Irrevocable Life Insurance Trusts (ILITs): Avoiding Litigation with the IRS
The Utah Business, Real Estate and Estate Planning Blog, in its article, “ILTSs as an Estate Planning Tool” by Matt Frankhauser, provides a clear and succinct summary of how an Irrevocable Life Insurance Trust (ILIT) may be used to keep the proceeds of life insurance policies out of the gross estate of the insured. We don’t want to try to improve on the summary and offer the entire article here. But, we offer a few comments to supplement it.
First, as a point of clarification for our readers who are not lawyers, it is widely known that the proceeds of life insurance policies, the death benefits, are not taxed as income to the recipient. It is less widely known that the death benefits are counted as part of the gross estate of the insured and subject to estate tax if the estate is large enough to be taxable. The life insurance proceeds, by increasing the size of the gross estate, can push the estate across the threshold from a nontaxable to taxable estate.
The focus of our blog is generally on litigation and, whenever possible, avoiding litigation. One type of litigation our business clients will definitely want to avoid, although it will affect their beneficiaries, not themselves (who are gone at that point), is litigation with the IRS over whether millions of dollars in life insurance death benefits ought to be taxed at a marginal rate of 45% or so. Thus, Mr. Fankhauser’s article notes that “if properly constructed and managed,” ILITs can be effective estate planning tools (emphasis added). His article does a nice job of communication elements of proper construction and management.
One aspect that is especially difficult to communicate, however, concerns the process of paying the premiums. Although covered in the Utah blog article, some elaboration may help to further understanding. The issue arises because premiums paid by the insured for policies owned by this artificial entity (the ILIT) are gifts.
Now, in addition to keeping the future proceeds of the life insurance out of the gross estate, a further goal is added, not to pay gift tax on the current gifts of the premiums to the trust. As mentioned, in the Utah blog article, this is often done by taking advantage of the annual gift tax exclusion (currently $12,000). Unfortunately, the tax code and the IRS have established two governing principles: (1) the annual gift tax exclusion may not be used for a gift of a future interest and (2) money given to the trust to pay premiums that may not result in death benefits for many years are future interests.
But, if someone can exercise the option to receive the gifts now, then the gifts are considered present (and not future) interests. The result is the procedure of the “Crummey Letters,” named after a court case that established the procedure. The beneficiaries of the trust are given the option, limited for a short period of time, to immediately demand the money intended to be used by the ILIT to pay premiums. The existence of this option establishes that the gifts to the trust (for premiums) are “present interests” and the annual gift tax exclusion does apply.
