The value of a life insurance policy for gift tax purposes is the interpolated terminal reserve plus any unearned premium rather than the policy face amount. This makes the gift of a life insurance policy a popular tax-saving device. Many persons use a trust. Under an irrevocable life insurance trust (ILIT), an insurance policy on the grantor’s life is owned by an irrevocable inter vivos trust, with the policy proceeds payable to the trust as beneficiary. Generally, should the grantor live more than three years from the date the trust is established, and if all incidents of ownership in the policy are relinquished, the proceeds will not be a part of the grantor’s taxable estate. If the policy is applied for and owned by the trustee from its inception, the policy death proceeds should be excluded from the gross estate even if death occurs within the first three years provided the purchase of the insurance was at the discretion of the trustee.
The trustee pays policy premiums from either the trust corpus or from annual gifts to the trust from the grantor. The latter is the more common case, although the gifts should not be designated as premium payments. The trustee will have been given the authority (at his or her discretion) but not required to purchase insurance and, if desired, to use trust funds—including those gifted annually by the grantor—to pay premiums.
For example, the widow’s estate, composed almost exclusively of land that has long been in the family, is valued at $5.1 million. Estate taxes are $2.7 million. Of course, the marital deduction is not available, hence, the high taxes. The widow’s will provide that her three children are to share equally in her estate. She had wisely and accurately estimated her estate settlement costs at $2.7 million and had created a JUT, which were the owner and beneficiary of a $2.7 million policy insuring her life. On her death, the life insurance company paid the $2.7 million death proceeds to the trust.
The trust agreement authorized the trustee to purchase property from the estate, which the trustee elected to do, thus acquiring family land valued at that amount and simultaneously providing the executor with the needed cash to pay estate taxes. The trustee distributed the land valued at $2.7 million to the three children in equal proportions. After paying the IRS, the executor distributed the remaining $2.4 million of family land equally to the children, thus providing each with a one-third total ownership in the land, valued at $1.7 million. We can see, therefore, that the life insurance—which was not included in the gross estate thanks to sound estate planning—has enabled the family to retain ownership of the land and to meet estate settlement obligations.
Considerations in Using an ILIT The funds gifted to the trust by the grantor/insured should qualify as gifts of a present interest if the trust contains a Crummey provision. To avoid the donor incurring gift taxation, the gifts should not exceed $10,000 ($20,000 if a split gift) per trust beneficiary. To avoid the beneficiaries incurring gift taxation from allowing their short-term general power of appointment to lapse, the donor’s annual gifts should not exceed the product of the number of trust beneficiaries’ times $5,000 (or 5 percent of trust corpus, if this is greater).
Death proceeds can be invested or distributed to trust beneficiaries through arrangements that are not available under life insurance policy settlement options. Therefore, it generally is more desirable to have policy proceeds paid in a single sum to the trust rather than have the insurance company pay the proceeds on an installment basis. Of course, there is no guarantee that the trustee will make wise investments, and there are no guarantees with the trust as there are under an insurance contract.
The need for an insurance trust rather than the outright gift of life insurance should be carefully considered. The $10,000 annual exclusion can be made available for the outright gift of a life insurance policy, as well as for the premiums paid on a policy by the donor. When a policy is assigned to such a trust or when premiums are paid on policies held in such a trust, the $10,000 annual exclusion may not be available unless a Crummey provision is included in the trust instrument, Therefore, the gift of a policy in trust and the future premium payments can be fully taxable gifts that are later added back to the estate for estate tax purposes. Also, there are no income tax savings for an insurance trust if the policy insures either the donor or his or her spouse. If the trust were sufficiently funded so that the incomes to the trust were adequate to pay the premiums, the trust income would still be taxed to the grantor.