When setting up an irrevocable life insurance trust (ILIT) as a part of an estate plan, there are several important factors to keep in mind, such as how the trust will be structured to avoid unnecessary gift tax, where the trust will have “situs” or be located, and who will be appointed as the trustee to make sure that the plan is carried out as the grantor intended.
Avoiding Gift Tax
Because contributions to an ILIT are considered gifts to the beneficiaries of the trust, an insurance trust must be properly drafted and appropriately administered by the trustee to avoid gift tax consequences. If an insurance trust is unfunded, the grantor will have to make regular contributions to the trust to cover the insurance premiums. In order for the contributions to qualify for the grantor’s annual gift tax exclusion, notice must be provided to the beneficiaries by the trustee. The notice, often called a Crummey letter, notifies the beneficiaries of their right to withdraw contributions, which, in turn, meets the Internal Revenue Service’s “present interest” requirement for the gift to qualify for the annual gift tax exclusion. The Crummey withdrawal period does lapse, typically 30 days after the date of the gift. The trustee can use the gift/contribution to pay the insurance premiums after the withdrawal right period ends.
Gifting Existing Life Insurance Policies to a Trust
The IRS has a three-year lookback period after an existing life insurance policy is transferred to a trust to determine whether the death benefit can be included in the grantor’s estate. If the grantor contributes an existing policy to a trust, but then passes within the three-year window, the proceeds could revert into the grantor’s estate, thereby defeating a primary purpose of establishing the trust. Another factor to consider is that there may be a gift tax consideration if the existing policy has accumulated cash value. When a trustee purchases a new life insurance policy in the trust after the trust is established, there is no lookback period. When considering the tax consequences of any transfer, a competent tax adviser should be consulted.
Choosing the Right Trustee
The decision of who to appoint as the trustee for a life insurance trust is a critical factor in the success of the estate plan. There are several important duties that the trustee is responsible for carrying out for the purpose of the trust to be achieved. A primary purpose of an insurance trust is often to remove the value of the insurance policy, the annual contributions, and the resulting insurance death benefit proceeds from a grantor’s estate. For this purpose to be achieved, the trustee cannot be the grantor or the grantor’s spouse. The trustee will be responsible for the filing of tax returns, payment of insurance premiums, issuing Crummey notices to beneficiaries to ensure annual contributions qualify for the grantor’s annual gift tax exclusion, and distributing trust proceeds in accordance with the terms of the trust and the grantor’s intent.
An important consideration for choosing the trustee of an insurance trust is the chosen trustee’s ability to manage consistent premium payments, legal responsibilities, tax filings, and notice requirements. Often, a professional or corporate trustee is the best option for an insurance trust because of the level of complexity and administrative work that must be carried out for these trusts.
Deciding a Trust Jurisdiction
Choosing where an insurance trust will be domiciled is an important decision when establishing an insurance trust. Since an irrevocable trust can be domiciled anywhere, it is often advantageous to choose a state that affords the best combination of low insurance premium tax, no state income tax, and the best asset protection laws for irrevocable trusts. In most states, the situs of an irrevocable trust is based on the location of the trustee where the trust administration occurs among other basic requirements that differ slightly from state to state.