Understanding Irrevocable Life Insurance Trusts and Their Tax Benefits in Estate Planning

Introduction

A typical challenge encountered by estates of varying sizes and complexities is the lack of liquidity to cover the costs of estate administration. These expenses may satisfy just debts to creditors or estate tax payments.  All too often, inheritances left to heirs in the form of hard, or illiquid, assets need to be sold to generate the funds required to satisfy these obligations.  It has been my experience that most clients would rather keep intact income producing illiquid assets, such as a closely held family business or commercial real estate, or even a securities portfolio, and leave a legacy to their heirs.  The paragraphs that follow will serve as a guide to understanding Irrevocable Life Insurance Trusts and the tax benefits they afford as an estate tax reduction tool in the transfer of wealth.  This type of trust is ideal for individuals with assets at or above Federal and/or State estate tax exemption thresholds (discussed in more detail below).  A properly crafted and administered Irrevocable Life Insurance Trust can provide needed liquidity to an estate, and more importantly, it can reduce the value of the taxable estate; therefore, minimizing estate tax exposure overall.

Life insurance is not an asset that passes through the probate process, as the death benefit is paid directly to the beneficiary named in the policy and is not taxable as income to the beneficiary.  However, the value of the death benefit is included in the gross taxable estate of the insured decedent for gift and estate tax purposes, at both the Federal and State levels.  By way of example, this means that if a person has a net worth of $5 million, and a life insurance policy in their name in the amount of $2 million, then the law deems that person’s net worth to be $7 million upon their death. The purpose of an Irrevocable Life Insurance Trust is to exclude the value of the life insurance death benefit from your gross taxable estate.  This is accomplished by making your trust the owner of your life insurance policy during your lifetime.

An Estate Tax Primer

There is no estate or gift tax under Federal and Connecticut law with regard to bequests and gifts between spouses, which is known as the unlimited marital deduction.  The tax concerns arise for unmarried individuals or when the second spouse passes away. The Federal estate tax exemptions that went into effect as of January 1, 2018 (under the Trump Administration’s Tax Cuts and Jobs Act) increased from $5.49 million to $11.2 million per individual, indexed to increase for inflation.  It increased to $11.7 million a few years ago, then to $12.06 million last year, and currently the exemption is $12.92 million based purely on inflation over the past 3 years. This is a temporary increase of the exemptions until the end of 2025 and will then revert to the 2017 levels in 2026, unless Congress acts beforehand. 

Based on Connecticut law effective as of January 1, 2018, the Connecticut estate tax exemption amount increased from $2.0 million to $2.6 million, which increased to $3.6 million in 2019, and to $5.1 million in 2020, and then to $7.1 million in 2021 and to $9.1 million in 2022 and has increased this year to match the federal amount (being the current exemption amount in 2023).  The Connecticut exemption is also expected to decrease when the Federal exemption decreases in 2026 unless the Connecticut General Assembly enacts legislation beforehand.  Any amounts above the aforementioned exemption amounts will be taxable to the estate, thereby reducing the inheritance amounts to your children and grandchildren.  This is especially in light of the fact that the current Federal unified estate and gift tax rate is 40% and the current Connecticut unified estate and gift tax rate is 12%.

One can only speculate as to what might happen with the estate tax exemptions as of January 1, 2026.  Congress may take legislative action and keep the higher exemption amounts, do nothing and allow the exemption to revert to 2017 amounts, or come up with a compromise amount.  It is also worth noting that while the law must be passed by Congress, the Biden Administration was nonetheless toying with the idea of proposing an exemption amount of only $3.5 million in 2021.  Luckily, that was met with a lot of resistance, and the current Biden Administration proposal has been raised to approximately $6.0 million.

Gifting as a Strategy to Reduce Value of Taxable Estate

As mentioned in the Introduction, the Irrevocable Life Insurance Trust is a tool to exclude the value of the life insurance death benefit from your gross taxable estate.  This is accomplished by making your trust the owner of your life insurance policy during your life.  Essentially, a time-honored technique used to reduce your taxable estate is to make gifts during your lifetime to other individuals, usually children or grandchildren, using the annual gift tax exemption afforded by the IRS Code ($17,000 in 2023 – indexed to increase for inflation every year).  You can make a gift up to the annual exemption to as many people as you choose in a given calendar year.

By way of example, if a donor has three children and wants to make gifts of $17,000 to each child, the donor can reduce his or her taxable estate by $51,000 each year.  A married couple can double their gifts and reduce their combined taxable estates by $102,000 each year.  If an heir is a minor or not yet mature enough to manage his or her own money, or is indebted to creditors, or has a dependency problem (i.e. drugs, alcohol, gambling) or marital issues that may end in divorce, the donor can place restrictions on the use of the gifts by establishing an Irrevocable Life Insurance Trust and making the gifts to the trust for the benefit of the Trust beneficiaries.  The trust can be crafted to give the trustee the discretion to stagger distributions of interest and principal to avoid a large lump sum of cash being distributed to a beneficiary with such aforementioned concerns. 

A trust can also be established to retain a level of control over the gifts after one is gone, and leave a lasting legacy, even if there are no dependency or creditor problems with any heirs.  The aforementioned reasons are no different than the reasons for establishing any other type of inter vivos, or testamentary trust, such as a marital disclaimer trust, credit shelter trust, grantor family trust, or other vehicle to govern and shelter one’s assets.  Again, as mentioned above, the overall goal is to establish an Irrevocable Life Insurance Trust to own the life insurance policy.  The proceeds of the policy at one’s death, along with the premiums that are paid during one’s life, will be excluded from the decedent’s taxable estate at death.  An Irrevocable Life Insurance Trust is also useful in the case of an unmarried couple (because there is no unlimited marital deduction as explained above), or where one or both beneficiaries are not U.S. citizen(s) (because a non-citizen will not benefit from the unlimited marital deduction under U.S. law).

There are certain formalities that must be followed in the administration of an Irrevocable Life Insurance Trust.  These include setting up a separate tax ID number, opening a separate trustee bank account, making the payment of the yearly premium, and taking advantage of the annual gift tax exclusion, through “present interest gifts” withdrawal rights and IRS “crummey notices” requirement.  These formalities are discussed below.

What is a Present Interest Gift?

For the value of a gift to be removed from one’s estate, it must be a gift of a present interest, which means that the recipient, or beneficiary of the gift, must have an absolute right to the use and enjoyment of the gift immediately.  Thus, if you give each child $17,000, that can be used upon receipt, then it is a present interest gift, and your estate is reduced by $51,000.  On the other hand, if you were to establish a trust for the benefit of your children and make a gift to such trust in the amount of $51,000 without granting them a right to withdraw the gift immediately (see “Crummey Notices” below), such a gift would be considered a future interest gift (not a present interest gift available in the calendar year it is made) and the amount would therefore be included in your taxable estate upon death.

The "Crummey Notice" Requirement

In order for your gift to an Irrevocable Life Insurance Trust to be considered a present interest gift, the IRS requires strict procedures for the payment of insurance premiums and formal notices to beneficiaries, referred to as “Crummey Notices."  The term originated from the federal tax case that established the requirement in 1968.  A Crummey Notice to a beneficiary must include the following information:

• A gift has been made to the trust which the beneficiary has the immediate right to withdraw;
• The amount (or proportionate share) that the beneficiary may withdraw;
• The expiration date for the beneficiary’s right to withdraw (typically 30 days); and
• How the withdrawal right may be exercised.

Trusts incorporating this withdrawal power are known as “Crummey Trusts”.  A Crummey Trust is not exclusive to life insurance.  For example, one can establish a Minor’s Crummey Trust, and gift the annual exclusion amount of $17,000 per child each year to the trust.  In the event of minor beneficiaries, the non-donor parent or guardian may exercise or decline to exercise the withdrawal rights on behalf of the minor. No matter the type of Crummey Trust used, by following the “mechanics” below, a present interest gift will be deemed to have been made.

Getting the Mechanics Right

The success of an Irrevocable Life Insurance Trust rests on the following procedures for making the gifts and payment of the premiums:

• The settlor, or grantor, of the trust must make the gift (the amount of premium due) to a bank account established by the trustee of the Irrevocable Life Insurance Trust;
• “Crummey Notices” must be sent by the trustee to the beneficiaries of the Irrevocable Life Insurance Trust; and
• The trustee must pay the premium to the insurance company after expiration of the withdrawal rights.

The failure to follow these procedures on an annual basis will negate the present interest gift and eliminate the tax benefits intended by the trust.  If the settlor, or grantor, makes the premium payment directly to the insurance company or if the trustee fails to send the Crummey Notice to each beneficiary, it will not invalidate the trust, but it may result in significant adverse gift and estate tax consequences, as the payments will be considered future interest gifts.

Beware of the Three-Year Lookback

The timing of the creation and funding of the trust is an important consideration, as the IRS imposes certain restrictions before qualifying for the tax benefits. If you transfer a current life insurance policy in which you are the named insured to an Irrevocable Life Insurance Trust within the three (3) years immediately prior to death, then the insurance proceeds will be included in your taxable estate at death.  As a matter of public policy, the law imposes this restriction to guard against death bed transfers to avoid taxation.  However, one can nonetheless avoid the 3-year lookback by having the trust make the application for the life insurance policy and acquire the policy directly.  The fact that the insured/grantor cooperates in the process and tenders the funds for the trust to acquire the policy does not expose the trust to the 3-year lookback. Purchasing a new policy will entail the cost of a new application, and a new physical, etc.  Therefore, for individuals who do not wish to go through this process (or cannot qualify for a new policy based on age and/or health concerns) then transferring current policies to a newly formed trust is appropriate, but one must simply remain aware that the tax benefits will only become effective three years after the transfer of the policy.

Parting Thoughts

It is important to understand the requirements of maintaining Irrevocable Life Insurance Trusts so that the intended goals can be fulfilled.  At the risk of being repetitive, the overall goal of establishing an Irrevocable Life Insurance Trust is for the trust to be the owner and the beneficiary of the policy.  The proceeds of the policy at one’s death, along with the premiums that are paid during one’s life, will be excluded from the decedent’s taxable estate at death, provided that the formalities discussed above are followed.  The proceeds of the life insurance death benefit can also provide needed liquidity to the Estate and avoid beneficiaries having to liquidate their inherited legacies to satisfy estate payments of expenses, debts, and taxes.

Pullman & Comley’s Trusts and Estates team is here to assist you in all aspects of individual estate and gift tax planning.  Please contact any of our attorneys if you have questions or need guidance in creating and Irrevocable Life Insurance Trust.