Irrevocable Life Insurance Trust and the Three-Year Rule

An irrevocable life insurance trust, also known as an ILIT, is a tool used to provide liquidity to an estate so insurance proceeds are available to pay for:

  • Estate taxes, both state and federal
  • Administrative expenses
  • Funeral expenses
  • Support in providing for the surviving spouse or surviving children
  • Education of surviving children

The concern with the three-year rule is that when an irrevocable life insurance trust is made, there is a gift either of the life insurance policy itself or of money to purchase the premium so that the trust is independently able to purchase a life insurance policy on the life of the original grantor. However, a gift of a life insurance policy made within three years of death, including the transfer of an existing policy, results in all of the proceeds of the policy being included in a transferor who is often the insured gross estate.

Insurance proceeds are also includable in a grantor’s estate for federal estate tax purposes when the gift was made more than three years prior to death, but the transferor or the insured retain one or more incidents of ownership and the retained incidents were owned at death or released within three years of death.

Premium Payment and the Three-Year Rule

If an insured pays premiums within three years of death for a policy that has been transferred more than three years prior to death, the payment of premiums will not cause any part of the policy proceeds to be included in the transferor/insured’s estate. In addition, the premium payments will not be included in the estate under the internal revenue code.

Reduction and Elimination of Includable Proceeds

An estate and trust lawyer can advise on available options for a grantor in reduction of includable proceeds into an estate depending on:

  • The age of the transferor
  • The health of the transferor
  • The amount of the assets of the transferor
  • The purpose and goal of the trust

There are a couple of options for a trust and estate attorney to recommend to have the includable proceeds eliminated. The first is to have the trustee purchase the policy so the trustee can apply for the policy on the life of the insured to avoid includability of their proceeds, even if the insured dies within three years, because the insured never had any incidents of ownership of the policy.

There are a number of other planning tools that a trust and estates attorney can consider:

  • Having the insured make the initial gift of the first year’s premium, then have the gift of the cash or property by the insured to the trust exceed the amount on the first year’s premium
  • Ensure that the insured does not hold any incidents of ownership
  • Have the gift to the trust be unconditional
  • Have the trustee pay the premium of the insurance policy
  • Have the trust document not allow the insured the power to change the manner of how the trust proceeds should be enjoyed

Consideration of a Contingent Marital Deduction

Generally, the marital deduction is a federal estate tax concept that allows for unlimited gifts in certain circumstances between spouses during their lifetime and unlimited distributions to the surviving spouse after death. Unlimited means that those gifts will pass or bequest will pass free of federal estate tax by the use of a deduction at the death of the first spouse, but the concept is to recapture them at the death of the second spouse.

There are some limitations on when a marital deduction can be permitted. Generally, to avoid a contingent marital deduction provision in a trust, a common tool is to use a qualified terminal interest property marital trust, commonly known as a QTIP, rather than allow for an outright marital distribution or spousal distribution from an irrevocable life insurance trust.