One important detail in creating an ILIT is the selection of the trustee. Unlike revocable trusts where you can be your own trustee, you cannot be the trustee of your own ILIT. The IRS will treat the life insurance as if it is still in your own taxable estate because you will have too much personal control over it. Your spouse or adult child may be the trustee, but because of the technical requirements of ILITs, a better choice might be your accountant, other professional advisor, or a bank or trust company. The choice of your trustee should be given careful consideration.
Another important detail involving ILITs concerns the transfer of the life insurance policy to the trust. You can transfer either existing policies into your ILIT or you can have your trustee purchase a new life insurance policy on your life that is owned by the trust.
If you transfer an existing policy into an ILIT, there are two cautions. The transfer of an existing policy to an ILIT is treated under the tax code as a taxable gift, with the potential to trigger gift taxes. Whether or not the gift of an existing policy is taxable depends on the value of the policy and the amount of the current gift tax exemption. The other drawback of transferring an existing policy to an ILIT is that if you die within three years of the transfer, the IRS will consider the transfer invalid and the policy will be still included in your taxable estate.
These limitations make it preferable to purchase a new policy if you are still insurable. If a new policy is purchased, you will not have to be concerned with either determining an existing policy’s value for gift tax purposes or with the three-year transfer rule. Many clients are not concerned about the small statistical chance of dying within three years of the transfer. They consider the opportunity to save sometimes hundreds of thousands of dollars of their life insurance well worth the risk and the cost of establishing the ILIT.
When a new life insurance policy is transferred to an ILIT, the ILIT becomes responsible for paying the premiums necessary to keep it in force. The ILIT receives the funds needed to pay such premiums by accepting cash gifts from you or others. When these gifts are made, special care must be taken to ensure that no adverse federal gift taxes are incurred. It would be pointless to avoid estate taxes only to incur gift taxes. Careful planning is needed to simultaneously avoid both gift and estate taxes.