Irrevocable Life Insurance Trusts

An irrevocable life insurance trust (ILIT) is created to purchase life insurance or to receive a policy that is already in effect so that the insurance proceeds will not be included in the estate of the insured. To exclude the insurance proceeds, federal tax laws requires that the insured does not have any incidences of ownership in the policy, which means that the grantor of the trust, who is usually the insured, must relinquish all control of the trust, including the ability to revoke the trust. Thus, the grantor cannot serve as trustee nor can he change the beneficiaries of the trust. The trust owns the insurance policy and continues to pay the premiums.

As an alternative to the trust, the life insurance policy could be given to the beneficiaries, but they may not continue to make the payments or they may cash the policy, if it has cash value, before the death of the insured.

IRS rules require that the trust be set up at least 3 years before the death of the grantor; otherwise it is includable in his estate.

A major drawback of the irrevocable life insurance trust is that the beneficiaries cannot be changed by the grantor, so he will not be able to add new beneficiaries who may not have been alive when the trust was created nor exclude a divorced spouse. However, if the trust document gives the trustee discretion, then the trustee can change beneficiaries, but the grantor cannot have any control over the discretion.

Crummey Trusts and Crummey Powers

A special type of irrevocable life insurance trust, called a Crummey trust, allows a wealthy grantor to transfer the proceeds of a life insurance policy to an irrevocable life insurance trust so that it is not included in the grantor's estate and allows the grantor to continue paying the premiums through the trust free of gift taxes. Since the beneficiaries do not have to pay any income taxes when they receive the proceeds of life insurance policy, the Crummey trust allows the transfer of considerable wealth tax-free.

Property or income that comes from a trust is considered to be a present interest when the beneficiary has the right to withdraw the money, thereby making it eligible for the annual gift exclusion. The Crummey trust – named after the 1968 court case, Crummey v. Commissioner, 25 TCM (CCH) 772 - Tax Court 1966 – is designed to pass property to beneficiaries free of both gift and estate taxes. The grantor makes a gift to the trust, usually equal to the annual exclusion, for each beneficiary. The beneficiaries are given a period of time, usually 30 days or less, but it can be no more than 60 days, to withdraw the gift. If they fail to do so, then the gift remains in the trust, where it is often used to purchase life insurance, with the proceeds going to the beneficiaries when the donor dies. Beneficiaries are notified of their gift by a letter, which is generally called a Crummey withdrawal right. However, if the parties have an agreement that the current Crummey power — as it is called — will not be exercised, then the IRS considers the power to be a sham and it will not be considered to be a gift of a present interest, and, therefore, not eligible for the annual gift exclusion.

Crummey powers were expanded in 1991 by Estate of Cristofani v. Commissioner, 97 TC 74 - Tax Court 1991, which allowed contingent remainder beneficiaries, such as grandchildren, to also be considered as having present interest.

The Crummey Trust and the Generation-Skipping Transfer Tax

A gift made to a Crummey trust that has beneficiaries in several generations will usually not qualify under the generation-skipping transfer tax (GSTT) annual exclusion because deemed allocation rules will not automatically apply to the gift unless the trust is a skip person because the IRS treats the transfer as a gift to the trust rather than to the beneficiary. Consequently, if any of the beneficiaries are non-skip persons, then the GSTT annual exclusion will not be automatically applied to the gift. In such a case, the grantor will either have to allocate his GST exemption to the transferred property by filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return or the skip beneficiaries will have to pay a GST tax on any property distributed to them at the time of the transfer. This GST tax can be avoided if the trustee directly pays providers of educational or medical services for the skip beneficiaries.

If a trust is designated as a skip person, then the deemed allocation rules will automatically apply the donor's GST annual exclusion to all gifts made to the trust. However, a trust can only qualify as a skip person if:

1. trust principal or income benefits only 1 skip person during her life;
2. trust assets become part of the beneficiary's gross estate if she dies before the trust terminates.

If a grantor wants to provide for more than 1 skip person and take advantage of the automatic GST exclusion, then a trust can be set up for each skip person.