Currently, the federal estate, gift, and generation-skipping transfer (GST) tax exemption equals $11.58 million per taxpayer. Assets included in a decedent’s estate that exceed the decedent’s remaining exemption available at death are taxed at a federal rate of 40 percent (with some states adding an additional state estate tax). This exemption amount is scheduled to be lowered in 2025 to $5 million (also indexed for inflation) unless new legislation is passed before then.
Current proposed legislation reduces the estate and GST tax exemption amount to $3.5 million per individual, while the exemption amount for gifts could be $1 million. In addition to reduced transfer tax exemption amounts, the proposed legislation increases the current maximum federal tax rate from 40% to 45%.
Although irrevocable life insurance trusts, or ILITs, have not been utilized as much recently as in the past (likely because of the historically high transfer tax exemption amounts), such a strategy is still a highly effective one—especially when the transfer tax exemption amounts may be significantly reduced in the near future and taxpayers find themselves in a use-it-or-lose-it position. This planning technique calls for a client to transfer property (usually cash) to an irrevocable trust, reducing the taxpayer’s remaining gift tax exemption somewhat. However, the cash in the hands of the trustee can be used to purchase life insurance on the taxpayer which will pay out upon the taxpayer’s death to the trust and ultimately to the trust beneficiaries free of income tax and estate tax. That is, the life insurance policy and its proceeds are not includible in the taxpayer’s estate for estate tax purposes at death. A taxpayer generally must have sufficient cash reserves to be able to contribute to the trust for the purchase of the policy and be in good enough health to qualify as the insured under the policy.
So, the primary objective of an ILIT is to make proceeds of life insurance policies available to trust beneficiaries in a manner that will not subject the policy proceeds to estate tax upon the death of the insured (or, if married, upon the death of the insured’s spouse). Another common objective of the ILIT is to qualify subsequent transfers to the trust, which will most likely be used for payment of insurance premiums, for the federal annual gift tax exclusion.
This may be accomplished through the use of what are known as Crummey withdrawal rights:
There is a requirement that must be observed when relying upon the federal annual gift exclusion to make gifts to an ILIT. The requirement is the result of an IRS rule which provides that a beneficiary must have a current right to the cash or property gifted by the Grantor(s) to the ILIT in order for such cash or property to constitute a gift. To satisfy this requirement and to evidence that this rule was observed, the trustee sends a “Crummey” letter to each beneficiary of the ILIT. Crummey is the name of a legal case wherein the use of such a letter was upheld by the court. A typical Crummey letter is not lengthy or complicated and basically advises a beneficiary that they have the immediate right for a period of 30 days, 60 days, or other period of time stated in the letter to the cash or property gifted by the Grantor(s) to the ILIT. The use of a Crummey letter presupposes that no beneficiary will demand the cash or property gifted during the stated period because each beneficiary understands that doing so would affect the ILIT’s ability to timely pay the required premium.