September 17, 2014

Irrevocable Life Insurance Trust/Crummey Trust

An irrevocable life insurance trust, commonly known as an "ILIT," is a type of trust used to avoid the inclusion of life insurance proceeds in a decedent's estate.

Many people erroneously assume that life insurance proceeds are always non-taxable. This is not entirely accurate. Life insurance proceeds are not considered taxable income.  However, life insurance proceeds are considered part of the decedent's estate if there is incidents of ownership. For example, if John Doe purchased a life insurance policy in his own name for the benefit of his wife, the proceeds would be included in his estate at death. The inclusion of life insurance proceeds in a decedent's estate is a material concern because life insurance proceeds can easily be millions of dollars.

When a person passes away, the federal government imposes a tax on estates that exceed a certain amount. Your estate is everything you own at death essentially. Of note, California does not currently have an estate tax. This exclusion amount is $5.34M in 2014. This is pegged to inflation so it will increase in 2015. If you pass away in 2014 and your estate eclipses $5.34M, the estate tax will generally be imposed. Since life insurance proceeds can be in the millions of dollars, this can be the difference between an estate being below or above the estate tax threshold. Thus, some people opt to create an ILIT so as to avoid the inclusion of life insurance proceeds in their estate given the concern of the estate tax. Although there are additional benefits for an ILIT. 

A typical way to create an ILIT is as follows. 

Maude, a wealthy widow, has only one child, a son named Sam. Maude's estate is above the estate tax threshold. Maude wishes to reduce her estate tax liability and simultaneously benefit Sam.

Maude meets with an estate planning attorney who tells Maude about the advantages of an ILIT. Convinced of an ILIT's benefits, Maude decides to create one. The attorney tells Maude that it is best to create an ILIT by gifting the maximum annual gift tax exclusion amount, $14,000 in 2014, to her son each year through a Crummey Trust. The trustee of the Crummey Trust then uses Maude's $14,000 gift to Sam to purchase a life insurance policy for her life.

Many years pass by and each year Maude gifts $14,000 to Sam's Crummey Trust. In turn, the Crummey Trust's trustee pays the premium on Maude's life insurance policy. When Maude ultimately passes away, multiple benefits are realized. First, by gifting thousands of dollars to Sam's Crummey Trust, Maude's estate has reduced her estate tax exposure because of the decreased value of it. Second, the life insurance proceeds for Maude's policy are not included in her estate for estate tax purposes because there is no incidents of ownership. Third, Sam receives the life insurance proceeds tax free.