Irrevocable Life Insurance Trust

To keep a large death benefit out of the insured's taxable estate, a common tool is:

1. A.Naming the estate as owner and beneficiaryNaming the estate does the opposite of what the client wants. Proceeds payable to the estate are squarely includable in it, and they also lose the creditor and probate protection a named beneficiary would provide.
2. B.An irrevocable life insurance trust (ILIT)Correct - removes ownership from the estate.
3. C.Owning the policy personallyPersonal ownership is what creates the estate-tax problem in the first place. Because the insured holds incidents of ownership at death, the entire death benefit is pulled into the taxable estate.
4. D.A revocable trust the insured controlsA revocable trust genuinely does help with probate, which is why it tempts. But the retained power to amend or revoke means the insured still controls the policy, so the proceeds stay in the taxable estate. Irrevocability is what severs that control.

Why: An irrevocable life insurance trust (ILIT) owns the policy, keeping the death benefit out of the insured's taxable estate.

To provide estate liquidity while keeping the death benefit OUT of the taxable estate, a client should use:

1. A.Naming the estate as ownerMaking the estate the owner defeats the objective. Ownership sitting in the estate guarantees inclusion, and routing proceeds through the estate also subjects them to probate and to the decedent's creditors.
2. B.A revocable trust the insured controlsRevocable means the insured can undo it, and that retained control is treated as continued ownership of the policy. The proceeds would still be counted in the taxable estate, so the liquidity would arrive with the tax problem attached.
3. C.Personal ownership of the policyHolding the policy personally is the default arrangement the strategy is designed to avoid. Incidents of ownership at death drag the entire proceeds into the taxable estate.
4. D.An irrevocable life insurance trust (ILIT)Correct - removes ownership from the estate.

Why: An irrevocable life insurance trust (ILIT) owns the policy, keeping the proceeds out of the insured's taxable estate.

To remove an EXISTING $2 million policy from his taxable estate, an insured transfers it to an irrevocable life insurance trust (ILIT). The transfer accomplishes the estate exclusion only if:

1. A.He survives at least three years after the transfer and retains no incidents of ownershipCorrect. Both the survival period and complete divestment are required.
2. B.He remains the trustee to manage the policyWrong-but-tempting. Trustee powers are incidents of ownership that ruin the exclusion.
3. C.The premiums are paid directly by his estate after deathWrong. Post-death estate involvement contradicts the plan entirely.
4. D.The trust files a gift tax returnWrong. Reporting the gift does not defeat the three-year rule.

Why: Gifted policies re-enter the gross estate if the insured dies within three years of transfer; success requires surviving the period and giving up all incidents of ownership. Having the trust purchase a new policy from inception avoids the rule. Citation: IRC Secs. 2035(a), 2042. Takeaway: transfer early, keep nothing - or let the trust buy the policy new.

Ottoline transfers cash to her irrevocable life insurance trust each year so the trustee can pay the premium on a policy the trust owns. Her attorney wants each transfer to qualify for the annual gift tax exclusion. What must the trust provide?

1. A.Naming Ottoline as trustee so she controls the timing of distributionsIncorrect. Retaining that control would give her incidents of ownership and cause estate inclusion, and it still would not create a present interest.
2. B.Crummey withdrawal powers, giving each beneficiary written notice and a limited right to withdraw the contributionCorrect. A Crummey power converts a future-interest gift into a present interest, which is what the annual exclusion requires.
3. C.A provision making the trust revocable for the first 30 days after each contributionIncorrect. Revocability would pull the policy back into her estate and defeat the entire purpose of the trust.
4. D.A spendthrift clause barring beneficiaries from assigning their interestsIncorrect. A spendthrift clause protects beneficiaries from creditors but does nothing to create a present interest.

Why: The annual gift tax exclusion is available only for gifts of a PRESENT interest. A gift into a trust is normally a future interest, because the beneficiaries cannot touch it now. The standard fix is a CRUMMEY power: each beneficiary receives written notice of the contribution and a limited window in which to withdraw his or her share. That withdrawal right converts the gift into a present interest and makes the annual exclusion available, even though beneficiaries in practice let the window lapse.