I. TYPES OF INSURANCE POLICIES.

A. First-to-Die.

Most clients are familiar with first-to-die insurance policies, which insure the life of one individual. When the insured individual dies, the death proceeds may be used for the benefit of the surviving spouse and children or any other designated beneficiary. Due to the unlimited federal estate marital deduction, all proceeds may pass to the insured’s surviving spouse without generating any federal estate tax liability. However, the remaining proceeds would be included in the surviving spouse’s estate and may be subject to federal estate tax at his or her subsequent death (depending on the value of the surviving spouse’s estate at his or her death).

In contrast, if the insurance policy is owned by an irrevocable life insurance trust, the death proceeds paid upon the insured’s death may be excluded from both the insured’s and his or her surviving spouse’s gross estates. Therefore, holding an insurance policy in an irrevocable life insurance trust can shelter the policy’s proceeds from estate tax.

B. Second-to-Die.

This type of insurance policy insures the lives of both spouses, with the death proceeds being paid upon the death of the surviving spouse. Because this type of policy insures two lives, the premiums are usually much lower than first-to-die policies, as the premiums will be paid during the lifetimes of both spouses. By acquiring a second-to-die (i.e., survivorship) policy in an irrevocable life insurance trust, the proceeds would be paid to the trust, and not to the estate of the surviving spouse. As a result, the proceeds are sheltered from estate tax and can be used to provide the liquidity necessary to satisfy any estate tax liabilities due upon the surviving spouse’s death, while preserving the estate for the client’s beneficiaries.

II. PURPOSE OF AN ILIT.

An ILIT is an “irrevocable life insurance trust” which is established and funded with newly acquired and/or existing insurance policies on a client’s life. Upon the insured’s death, the insurance proceeds will not be paid directly to the beneficiary (e.g., a spouse or child). Rather, the proceeds will be paid to the ILIT, and the ILIT will be administered for the benefit of the beneficiary (e.g., a spouse or child). The two primary purposes of an ILIT are (1) to remove the insurance policy proceeds from the client’s taxable estate and (2) to provide a source of estate tax-free liquidity to pay any estate taxes owed for other assets owned at the surviving spouse’s death.

III. ESTABLISHING AN ILIT.

ILITs generally hold two assets – one or more life insurance policies and cash for paying premiums. ILITs can be funded with a newly purchased insurance policy, a pre-existing life insurance policy, or both.

To fund the ILIT with an existing policy, ownership of the policy must be irrevocably assigned to the trustees of the ILIT, and the trustees of the ILIT must be named as the policy’s beneficiary. The disadvantage of funding an ILIT with an existing policy is that the policy’s proceeds will not be excluded from the client’s estate for federal estate tax purposes (and will therefore be subject to estate tax) if the client dies within three years of funding the ILIT with the existing policy (the so-called “3-year rule”). Because of the estate tax inclusion risk, it is preferable to have the trustees of an ILIT apply for and purchase a new life insurance policy on the client’s life. When the ILIT purchases a new policy and the client reserves no incidents of ownership in the policy or any ability to modify the ILIT, the three-year rule does not apply and the insurance policy proceeds are not part of a client’s taxable estate, even if the client dies within three years of the purchase of the new policy.

IV. BENEFITS OF USING AN ILIT.

Generally, life insurance proceeds held outside of a trust will be included in a client’s taxable estate. However, by holding a life insurance policy within an ILIT, the policy’s proceeds may be sheltered from estate tax. There are two main benefits when using ILITs.

First, establishing an ILIT reduces a client’s estate tax liability by removing the life insurance proceeds from his or her estate, so that the policy’s proceeds are not subject to estate tax.

Second, the proceeds from the life insurance policies owned in an ILIT may provide a source of tax-free cash that may be used to pay estate taxes due on other assets. In the absence of an ILIT holding an insurance policy, many estates lack liquid assets that can be used to pay owed estate taxes, which are generally due within nine months of death. For example, rather than needing to sell real estate or a business at “fire-sale” prices to satisfy an estate tax liability, the estate tax-free insurance proceeds may be used to purchase interests in the real estate or business, and the sale of the real estate or business to an unrelated buyer may be postponed until more favorable terms are negotiated. In addition, the proceeds will be available for other expenses associated with the administration of a client’s estate. Insurance proceeds remaining after the satisfaction of taxes and other estate expenses may continue in the trust for the benefit of the client’s children and other beneficiaries.

V. FUNDING THE ILIT.

As discussed above, ILITs are generally funded with life insurance policies and with cash for paying premiums. We recommend that the client write a check or authorize an initial deposit into the ILIT’s bank account in an amount sufficient to cover the cost of the first premium payment, the cost of printing checks, and the bank’s required minimum account balance (if any), to prevent monthly maintenance charges. The check deposited into the ILIT bank account should be made payable to the trustees of the ILIT and the client should note on the memo line of the check “Contribution to the (ILIT’s name).”

It is important to note that all amounts deposited into the ILIT’s bank account must come from the client’s personal account. Please remember that no one other than the client should contribute any funds to the trust or to the trust’s account.

VI. PAYMENT OF INSURANCE PREMIUMS.

Once the initial deposit to the ILIT’s checking account has been made, the trustees must send letters to the trust beneficiaries notifying them of the contribution to the trust’s bank account and of the beneficiaries’ right to withdraw a portion of the amount contributed. (These letters are often referred to as Crummey Notices.) It is unlikely that beneficiaries will withdraw any portion of the client’s contributions if the beneficiaries understand that the purpose of these contributions is to pay premiums on the life insurance policy. However, in order to qualify the client’s contributions for his or her annual exclusion from federal gift tax, the beneficiaries must have a “present interest” in the amounts contributed to the ILIT, which is the reason for issuing the Crummey Notices. Generally, after thirty days, the ILIT beneficiaries’ rights of withdrawal will expire, and the funds remaining in the ILIT’s checking account can be used by the trustees to pay the insurance premiums. The contribution should remain in the account for thirty days, as this is the period of time during which the beneficiaries have the right to withdraw these amounts, so it is important that the client make any necessary contributions at least one month before the premium due date.

VII. OPERATION AFTER DEATH.

At the insured’s death (or at the death of the second-to-die of the insureds), the proceeds on the ILIT’s insurance policies will be paid directly to the ILIT free of income and estate taxes. If the client’s estate (consisting of assets outside the ILIT) is large enough to generate an estate tax liability, payment of federal estate taxes will be due nine months from the date of death. The insurance proceeds may be used to provide liquidity to the estate to satisfy the estate tax liability, and also with estate administration costs. Accordingly, the ILIT will prevent liquidation of estate assets, and will allow the client to transfer more of his or her estate to the client’s descendants. After the estate tax liability and administrative expenses are satisfied, the remaining insurance proceeds will continue in trust for the benefit of the client’s spouse and/or descendants.