Irrevocable Life Insurance Trusts (ILITs) are planning tools used to store life insurance proceeds excluding taxable property.
For example, if a married couple has an inheritance of 6 million, they can pass on the 4 million to the next generation without taxes if they set up the right trust arrangements to take advantage of the maximum lifetime integrated credit. That leaves 2 million still taxed under current legislation.
The logical thing to do is to buy a survivorship life insurance policy for projected taxes. However, a policy purchased in a way that is familiar to most people, the problem is not solved; it’s made worse.
If a spouse has an “occurrence of ownership” in the policy, it will be included in the estate. The one million dollar policy purchase increased the estate to 7 million. Four million passed tax free, but now the taxable property is 3 million. This increases taxes by about $225,000.
Enter the Unrevocable Life Insurance Trust
Lawyers design irrevocable Life Insurance Trusts. The trust will file its own Federal Tax ID number. The trust will then apply to the survivorship life insurance policy. These will be the applicant, owner and beneficiary of the policy. Typical wording is “John and Mary Smith Irrevocable Life Insurance Trust dated April 5, 2007, JPMorgan Chase Bank, trustee.”
In this example, because neither John nor Mary have an “event of ownership” in the policy, it will not be part of their taxable estate.
Owners and Beneficiaries
In contrast to using ILIT, I have worked with several cases where the only child or children were the owner and beneficiary. This might work. However, every year the parents give money to pay the premium, there is no guarantee that the money will be used to pay the premium. Furthermore, children, as owners, have access to cash value. ILIT has more guarantees.
I’ve seen a guardian become a child, a spouse’s attorney, an accountant or an old friend of the family. All of these will work, but an impartial third party, such as a bank, is much better. If someone is a trustee, specify the bank as a substitute trustee. Banks are not dead.
Poor letter
Usually, life insurance premiums are paid by parents in the form of an annual gift to the Irrevocable Life Insurance Trust. Currently (2007) a person can give up to $12,000 annually to as many people as they want without paying any gift tax or the amount deducted from their lifetime exemption. However, this gift must be a “current interest” gift, meaning the recipient must have direct rights to the gift.
A gift to ILIT, for paying premiums on a life insurance policy owned by ILIT, is not a “interest now” gift. A “Crummey” letter qualifies a gift as a “flowers now” gift. The letter was not ugly or poorly written; the letter takes its name from a court case initiated in 1968 by Clifford Crummey, who tried to do the same thing: make an annual gift of flower gifts. Ultimately, the outcome of the case necessitated the use of letters, now known as “Crummey” letters.
A letter is sent annually to each ILIT beneficiary. It simply states that the prize has been awarded to ILIT and they can withdraw it if they wish within a certain period of time, usually 30 or 60 days. If they do not exercise this right, the gift becomes a gift of interest.
Obviously, there is an “agreement” between parents and children to ignore these letters, as they are part of the overall inheritance plan. Annual gifts and subsequent annual Crummey letters do not have to be given to children with legal capacity, such as age 18. I have seen letters written to 4 month old babies. In this case, even if the baby cannot read the letter or understand the reason for the inheritance planning behind it, he is not exercising his right to the gift. Phew, another legal bullet was dodged.
As you can see, it was very important to organize the annual compilation of Crummey’s letters. Some bank trust departments usually provide this service if they are the trustee. This is just out of respect because they will never see or manage life insurance results.
The best bet is to have your attorney do the paperwork. I have one client whose law firm (under a set of written instructions) had a premium notice from a life insurance company sent to their firm, prepared and mailed Crummey’s papers and then paid the premium. All clients have to do is open a letter each year from the law firm showing that premiums are due and send them a check. In addition, they do not need to lift a finger. Nice service.
If you own an estate that is subject to property taxes and your advisor recommends a life insurance policy pay taxes at a discount, make sure you evaluate your use of an Irrevocable Life Insurance Trust.