Irrevocable Life Insurance Trusts: What To Do With Existing Policies*

Previously, we explored the steps that are taken when funding an Irrevocable Life Insurance Trust (ILIT) with a brand new insurance policy.  But what if a client trustmaker is no longer insurable or premiums would simply be too expensive?  Can we use policies that the client already owns?  The answer is "yes," but with caution.

The proceeds from an insurance policy are includable in the estate of a decedent if the decedent possessed "incidents of ownership" either at death or within three years of death.  This means that if a trustmaker transfers a life insurance policy that he or she currently owns by gift to an Irrevocable Life Insurance Trust, and if the maker dies within three years, the life insurance proceeds will be subject to estate tax.  This is the primary reason that new policies should be purchased by the trustee of the ILIT when possible.  It eliminates the three-year look-back for inclusion.

Another potential problem arises when using existing life insurance to fund an irrevocable life insurance trust.  Many times, the life insurance has a substantial cash value.  If it does, then the value of the policy is treated as a gift to the irrevocable life insurance trust.  If the value exceeds $13,000 multiplied by the number of demand right beneficiaries, then the excess will reduce the $5,000,000 (2011) exemption equivalent.  If the exemption equivalent has been used, then a gift tax will be due.

If the existing life insurance policies are sold to the life insurance trust, this three-year rule is avoided.  Of course, for the irrevocable life insurance trust to be able to purchase the policies, enough cash will be need to be given to the irrevocable life insurance trust to pay for the policies.

When life insurance policies are sold, we must consider whether or not the sale will be a "transfer for value" which will result in the death benefit being income taxable.  To avoid this result, the sale must fall into one of the exceptions to the transfer for value rule.  The most frequent solution to this problem is to sell the policy to a partner of the insured.  By giving interests in a family limited partnership, for example, to the irrevocable life insurance trust, the irrevocable life insurance trust becomes a partner of the insured person.

Care must be taken to insure that the policy is being sold for fair market value.  In most cases, the policy value information provided by the insurance company will suffice.  However, if the insured person is in poor health, an outside appraisal of the policy may be needed.

If a trustmaker insists on using an existing policy, and none of these solutions are available, an existing life insurance policy can still be placed into an ILIT.  However, the trustmaker must be aware of the rule and understand that the strategy won't be fully effective until three years have passed.  Or, if insurable, the trustmaker might consider the purchase of a three-year term policy in case of death during the waiting period.

*Adapted from the Planning Partners Press.