Irrevocable Life Insurance Trusts: Handle With Care*

Although Irrevocable Life Insurance Trusts (ILITs) are a wonderful planning tool, they must be implemented carefully to avoid serious problems.  Here is a quick summary of the process that should be followed when a client contemplates purchasing a brand new life insurance policy:

• The need for life insurance is established by analyzing the liquidity and estate planning goals of the family.
• The family's life insurance expert gathers preliminary medical information and schedules physicals in order to determine insurability.
• After determining insurability, the irrevocable life insurance trust is prepared. The trustmaker (or trustmakers if a joint irrevocable life insurance trust is to be created by a husband and wife) signs the irrevocable life insurance trust.
• The trustee applies for a taxpayer identification number for the trust and opens a bank account in the name of the trust.
• The trustmaker makes a gift to the irrevocable life insurance trust that the trustee deposits in the trust's bank account.
• The trustee notifies the beneficiaries of their limited right to withdraw their share of the gift from the irrevocable life insurance trust.  (Often referred to as Crummey Notices based on the name of a plaintiff in a court case against the IRS.)
• The beneficiaries sign an acknowledgment that they have received the notice and return it to the trustee for the trust's records.
• The beneficiaries allow their withdrawal rights to lapse (as opposed to waiving the rights).
• The trustee signs applications for the life insurance.
• The trustee pays the life insurance premium and the policy is issued showing the trust as the owner and the beneficiary.

Irrevocable trust are used extensively in sophisticated estate planning because they remove assets from an individual's estate and allow a certain degree of control by their makers.  When they are properly designed and implemented, they also allow a surprisingly high degree of flexibility.

However, professional advisors must exercise caution to avoid shortcuts that might cause the strategy to fail.  If the withdrawal notices are not issued, for example, the trustmaker has made a gift of a future interest which doesn't qualify for the annual gift tax exclusion.  Or if the insured is listed as the policy owner on the insurance app (instead of the ILIT being listed as owner), the IRS can find "incidents of ownership" that will cause the insurance proceeds to be included in the taxable estate -- in spite of all the precautions taken to prevent that.

Each step of the process is there for a reason, and must be carefully and patiently followed.

*Adapted from the Planning Partners Press.