Irrevocable Life Insurance Trusts in Estate Planning: Common Pitfalls

Life insurance is often a cornerstone of a comprehensive estate plan, particularly when an estate consists of largely illiquid assets.

Irrevocable life insurance trusts (ILITs) are a common planning tool used to maximize the benefits of life insurance when it is being purchased to provide liquidity to pay estate tax.

Although ILITs have been around for decades, there are a number of pitfalls that can undermine their effectiveness.

By being aware of some of the more common snares, advisors can help their clients (who, more often than not, rely on their advisors to navigate sophisticated planning) to avoid these traps.

Outlined below are three of the common problems that arise in connection with funding and administering ILITS.

Pitfall 1: Purchasing a New Policy Outside of the ILIT

If an individual purchasing a new life insurance policy buys the policy and then transfers it to an ILIT, the death benefit will be included in the insured's estate for estate tax purposes if they die within three years of the transfer.

This is because Internal Revenue Code Section 2035 causes estate tax inclusion for an individual who transfers or otherwise gives up power over a life insurance policy within three years of death.

However, if an individual who plans to create an ILIT instead establishes and funds the ILIT first so that ILIT can purchase the policy directly, the death benefit will be excluded from the insured's estate regardless of how long they survive the purchase date.

Thus, to avoid this pitfall, advisors should determine at the outset whether their clients plan to create ILITs so that purchase of the policy can be appropriately sequenced.

Pitfall 2: Failing to Abide by the Crummey Protocols

Unless or until the premiums on a life insurance policy are fully paid or otherwise self-sustaining through a draw on the cash surrender value, the insured must make gifts to the ILIT to cover the premiums.

Oftentimes, clients wish to use their annual gift tax exclusion to make such contributions.

To qualify the gifts for the annual gift tax exclusion, the beneficiaries of the ILIT must have the right to withdraw certain amounts that are transferred into the ILIT.

Failure to include the requisite withdrawal rights may eliminate the ability to offset gifts by the annual exclusion amount.

Even if an ILIT includes so-called Crummey withdrawal rights, a client also will not be able to take advantage of the annual gift tax exclusion if the beneficiaries are not informed of their withdrawal rights each time an eligible contribution is made to the ILIT.

By way of example, assume that your client makes a gift to an ILIT of which their two children are the current beneficiaries.

Assume further that the ILIT provides that each time a contribution is made to it, the trustee must notify the children that they have the unrestricted right to withdraw a proportionate share of such contribution (up to the annual gift tax exclusion amount) for a fixed period of time from the date of the contribution (e.g., 30 days).

If the trustee fails to provide such notice, then the gift to the ILIT will not qualify as an annual exclusion gift.

Similarly, if, prior to the expiration of the fixed period, the trustee makes a disbursement from the ILIT that causes the value of the ILIT's assets to drop below the amount subject to a withdrawal right, then the gift will not qualify for the annual exclusion.

To avoid these pitfalls, advisors should, first, review an ILIT before it is signed to confirm that it includes Crummey withdrawal rights, and, second, help their clients establish procedures for providing the requisite notice and waiting the required period each time a gift is made.

This may include setting a reminder for their clients to fund their ILIT each year on a date to allow sufficient time for the fixed period to lapse before a premium payment is due (e.g., 45 days before the premium due date if the fixed waiting period is 30 days).

Pitfall 3: Forgetting to Account for Administrative Expenses

During the insured's lifetime, ILITs often have limited assets as they may only be funded with the insurance policy and the amount needed to cover the premiums thereon.

As a result, if the ILIT has any administrative expenses such as accounting, legal or trustee fees, there are insufficient assets in the ILIT to pay them.

If the client pays these expenses directly, they will be treated as making a gift for gift tax purposes because the client will be deemed to have first transferred to the ILIT any amounts paid on its behalf.

Thus, to avoid this issue, clients should fund their ILITs with the amount necessary to pay premiums and administrative costs.

(If the class of beneficiaries holding Crummey withdrawal rights is broad enough, this can be done solely through annual exclusion gifts.)

Clients rely on their advisors to help them identify the right insurance policy and determine how best to finance the policy in order to achieve their planning goals.

But when an ILIT is involved, advisors can add value by helping their clients avoid the pitfalls that may otherwise undermine their efforts.

Elizabeth G. Acevedo is a shareholder at Weinstock Manion, a law firm that focuses on trusts and estates. She develops estate plans for high-net-worth individuals and families.