insurance proceeds upon the death of the insured individual.  Life insurance proceeds payable upon the death of an insured individual are not subject to income tax, therefore the beneficiary is not required to report any taxable income or pay income tax as result of having received the insurance proceeds.

 

For federal estate tax purposes, however, the insured individual's gross estate will include the proceeds of life insurance on their life if:

 

1.   they own the policy;

2.   they can designate or change the beneficiary of the policy; or

3.   they possess any "incidents of ownership" of the life insurance policy.

 

For married individuals, an estate tax is not generated at the death of the first spouse if the insurance proceeds are payable to the surviving spouse or are ultimately received by the surviving spouse through a marital deduction formula contained in the deceased spouse's Last Will and Testament or Revocable Trust Agreement.  This result occurs because the marital deduction is unlimited.  The problem occurs on the death of the second spouse, where the paid proceeds of the insurance from the first spouse are included in the estate of the second spouse.  The purpose of forming an Irrevocable Life Insurance Trust (ILIT) is to avoid the inclusion of the life insurance proceeds in either spouses' estate.

 

Purchasing or Transferring Life Insurance Policies Into an ILIT

 

An ILIT is a trust specifically designed to hold life insurance policies.  The Grantor of the trust is generally the insured individual. Once the ILIT is established, the Grantor can gift cash to the trust to be used to purchase a new life insurance policy or the Grantor can contribute existing life insurance policies to the ILIT.

 

If a new life insurance policy is purchased by an ILIT naming the ILIT as the owner and beneficiary of the policy, the insurance proceeds are not includable in either spouse's estate regardless of when the death of either spouse occurs.  However, for existing life insurance policies that are transferred into an ILIT, the transferor must survive the date of transfer by 3 years in order for the insurance proceeds to avoid being included in the transferor's estate.

 

Whenever a new policy is acquired by an ILIT, the Trustee of the ILIT should sign the insurance application as the applicant, and should be designated as the policy's owner and beneficiary.  The insured should sign the application only to authorized the insurance of the policy and to provide necessary medical information.

 

Premium Payments

 

As the policy owner, the ILIT is responsible for the payment of the insurance premiums due.  Generally, the ILIT will not own property other than the life insurance policies.  As a result, cash contributions will need to be made by the Grantor to the trust from time to time to provide funds to the trust in order to pay the life insurance policy premiums. The cash contributions to the trust are considered gifts since the beneficiaries of the trust are persons other than the Grantor. The current annual gift tax exclusion is $14,000 per person, however, the annual exclusion only applies to gifts of a present interest.  Since the trust beneficiaries only have a future interest in the trust and not a present interest, gifts to the trust generally would not qualify for the annual exclusion but for the "Crummey" demand powers or withdrawal rights contained therein.  Each time a contribution or gift is made to the ILIT, the beneficiaries have the right to withdraw their respective proportionate shares of the contribution.  This limited right to withdraw, which only lasts for 30 days, qualifies the contribution as a gift of a present interest thereby allowing it to be subject to or qualify for the annual exclusion.

 

The Law Office of John Kachmarsky can assist you or your insurance agent regarding the establishment of an Irrevocable Life Insurance Trust, guide you through the procedures for purchasing a new life insurance policy or help you transfer your existing policy into an ILIT. Contact us today to discuss your immediate estate planning needs and long-term estate planning goals.