Irrevocable Life Insurance Trusts (ILITs)
Never own a large life insurance policy in your own name if your estate is anywhere near the exemption. The death benefit is income-tax-free, which is what everyone remembers, but it is not estate-tax-free—under IRC §2042, “Proceeds of life insurance” the proceeds are pulled into your gross estate if you held any incident of ownership, which includes the right to change the beneficiary, borrow against the cash value, or surrender the policy. A irrevocable life insurance trust (ILIT) exists to break that link. The trust applies for the policy, owns it, pays the premiums, and collects the death benefit, so the money arrives outside your taxable estate. On a $5 million policy that is $2 million of estate tax that simply never happens. The estate-liquidity arithmetic—why you buy the policy at all when the estate is illiquid—is worked through in section “Life Insurance Workaround”.
Two rules govern execution, and the first one is unforgiving. Have the trustee buy the policy from the outset. If you transfer a policy you already own into the ILIT and die within three years, IRC §2035, “Adjustments for certain gifts made within 3 years of decedent’s death” yanks the entire death benefit back into your estate, and the trust accomplished nothing. There is no cure for this other than surviving. When an existing policy must move, the alternative is a sale to the trust for fair value rather than a gift—which avoids §2035 but runs into the transfer-for-value rules, so it needs real advice, not a form.
An ILIT needs cash every year. You gift it, and you want those gifts to qualify for the $19,000 annual gift tax exclusion under IRC §2503(b) so they never touch your lifetime exemption. The obstacle is that the exclusion applies only to a gift of a present interest, and a contribution to a trust the beneficiaries cannot touch for decades is a future interest. The solution, blessed in Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), is to give each beneficiary a temporary right to withdraw their share of the contribution—typically 30 days. That withdrawal right makes the gift present, the exclusion applies, and when the window closes unexercised the money stays in the trust and buys insurance.
Everyone gets the concept and half of them botch the paperwork. Send the notice, in writing, every single year, and keep the signed acknowledgments. A withdrawal right nobody was told about is not a withdrawal right, and this is the first thing an examiner asks for—the failure mode is not losing an argument about theory, it is having no file. Deposit the cash before the premium is due and let the window run; premiums paid directly by you, bypassing the trust account, undercut the whole structure.
One drafting trap follows from the same mechanism. When a beneficiary lets a withdrawal right lapse, the lapse is treated as a taxable release of a general power of appointment by them to the extent it exceeds the greater of $5,000 or 5% of trust assets—the “5-and-5” limit of IRC §2514(e). Cap the withdrawal right at that amount, or use a “hanging” power that lapses gradually over later years, so your beneficiaries are not quietly making taxable gifts to their own trust. If the ILIT is also meant to serve grandchildren, note that qualifying for the gift tax annual exclusion does not automatically qualify the contribution for the GST annual exclusion—see section “Generation-Skipping Trusts (GSTs)”.
For gifts to a minor where no insurance is involved, a IRC §2503(c) minor’s trust is the simpler route: property may be spent for the child before 21 and must pass to them at 21, and gifts qualify for the annual exclusion with no withdrawal notices at all. The cost is that the child gets the money outright at 21, which is exactly the outcome most readers of this chapter are trying to prevent—so the Crummey structure survives despite the paperwork.