Possible 2010 ILIT Issue

As we all know, the estate and GST taxes will return in 2011. One of the most efficient ways to avoid these taxes is to use an irrevocable life insurance trust (ILIT).

Here’s how an ILIT works:

Taxpayer gifts money to Trustee. Trustee notifies Beneficiary of his right to withdraw the gifted money, but Beneficiary chooses not to withdraw the money. Trustee then uses the gifted money to pay the annual premiums on a life insurance policy insuring Taxpayer’s life. If Taxpayer pays $300,000 in premiums over his lifetime and his Beneficiary receives $1,000,000 upon his death, Beneficiary doesn’t have to pay capital gain tax on the $700,000 increase. Further, Taxpayer doesn’t have to pay gift taxes (if his gifts are below the annual gift exemption amount) and his estate doesn’t owe estate taxes on the proceeds.

In 2010, the effectiveness of this tool is uncertain because there is no GST tax and thus no GST exemption. Therefore, Trustee cannot file a paper in 2010 claiming a GST tax exemption. So does this mean that the death benefits are in the taxable estate of Beneficiary? Or is it subject to GST tax in Taxpayer’s estate?

The solution to this 2010 issue is for Taxpayer to loan the money to Trustee rather than gift it. The loan can be repaid in the future, either from additional gifts from Taxpayer or from a loan from the insurance policy. If you have an ILIT, make sure to analyze whether or not this problem applies to your trust.

See Christopher Hill, How Avoiding Estate Taxes Can Actually Create More Taxes, ProducersWeb.com, July 15, 2010. 

Special thanks to Jim Hillhouse (WealthCounsel) for bringing this to my attention.