Life insurance proceeds are income-tax-free but includible in the insured's gross estate if the insured holds any incident of ownership (IRC 2042). An irrevocable life insurance trust (ILIT) owns the policy so the death benefit escapes estate tax, provides liquidity to pay taxes and equalize heirs, and can hold the proceeds in a protected, GST-exempt trust for descendants.
- The ILIT (not the insured) applies for and owns the policy and is the beneficiary; the insured must retain no incidents of ownership (power to change beneficiaries, borrow, surrender, assign).
- The trustee should be independent; avoid giving the insured or a beneficiary-trustee powers that cause inclusion.
- Fund premiums with cash gifts to the trust, structured to qualify for the annual exclusion via Crummey powers.
Three-year rule
If an existing policy is transferred to an ILIT and the insured dies within three years, the proceeds are pulled back into the estate under IRC 2035. Have the ILIT purchase a new policy where possible to avoid the lookback.
Transfer-for-value trap
Transferring an existing policy for consideration can make the death benefit income-taxable under IRC 101(a)(2) unless an exception applies (e.g., transfer to the insured or to a grantor trust treated as the insured). Vet every policy move against the transfer-for-value rules.
Gifts to an irrevocable trust are future interests and do not qualify for the annual exclusion — unless beneficiaries hold a Crummey right to withdraw contributions for a limited window. The withdrawal right converts the gift into a present interest. Proper administration is essential and frequently litigated.
- Give beneficiaries actual, timely written notice of each contribution and a real opportunity (commonly 30 days) to withdraw.
- Document notices and non-exercise; the IRS attacks ILITs on missing Crummey notices.
- Manage the '5-and-5' problem: a lapse of a withdrawal right exceeding the greater of $5,000 or 5% of trust assets is a taxable gift by the beneficiary and can create estate inclusion for them. Use hanging powers or limit contributions to the 5-and-5 amount.
- Consider whether beneficiaries with withdrawal rights are 'skip persons' affecting GST treatment.
Key takeaways
- An ILIT keeps insurance proceeds out of the estate — the insured must hold no incidents of ownership.
- Have the ILIT buy a new policy to avoid the IRC 2035 three-year lookback, and watch the transfer-for-value rule on existing policies.
- Crummey notices make premium gifts annual-exclusion-eligible; document them rigorously.
- Address the 5-and-5 lapse problem with hanging powers or capped contributions.
Authorities
- IRC 2042 (incidents of ownership), 2035 (three-year rule), 101(a)(2), 2514(e), 2041 (5-and-5)
- Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968)