December 9, 2016
Irrevocable life insurance trusts ("ILITs") are commonly used in estate planning to remove life insurance proceeds from the insured's taxable estate, allowing the life insurance proceeds to pass free of estate tax. The ILIT will also receive the life insurance proceeds free of income tax, providing significant liquidity at the insured's death.
Although commonly used in estate planning, the technical aspects of administering an ILIT are often misunderstood and mistakes can easily be made. Failure to properly administer an ILIT can result in adverse tax consequences to the grantor and to the beneficiaries, with consequent liability to the trustee, so it is important to be mindful of the following issues in administering an ILIT.
Opening a Bank Account and Paying Insurance Premiums
The trustee should open a bank account for the trust. The account should be used for the annual gifts made to the ILIT (generally in the amount of the insurance premiums). These gifts should be deposited from the grantor's individual bank account into the ILIT's bank account at least thirty days before the premium due date in order to allow the trust beneficiaries the ability to exercise their "Crummey" rights of withdrawal under the trust agreement (as discussed further below). As soon as the withdrawal period lapses, and assuming the beneficiaries have not exercised their withdrawal rights, the trustee should promptly pay the insurance premiums from the trust account, as the failure to make timely payments could result in a lapse of the policy.
In most cases, funds will only be held in the account for short periods of time, so a non-interest bearing account may simplify tax matters, as there will then be no interest income requiring the filing of an income tax return for the trust.
During the grantor's lifetime, it is not necessary for the trustee to obtain an Employer Identification Number (EIN) and the ILIT may use the grantor's social security number. However, in some instances a bank or insurance company may insist upon the ILIT obtaining a separate EIN, in which case the trustee can complete and submit IRS Form SS-4 to obtain a separate EIN.
Notice to Beneficiary Concerning "Crummey" Withdrawal Rights
Generally, the amounts gifted to a trust are taxable gifts. To qualify gifts to an ILIT for the annual exclusion (currently $14,000 per donee), the trust agreement will commonly grant some or all of the beneficiaries the right to withdraw certain amounts each year (commonly referred to as "Crummey" rights of withdrawal). The trustee should notify any beneficiaries (or, in the case of a minor beneficiary, the non-insured parent or guardian of the minor) who have Crummey withdrawal rights whenever the grantor makes any gifts to the ILIT. Importantly, a gift to the ILIT may include, for example, the contribution of a life insurance policy to the ILIT, the contribution of funds necessary to pay the insurance premiums or the direct payment of insurance premiums to the insurance company. The notice should be in writing, given immediately after the gift is made, contain a description of the gifted property, describe the respective rights of withdrawal in the beneficiary resulting from the gift and advise regarding the period of time in which the beneficiary has a right to exercise his or her power of withdrawal. Failing to provide such notice contemporaneously could result in adverse gift tax consequences.
The trustee should establish and maintain a permanent file to preserve important trust documents, including the trust agreement, insurance policies, assignments of insurance policies and valuations (if any), EIN (if required), and copies of all notice letters sent to Crummey beneficiaries. The trustee should also keep records of all trust activity, including receipts of deposits and payments of insurance premiums.
Monitor and Review Insurance Policy and Company
Trustees have a fiduciary obligation to make prudent investment decisions regarding trust assets, including life insurance policies. As such, the trustee should monitor and review the performance of the policy (or policies) as well as the financial health of the insurance carrier, and should be prepared to take action if necessary. The trustee should maintain a copy of the original illustration for each policy and should also obtain "in force" illustrations periodically to monitor whether such policy is performing in line with the projections and determine if any adjustments, including, if warranted, exchanging or surrendering the policy, are necessary to better satisfy the ILIT's objectives. This is particularly important with universal or variable policies.
Given today's low interest rate and low return environment, longer life expectancies and higher expenses being charged by some carriers, the trustee may find that policies are underperforming and expected cash values are being depleted, requiring the payment of premiums for a longer period or of a higher amount than anticipated and/or resulting in potentially reduced death benefits or worse, the ultimate lapse of the policy.
Collection of Insurance Proceeds
On the death of the insured, the trustee has the obligation to collect the proceeds of the life insurance policy held by the ILIT and to distribute the proceeds in accordance with the trust agreement.
ILITs can be great estate planning tools. However, mistakes in maintaining them, even honest mistakes, may prompt the IRS to challenge the trust and tax the insurance proceeds.