The client is reluctant to incur the expense of drafting a trust until she is certain she is insurable at a reasonable cost. This article discusses some of the issues to consider when applying for a life insurance policy to be owned by an irrevocable trust.

 

The key issue in creating an irrevocable life insurance trust (ILIT) is making sure that the proceeds of the life insurance policy will not be included in the insured's estate. If, at death, the insured owns the policy or incidents of ownership in the policy, the entire proceeds will be included in her estate. 

 

Incidents of ownership is a broadly defined term that includes most rights over a policy including the right to change beneficiaries, take loans or withdrawals, to pledge, surrender, assign or revoke the policy or the right to any economic benefit from the policy. Insured can be deemed to own incidents of ownership either directly through the policy or indirectly through retained powers over the trust.

 

Furthermore, Section 2035 of the Internal Revenue Code includes the proceeds in the insured's estate if the insured transferred the policy or any incidents of ownership in the policy within three years of death. To avoid the three-year rule, the client should never own the policy or any incidents of ownership therein.

 

The client faces a dilemma. She doesn't want to incur legal expenses until insurability is established, but if she owns the policy or any incidents of ownership therein at death or within three years prior to death, the proceeds will be included in her estate. 

 

 

Trial Application. A trial application involves submitting an insurance application with the medical information completed but with the owner and beneficiary lines left blank. If the underwriting on the client is favorable, the attorney can draft the trust. When the trust is completed, the trustee can then resubmit the application with the trust listed as owner and beneficiary. The proceeds should not be included in the client's estate because she never owned any interest in the policy. 

 

Because the client has already been underwritten, the policy should be issued quickly. A downside to a trial application is the delay in getting the insurance in force until the second application.

 

Third Party Ownership. Another solution is to have an adult child or other third party apply for the policy. After the trust is completed, the third party owner transfers the policy to the trust. In cases with large premiums, gift tax problems can arise on the transfer from the third party to the trust.

 

Term Rider. Another option is for the client to apply for and own the policy, then transfer the policy to the trust when it is completed. Term insurance can be used to cover the tax risk that the insured might die during the three-year period. After the insured lives safely past the three-year period, the term insurance can be dropped. Many survivorship policies offer an inexpensive limited term rider to cover the possibility that the policy might be included in the estate.

 

Existing Insurance
If a client transfers existing insurance to an ILIT the
three-year rule applies. However, even if the client dies within that time she is no worse off than had she retained ownership of the policy. If a policy is no longer required for survivorship needs, the client should consider  transferring the policy to start the clock ticking.

 

A life insurance policy owned by an irrevocable trust can be a tax efficient method to provide estate liquidity. Care must be taken during the application process to be certain the policy proceeds will not be included in insured's estate either through direct ownership or under the three-year rule.