237 / What are some of the differences between a funded and unfunded irrevocable life insurance trust (ILIT)?

An ILIT may be either “funded” or “unfunded.” In a funded trust, the trust owns income-producing assets, such as securities, in addition to the life insurance policy. Income generated by these underlying investment assets may be used to pay the insurance premiums. The grantor not only transfers the life insurance policy to the trust, but also transfers other property to the trust from which the premium payments may be made. The major drawback of the funded life insurance trust is that the trust income may be taxed to the grantor if it can be used to pay premiums on a policy on the life of the grantor or his or her spouse.

In an unfunded trust, the only asset owned by the trust is the life insurance policy. The trustee has no other property in the trust with which to pay premiums, and is dependent on annual cash gifts from the grantor. This results in the need to transfer funds into the trust to be used to pay the premiums on the policy. Gifts of premium dollars to the trust by the grantor may be sheltered from gift tax using the annual gift tax exclusion. Gifts to an unfunded trust, however, will be considered present interest gifts, qualifying for the annual gift tax exclusion only to the extent that the trust beneficiaries are given immediate withdrawal rights with respect to the amounts transferred to the trust (see Q 236 on gifting as a method for funding an ILIT).