Key Takeaways
- ILIT holds life insurance outside the estate
- Crummey powers allow gifts to trust to qualify for annual exclusion
- Second-to-die policies provide liquidity at second death
- Three-year rule applies to transferred policies
Life Insurance for Estate Liquidity
Life insurance is the most powerful tool for providing estate liquidity because it creates an immediate, predictable source of funds at exactly the moment they are needed. When properly structured through an Irrevocable Life Insurance Trust (ILIT), life insurance proceeds can be both income tax-free and estate tax-free.
The Irrevocable Life Insurance Trust (ILIT)
An ILIT is an irrevocable trust designed specifically to own life insurance policies on the grantor's life. The trust serves as both the owner and beneficiary of the policy, keeping the death benefit outside the insured's taxable estate.
Why Use an ILIT?
When an individual owns a life insurance policy on their own life, the death benefit is included in their gross estate under IRC Section 2042 because they possess "incidents of ownership." This can result in up to 40% of the death benefit being consumed by estate taxes.
Example: Without an ILIT, a $5 million death benefit included in a taxable estate could result in $2 million in estate taxes, leaving only $3 million for heirs.
An ILIT removes this problem by ensuring the insured never possesses incidents of ownership in the policy.
ILIT Structure and Parties
| Party | Role |
|---|---|
| Grantor | Creates the trust; typically the insured person |
| Trustee | Manages the trust; should be independent (not the insured) |
| Beneficiaries | Receive trust assets; often spouse and/or children |
| Insurance Company | Issues policy; trust is owner and beneficiary |
Key ILIT Requirements
For the death benefit to remain outside the taxable estate:
- Insured cannot be trustee - The insured should not serve as trustee to avoid incidents of ownership
- No reversionary interest - Trust must be truly irrevocable with no retained interests
- Independent trustee - Should have power to deal with insurance company
- Properly funded - Grantor gifts premium payments to trust
Crummey Powers: Making Gifts to the ILIT
Premium payments to an ILIT are gifts to the trust. To qualify for the annual gift tax exclusion ($19,000 per beneficiary in 2025), gifts must be of a "present interest" - the recipient must have immediate access to the gift.
Since trust beneficiaries don't have immediate access to premium payments, Crummey powers (named after the Crummey v. Commissioner case) solve this problem.
How Crummey Powers Work
- Grantor contributes premium payment to the ILIT
- Trustee notifies beneficiaries (Crummey letter) of their right to withdraw a portion of the contribution
- Withdrawal period of 30-45 days during which beneficiaries could take the funds
- Beneficiaries allow withdrawal rights to lapse (as expected)
- Trustee uses funds to pay insurance premiums
The temporary right to withdraw converts the gift from a future interest to a present interest, qualifying it for the annual exclusion.
Crummey Letter Requirements
Each time a contribution is made, the trustee must send written notice to beneficiaries including:
- Amount of the contribution
- Their right to withdraw (usually equal share of contribution, up to $19,000)
- Duration of withdrawal period (typically 30-45 days)
- How to exercise the withdrawal right
Important: Beneficiaries must have genuine notice and a real opportunity to withdraw, even if they are not expected to exercise the right.
The "5 and 5" Lapse Rule
When a beneficiary allows their Crummey withdrawal right to lapse, they are technically making a gift to the other trust beneficiaries. This could trigger gift tax consequences.
The Problem
Under IRC Section 2514, the lapse of a general power of appointment (which a Crummey power is) is treated as a release and therefore a taxable gift.
The Solution: 5 and 5 Safe Harbor
IRC Section 2514(e) provides a safe harbor: a lapse is not treated as a taxable gift if the lapsed amount does not exceed the greater of:
- $5,000, OR
- 5% of the trust assets
Example: If a trust has $100,000 in assets, a lapse of up to $5,000 (the greater of $5,000 or $5,000) is not a taxable gift.
Hanging Crummey Powers
For larger contributions that exceed the 5 and 5 limit, trusts can use "hanging" powers:
- The withdrawal right doesn't fully lapse each year
- Only the 5 and 5 amount lapses annually
- Excess "hangs" until future years when trust assets are large enough
- Eventually, all hanging powers lapse (typically when death benefit is paid)
Second-to-Die (Survivorship) Life Insurance
Second-to-die policies (also called survivorship policies) insure two lives and pay the death benefit only when the second insured dies.
Why Second-to-Die for Estate Liquidity?
| Advantage | Explanation |
|---|---|
| Timing matches need | Estate tax is typically due at second death (unlimited marital deduction at first death) |
| Lower premiums | Insuring two lives costs less than two individual policies |
| Easier underwriting | Combined health of two insureds can result in better rates |
| ILIT synergy | Perfect fit for ILIT structure; proceeds available exactly when needed |
Planning with Survivorship Policies
A married couple with a potentially taxable estate should consider:
- Establish ILIT owned by children or descendants
- ILIT purchases survivorship policy on both spouses
- Spouses make annual gifts to ILIT for premiums (using Crummey powers)
- At second death, ILIT receives tax-free proceeds
- ILIT provides liquidity to estate without inclusion
The Three-Year Rule (Section 2035)
Section 2035 creates a potential trap for transferred life insurance policies.
The Rule
If an insured transfers an existing life insurance policy to an ILIT and dies within three years of the transfer, the entire death benefit is included in the insured's gross estate - defeating the purpose of the ILIT.
Why This Rule Exists
Congress wanted to prevent "deathbed" transfers of life insurance to avoid estate taxes. The three-year rule ensures that transfers made in contemplation of death are still included in the estate.
How to Avoid the Three-Year Rule
| Strategy | Description |
|---|---|
| ILIT purchases new policy | Have the ILIT apply for and purchase a new policy from the start; insured never owns it |
| Survive three years | If transferring existing policy, insured must survive three years |
| Sell policy to ILIT | Selling (rather than gifting) the policy for fair market value may avoid Section 2035, but beware transfer-for-value rule |
Best Practice: Always have the ILIT purchase a new policy directly rather than transferring an existing policy.
How the ILIT Provides Liquidity to the Estate
The ILIT cannot simply pay the estate's taxes directly (this could cause estate inclusion). Instead, the ILIT provides liquidity through two methods:
1. Purchase Assets from the Estate
- ILIT uses insurance proceeds to buy assets from the estate
- Estate receives cash to pay taxes and expenses
- ILIT holds the assets for beneficiaries
- Assets receive stepped-up basis in the estate
2. Loan Money to the Estate
- ILIT loans insurance proceeds to the estate
- Estate uses funds to pay taxes and expenses
- Estate repays loan (with interest) over time
- ILIT eventually receives principal plus interest
Important: The trust document must authorize these transactions, and they should be conducted at arm's length with proper documentation.
Key Planning Considerations
2026 Estate Tax Increase: Under the One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, the federal estate tax exemption permanently increased to $15 million per individual ($30 million for married couples) beginning January 1, 2026, with annual inflation adjustments thereafter. While this higher exemption reduces estate tax exposure for many estates, ILITs remain valuable for larger estates, state estate tax planning (many states have lower exemptions), and those seeking tax-free liquidity regardless of exemption levels.
State Estate Taxes: Many states have estate taxes with lower exemptions. Life insurance and ILITs can provide liquidity for state taxes even when federal estate tax is not a concern.
Policy Type Selection: Permanent life insurance (whole life, universal life) is typically preferred for estate liquidity because coverage is needed for an uncertain death date. Term insurance may lapse before death.
Trustee Selection: Choose an independent trustee who can manage the trust, send Crummey notices, and make decisions about providing liquidity to the estate.
Thomas transfers his $2 million life insurance policy to an ILIT and dies 18 months later. What is the estate tax consequence?
Which of the following best describes the purpose of Crummey powers in an ILIT?
Under the '5 and 5' lapse rule, what is the maximum amount that can lapse without gift tax consequences if the ILIT has $200,000 in assets?