Irrevocable Life Insurance Trusts (ILITs) are planning tools used to keep life insurance proceeds outside of the taxable estate. The life insurance may be desired to pay estate taxes or to provide liquidity for an illiquid estate. For example, say Mr. Smith age 76 owned a commercial building worth $8 million as his only asset and his oldest son uses the building for his business. Mr. Smith might get an $8 million life policy so that he leaves the building to his oldest son for his business and the youngest son receives the life insurance policy death benefit. Each son thereby receives the same value inheritance.
If Mr. Smith simply buys the policy and owns it, the $8 million death benefit will be included in his estate and subject to estate tax on $2.75 million. This estate tax can be avoided.
Enter the Irrevocable Life Insurance Trust
Attorneys draft Irrevocable Life Insurance Trusts. The trust will apply for its own Federal Tax ID number. The trust will then apply for the life insurance policy. The trust, not Mr Smith, will be the applicant, owner and beneficiary of the policy. Typical wording is "The John Smith Irrevocable Life Insurance Trust dated May 15, 2007, Midland Bank, trustee."
In this example, since Mr. Smith has no "incidence of ownership" in the policy, it will not be part of his taxable estate.
The Crummey Letter
Typically, the life insurance premium is paid by Mr. Smith in the form of annual gifts to the Irrevocable Life Insurance Trust. Currently (2007) a person can give up to $12,000 each year to as many people as they want without paying gift tax or having the amount subtracted from their lifetime exclusion. However, these gifts must be "present interest" gifts, which mean the recipient must have immediate rights to the gift.
Gifts to an ILIT, for paying premiums on a life insurance policy owned by the ILIT, are not "present interest" gifts. A "Crummey" letter qualifies the gift as a "present interest" gift. The letter takes its name from a court case initiated in 1968 by Clifford Crummey, who was trying to do this very same thing: to get IRS to treat premium payments for life insurance that would pay off in the future as present interest gifts. Ultimately, the outcome of the case in which IRA acquiesced required the use of a letter, now known as the "Crummey" letter.
A letter is sent every year to each of the beneficiaries of the ILIT. It simply states that a gift has been made to the ILIT and they can withdraw it if they want within a certain timeframe, usually 30 or 60 days. If they don't exercise this right, the gift becomes a present interest gift.
Obviously, there is an "understanding" between the parent and children to ignore these letters, as it is a part of the overall estate plan. The best bet is to have your attorney do the letters. If you have an estate that will be subject to estate taxes or you want to equalize an inheritance to heirs, consider a life insurance policy use of an Irrevocable Life Insurance Trust to keep the policy out of your estate.