Life insurance in an estate: the ILIT and the three-year rule

Life insurance is income tax free and not estate tax free, and clients regularly conflate the two.

Incidents of ownership

The full death benefit is in the gross estate where the decedent held any of them. The list is broader than owning the policy outright.

• The right to change the beneficiary.
• The right to surrender or cancel the policy.
• The right to borrow against cash value.
• The right to assign the policy.
• A reversionary interest exceeding a specified threshold.

Any one of them is enough. A client who transferred a policy but kept the right to change beneficiaries has kept an incident of ownership and has achieved nothing.

The three-year rule

Transferring an existing policy away brings the full death benefit back into the estate if the transferor dies within three years.

The rule exists to prevent deathbed transfers. Its practical consequence is clear: where a new policy is being purchased, the trust should apply for and own it from the outset, so there is never a transfer to claw back.

The irrevocable life insurance trust

The trust owns the policy and is the beneficiary. The grantor makes gifts to the trust, which the trustee uses to pay premiums.

Proceeds are outside the estate, available to the trust, and the trust can lend to the estate or buy assets from it - providing liquidity to pay estate tax without the proceeds themselves being taxed.

That indirect route is deliberate. A trust obliged to pay the estate's taxes would be treated as an estate asset, so it lends or purchases instead.

Crummey powers

Gifts into a trust are future interests and do not qualify for the annual exclusion. A Crummey power gives each beneficiary a temporary right to withdraw the contribution, converting it to a present interest.

Notice must actually be given, and the withdrawal window must be genuine. A trust where beneficiaries were never notified is a common failure, and it means the exclusion was never available.

When the ILIT is not needed

At a USD 15 million exclusion, most clients have no estate tax exposure and therefore no need for the structure.

It remains useful for a state with a low exclusion, for a very large estate, for a business owner needing liquidity, and for control over how proceeds are used. Recommending one for a client with no exposure is over-engineering, and questions do test proportionality.