Holding life insurance through an irrevocable life insurance trust (“ILIT”) has been a common estate planning strategy for decades. ILITs are commonly designed to ensure that the life insurance death benefit is not included as a part of the insured’s estate, and therefore is not subject to estate tax. At the insured’s death, the life insurance proceeds pay to the ILIT, and from there the funds can be loaned to the insured’s estate to pay estate taxes if necessary.
The premium payments owed on the life insurance policy are “indirectly” paid by the insured, who makes annual gifts to the ILIT to cover the amounts due. Often these annual gifts are within the gift tax annual exclusion amounts, with the ILIT beneficiaries being deemed the recipients of the gifts. This very standard strategy may find itself in the eye of the storm of the pending tax legislation. Due to a quirky provision of the tax code, ILITs are almost always considered “grantor trusts” for income tax purposes. Unfortunately, the tax bill comes down hard on grantor trusts (as discussed in the above article).
Under the proposed bill, existing ILITs would be grandfathered from the new tax treatment directed at grantor trusts. However, when the insured makes future gifts to the ILIT to cover the annual premium payments, those gifts will cause some portion the insurance death benefit to be included in the insured’s taxable estate at death. Moreover, under existing rulings, it will be difficult to design an ILIT that is not considered a grantor trust.
So what is one to do with an ILIT where the annual premium payments are routinely funded with gifts? The best option (if financially feasible) is to pack the ILIT with sufficient liquidity now to cover the anticipated future premium payments. Gifts in advance of the enactment of the new law will clearly be grandfathered. An insurance professional should be consulted to determine what the expected future premiums might be over the life of the policy, considering of course the gift tax implications of a substantial current gift.
Beyond that, there is not a lot of clarity on the “best way forward” at this point. Commentators have suggested loans to the ILIT might be made in lieu of future gifts. Note however, the current language of the tax bill implicates all future “contributions” to a grantor trust, and at this early stage it is unclear whether loans will be considered contributions. Decanting to a new trust may offer a way forward, but the necessary terms to avoid grantor trust status remain subject to IRS interpretation. Given this uncertainty, we recommend that our clients consult with us before making any transfers to an ILIT after the enactment of the tax bill.
This storm may be churning for a while. We will continue to watch as it develops.