Life Insurance Trusts

Many families have life insurance policies on the parents, especially while the children are minors. The idea is to provide financial support for minor children and to provide liquidity in an otherwise illiquid estate. But if your estate has any sort of assets, your estate may run into tax problems - you'll owe money to the IRS. This can sometimes be avoided or minimized with a life insurance trust.

A life insurance trust is a separate entity apart from the insured so the policy is not included in the insured's estate. But there are many rules to follow when setting up a life insurance trust to make sure that it is properly segregated from the insured's estate.

First off, the life insurance must be an irrevocable trust. This means that once you make the trust, you cannot change the terms of the trust. This also means that you, as the insured, will not be able to change the beneficiaries of the life insurance policy.

Second, you must name a trustee that will manage the trust. You cannot be the trustee, and if you are named as the trustee, the insurance policy will be included in your estate (the objective being to keep the policy out of your estate). Often times, you will see the family accountant or attorney named as the initial trustee.

Next, the irrevocable life insurance trust must own the life insurance policy. This can be achieved in basically two ways: the trust may purchase the policy or the insured may gift a pre-existing policy to the trust. If a gift is made, then the insured must live at least three years or the policy will still be included in the insured's estate. If the trust purchases the policy, it must obtain the cash in order to do so. In the typical trust, the premiums are obtained from the insured via gift.

This leaves a substantial problem - the gift of a future interest. The gift would still be included in the insured's estate. The solution: Crummey letters, named after the case that first presented this solution. In the typical Crummey letter solution, the Grantor/insured makes a gift to the trust, then the trustee sends a letter to the beneficiaries stating that they have the ability to withdraw the gift for a certain period of time. Once that period expires, the trustee then uses the cash to pay the annual premiums. By giving the beneficiaries a right to withdraw the gifts to the trust, the premiums become a present interest and thus excludable from the insured's estate.

Once the insured passes on, the policy is paid to the trust. The trust is then distributed to the beneficiaries (typically the insured's children) according to the terms of the trust set up at the beginning.

Irrevocable Life Insurance Trusts ("ILIT" for short) are good vehicles to provide liquidity to estates, but still be able to avoid estate tax consequences if done properly.