How shocking of a revelation would it be to set up an ILIT thinking you have successfully removed life insurance death benefits from your estate, only to find out, upon dying (talk about insult to injury), that because of three little sentences, that entire death benefit is pulled back into your estate and subject to estate tax (it is coming back).
Some generalizations are necessary for understanding. As with anything tax related, all generalizations mask excessively more complex specifics. However, blogging about Treasury Regulation 20.2036-1 and whether there is, in fact, a difference between a time period not ascertainable without reference to someone's death and a time period which does not in fact end before someone's death, is not really helpful. FYI, there is a difference and only we tax attorneys care.
First generalization: The IRS frowns upon donors gifting property with strings attached. Accordingly, it enacted IRC Sections 2036 – 2038. Essentially, these code sections describe retained "powers" that result in estate tax inclusion of property thought to have been gifted away. In the parlance of our times, the powers retained are referred to as a life estate, reversionary interest, or retained power to revoke.
Today we discuss IRC 2036:
2036 – The most common example is Donor gifts property into a trust but retains the right to recieve the income. Although the donor has no right to the trust principal, the entire date of death value of the trust is included in the estate. Why is this particularly egregious in the ILIT context? As a general matter the date of death value is 30-40 times greater than the value of the original gift into the trust, which likely consisted of the cash surrender value of an existing life insurance policy.
A retained income interest can come in many different shapes and sizes; however, the general pitfalls associated with an ILIT will be the following:
1. Jointly owned second to die policy that provides an income interest to the surviving spouse.
This would result in inclusion in the surviving spouse's estate of 50% of the death benefit.
2. SIngle life policy ILIT on Husband's life that grants an income interest to the surviving spouse.
Must be sure the Surviving Spouse avoids any further gifts to the ILIT (given an ILIT is an irrevocable trust already in existence, and generally provides crummey withdrawal rights, it offers the perfect vehicle for lifetime gifts in trust that qualify for the annual exclusion). Once the spouse gifts to the trust while retaining the income interest she now falls within the grips of IRC 2036, and will be subject to estate tax.
One very notable exception to IRC 2036 is split gifts from a husband and wife when the non-grantor spouse has an income interest. Letter Rulings have indicated that split gifts by the grantor spouse who does not have a retained income interest will not trigger 2036 for the non-grantor spouse.
The above really only scratches the surface of the 2036 retained interest issues that could be associated with ILITs. It is imparative that an ongoing relationship with an estate planning attorney is maintained, and that any future transactions are vetted through such attorney prior to their completion. The adverse consequences that can result from the simplest of transfers are devastating and should and can be avoided with appropriate planning and ongoing professional oversight.
Our ILIT series will continue with pitfalls associated with other retained interests, and one of the more cunning issues, 2041 general poiwers of appointment. In the meantime, if you have any questions, please do not hesitate to contact our office.