Advanced Underwriting Consultants

Question of the Day – October 26

Ask the Experts!

Here’s the question of the day.

Question: My client wants to wait to draft his irrevocable trust until after he’s sure he wants to buy the life insurance.  How can I make that work?

Answer: Life insurance death proceeds are includible in the taxable estate of the insured if the insured owns the policy.  If the insured transfers a policy on his life by gift, and dies within three years of the transfer, the death benefit is also included in the insured’s taxable estate.

To avoid having life insurance be included in the insured’s taxable estate, we usually recommend having an irrevocable life insurance trust (ILIT) own the policy from inception.

In a perfect world, ILITs are implemented this way:

  1. The ILIT is created and funded by the grantor.
  2. The trustee of the ILIT sends withdrawal notices to the beneficiaries.
  3. The beneficiaries decide not to withdraw the money.
  4. The trustee decides to apply for insurance on the life of the grantor.
  5. The insurance is approved.
  6. The trustee pays the premium.

The reason for these theoretical steps is to conform to the requirements of the court cases and ILIT rules and regulations.

The procedure described is NOT the only way to achieve estate tax exclusion of the death benefit.  However, some variations from the perfect implementation may create a danger of inclusion in the grantor’s estate for three years after the purchase of the insurance.

According to IRS Technical Advice Memorandum (TAM) 9323002, an application can be submitted to the insurance company without any kind of premium deposit, and so long as the trust is executed by the completion of the underwriting, a new application can be filed with the insurance company.  If the policy is issued with the trust as the owner—and the first actual premium payment is made by the trustee as the owner—then the IRS said there’s no policy transfer.  No transfer means no three year estate tax inclusion.

A prospective insured following the TAM procedure might sign an application, get approved for the coverage, get his lawyer to draft an ILIT in a hurry, and have the agent ask the insurance company to list the trust as owner and beneficiary prior to the policy being put in force.

Of course, the TAM is not authority that any particular taxpayer can rely on, but it is a reflection of how the IRS generally looks at these issues.  The best advice is to let the client’s attorney make the call on whether the attorney is comfortable with the procedure described.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.