Funding an ILIT; and 21 Common ILIT Errors

Common considerations and helpful hints, both high-level and summarized in a list

This is a continuation of the series titled Everything You Ever Wanted to Know About Estate Planning Trusts.  For an intro and index to this series, please click here.  For the prior article in this series on ILITs, please click here.

Table of Contents:

1. Intro

2. The Three-Year Rule

3. Premium (And Other Ongoing) Payments

4. Initial Transfers

5. Annual Funding

6. Promissory Note Payments

7. Funding with Income-Producing Assets

8. Use of Term Policies

9. Use of Permanent Policies

10. 21 Common ILIT Errors

Intro

Previous articles in this series discussed the tax issues inherent in funding ILITs, from a timing perspective, and the ways in which ILIT liquidity can be used to get cash to the probate estate or revocable trust (which have the primary obligation for payment of estate taxes not generated by the ILIT). 

For now, let’s circle back to the most frequent problem – funding the ILIT – to explore the importance of getting this right.  This will be a discussion that is broad on the number of principles discussed, but not as deep on each principle because I have discussed or will discuss each principle in its own separate article(s). 

To that end, while I will have the potpourri of usual educational points highlighted below, I will wrap up with a list of 21 common errors in ILIT funding. 

The Three-Year Rule

As previously discussed, any transfer of an incident of ownership for less than full and adequate consideration in money or money’s worth invokes IRC Section 2035, which can disregard such transfers if they occur within three years of the transferor’s death.  The outcome in the case of an ILIT is that IRC Section 2042 would still apply, causing the entire death benefit to be included in the gross estate for policies gifted or sold for insufficient consideration within 3 years of the insured’s death. 

And, while a transfer that fails the bona fide sale exception in IRC Section 2035(d) (often due to inadequate consideration) may have its estate tax value reduced under IRC Section 2043, this reduction in value looks only to the value of the consideration received by the decedent during life at the time of the transfer.  In other words, if you sell a policy to an ILIT and get the consideration wrong, then the 2035/2042 combo can still be invoked and depending on the type of policy involved, the consideration received from the ILIT during life (whether in the form of cash, property, or a promise to pay) may not move the needle much due to the large difference between gift tax values and policy death benefits. 

Which brings us around to the primary issue.  It is not necessarily the three-year rule we are concerned with.  It is, instead, the gift tax value of the policy.  Getting this right is extremely important, but it is a value that is often provided by the insurer issuing the policy on IRS Form 712.[i]  For similarly-structured policies, this value can vary widely.  In this vein, we must consider the difference between transferring an existing policy from an insured grantor to an ILIT, versus having the ILIT acquire the policy itself. 

Before getting there, however, there is another issue to tackle.

Premium (And Other Ongoing) Payments

Getting the policy into an ILIT is only the start of the battle.  From there, premiums have to be paid each year. 

While payment of premiums itself is not an incident of ownership, the insured’s payment of premiums directly is treated as an indirect gift to the ILIT beneficiaries.[ii]  The outcome of these direct payments is a loss of the gift tax annual exclusion, thus requiring (1) the filing of a gift tax return,[iii] and (2) use of lifetime applicable credit against gift tax.  An ongoing issue we are going to see with ILITs is the failure to file gift tax returns, or at least account for transfers that could be subject to gift tax.  GST exemption will also be automatically allocated to these premium payments if the ILIT is a GST trust under the automatic allocation rules of IRC Section 2632(c), unless a gift tax return is filed to elect out of automatic allocation.  

(As an aside, this is a common issue and risk I see for most ILITs.  There are a ton of ILITs out there for which the grantor is simply paying the premium directly, without knowing there is a gift tax return filing obligation.  In the best case, this requires forensic accounting by the ILIT trustee to determine allocations of GST exemptions.  In the worst case, it leads to an increase in estate tax due to an increase in adjusted taxable gifts in the estate tax base.) 

So, the alternative would be a transfer of property to the ILIT.  This could be an annual transfer of cash to the ILIT for payment of premiums.  It could also be a transfer of income-producing property that generates income sufficient to pay ongoing premiums.  In either case, additional compliance is needed.

Likewise, it is possible that the ILIT could purchase the policy from the insured if it is a grantor trust.  In this case, a sufficient seed gift may be needed for payment of the policy value in full or in part – creating a circular flow of funds.  If payment will not be in full, the insured must also consider the enforceability of a promissory note payable from the ILIT to the insured (including the application of split-dollar rules if the note is to be paid from life insurance death benefits at the insured’s death). 

Let’s look at each of these transfers in turn from a gift tax and sale perspective, followed by the list of 21 common errors.