Irrevocable Trusts are a valuable estate planning tool for larger estates. They are used to remove assets (typically life insurance) from estates that would otherwise be taxable. Unlike Revocable Trusts, which may be amended or revoked at any time during the Grantor’s lifetime, Irrevocable Trusts may not be amended or revoked. Also, unlike Revocable Trusts, the Settlor of an Irrevocable Trust may never act as Trustee. Thus, once established, the Settlor of an Irrevocable Trust relinquishes control over both the terms and the administration of the Trust.

People who establish Irrevocable Trusts are not crazy! Quite the contrary. On the advice of counsel, they willingly trade their ability to amend, revoke or administer such Trusts in exchange for exclusion of Irrevocable Trust assets from their taxable estate.

Under Federal tax law, a decedent’s taxable estate consists of assets over which the decedent exercised control at the time of his or her death. By relinquishing all such control in an Irrevocable Trust, the Settlor is able to deposit hand-picked assets into the Irrevocable Trust, which then fall outside the grasp of the Federal estate tax. To avoid having Irrevocable Trust assets leech back into the estate of the Settlor, the Settlor must permanently forego the benefit or use of Irrevocable Trust assets. The Settlor must therefore carefully select assets over which he or she is comfortable in permanently relinquishing all control or enjoyment.

Irrevocable Trusts are most often used by individuals with taxable estates, that is, unmarried individuals with estates exceeding $650,000 (1999) and married couples with estates exceeding $1.3 Million Dollars. Irrevocable Trusts permit the Settlor to make gifts without allowing the beneficiary to exercise control of the gifted property. A parent with a large estate may begin a substantial gifting program and be assured that the donee will not spend the gifted assets until after the Settlor’s death.

LIFE INSURANCE

Life insurance makes an attractive Irrevocable Trust asset. The true value of life insurance is not realized until the death of the Settlor. Consequently, the fact that a life insurance policy is outside the control of the Settlor during the Settlor’s lifetime has no real economic impact on him or her. Owning life insurance in an Irrevocable Trust also makes good estate tax sense. While insurance proceeds are almost always received by the beneficiary income-tax free, they are fully includible in the estate of the insured for Federal estate tax purposes. Owning life insurance in an Irrevocable trust makes the life insurance tax-free in all respects.

Life insurance provides liquidity to larger estates. Life insurance proceeds are available to satisfy the immediate needs of the decedent’s family, as well as to pay any estate tax (which is due within nine months of the decedent’s death) which may be owing. As a result, estates consisting primarily of real estate, closely held businesses and other illiquid assets need not sell assets to provide living expenses for the survivor’s family or to pay estate tax. An Irrevocable Trust removes the value of the life insurance proceeds from the decedent’s estate so as to not compound the decedent’s estate tax liability.

Life insurance is included in the estate of its owner to the extent the owner retains any “incidents of ownership.” Incidents of ownership include the right to name or change the beneficiary of the policy, the right to borrow from the policy, as well as the right to exercise any other right typically possessed by an owner. By relinquishing his or her incidents of ownership in the life insurance policy, either directly or through the Irrevocable Trust, the Settlor removes the proceeds of the life insurance from his or her estate.

CHOICE OF INSURANCE

Life insurance policies are like snowflakes; each one is different. Consultation with a qualified life insurance professional is essential to the proper selection of life insurance. Whether to purchase “Term”, “Whole Life”, “Universal Life”, “Variable Life”, “Split Dollar” or some hybrid, depends on the particular needs of the client. Life insurance can insure the life of a single “insured,” or can be purchased on joint lives.

A relatively new product called “second to die” or “last to die” has been developed in recent years to address the estate planning needs of married couples. The effect of the unlimited marital deduction, is that the estate tax is not due until the death of the surviving spouse. Consequently, life insurance purchased for the purpose of paying estate tax need not mature until the death of the surviving spouse. Second to die life insurance pays on the death of the second spouse to die. Since the life expectancy of any two spouses will always be longer than the life expectancy of either of the spouses individually, second to die life insurance will always be cheaper than a policy insuring either of the spouses individually.

An Irrevocable Trust which owns life insurance is sometimes called an Irrevocable Life Insurance Trust (“ILIT”). It is not advisable to fund a newly created ILIT with existing life insurance. A gift of a life insurance policy within three years of death will be pulled back into the estate of the decedent, thereby negating the value of the ILIT. Accordingly, unless the Settlor is uninsurable, a new life insurance policy should be acquired by the trustee of the ILIT. To avoid the three-year rule, the ILIT should be the applicant and initial owner of the new life policy. For this reason, it is important to create an ILIT as soon as the decision is made to purchase life insurance.

ILIT FUNDING

To avoid adverse gift tax consequences, strict procedures must be followed when making contributions to an Irrevocable Trust. An individual may make gifts of $10,000 per beneficiary per year without incurring gift tax. To qualify for the gift tax exclusion, gifts must be of a “present interest”. For a gift to be of a present interest, the beneficiary must be able to enjoy the gift currently. A transfer to an Irrevocable Trust is certainly a gift. However, the fact that the beneficiary of a typical ILIT does not receive a benefit until the death of the Settlor makes the transfer a gift of a future interest. Fortunately, gifts in trust can be converted from future to present interest transfers by a device known as a “Crummey Notice.”

A Crummey Notice is given to all ILIT beneficiaries contemporaneously with each contribution to the ILIT. The Crummey Notice notifies each beneficiary of his or her right to withdraw his or her prorata share of the contribution. Under the terms of the Crummey Notice, if such right of withdrawal is not exercised within thirty day of receipt, it lapses. Despite numerous attacks by the IRS, the Courts have consistently upheld the validity of Crummey Notices.

It is the responsibility of the ILIT trustee, as the owner of the life insurance policy, to make annual life insurance premium payments.

The settlor should not make premium payments directly to the insurance company (bypassing the ILIT), as this could cause inclusion of the proceeds of the policy in the settlor's estate at death. Instead, the settlor should make premium payments to the ILIT. Contemporaneous with the transfer, the settlor (or the trustee of the ILIT) must issue a Crummey notice to each ILIT beneficiary. Only after the 30 day Crummey notice period has lapsed (presumably no beneficiary has elected to withdraw a share of the annual contribution), may the ILIT Trustee make the annual premium payment to the insurance company. (See illustration below)

It is extremely inadvisable to name either the settlor or the settlor's spouse as Trustee of the ILIT. As trustees, the settlor or settlor's spouse would have prohibited powers, causing the life insurance proceeds to be included in their estate. It is common practice, however, to appoint other ILIT beneficiaries such as the settlor's children as trustee.

The procedure for making annual life insurance premium payments is summarized in the following illustration:

Clients of the author are given the following summary of the procedures to be followed when making annual ILIT premium payments: