Life Insurance Trusts: Consider the Need to File a Gift Tax Return– Posted by Christopher J. Yoson
Life insurance policies held in irrevocable trusts (commonly referred to as “ILITs” – Irrevocable Life Insurance Trusts) are most commonly funded through gifts of cash to the trust, usually by the grantor of the trust or the insured on the policy. Following the gift, the trustee uses the cash to pay premiums to the insurance carrier. Although it is a simple form of funding, a federal gift tax return (Form 709) may need to be filed for the gifts in certain circumstances.
Contributions in Excess of Annual Gift Tax Exclusion Amount
For example, a gift tax return might be required if contributions to the trust exceed the annual exclusion amount for federal gift taxes. By way of background, taxpayers are provided an annual exclusion from gift tax, currently $14,000 (for 2016). Importantly, this annual exclusion applies separately to each donee – each taxpayer can make a gift to any person (other than a spouse) in an amount equal to or below the exclusion amount free of gift tax and reporting. Married couples can effectively double up on their gifts by using both of their annual exclusions for each beneficiary.
Generally, ILITs are structured so that each trust beneficiary has the right to withdrawal a pro-rata portion of each contribution to the trust up to the annual exclusion amount. As a result, the donor can make annual gifts to an ILIT, free of gift taxes and reporting, in an amount equal to the annual gift tax exclusion multiplied by the number of trust beneficiaries. For example, if the trust has one donor and two beneficiaries who are permitted to withdraw contributions, $28,000 can be contributed free of gift tax and reporting. If, instead, two donors are making a contribution to the same trust (i.e., a married couple is jointly making the contribution), $56,000 can be contributed free of gift tax and reporting. If the annual contributions are in excess of these amounts, a gift tax return for the applicable year must be filed. Note that the annual gift tax exclusion applies to all gifts to a donee in one year – whether in trust or otherwise. If additional gifts are being made to a trust beneficiary outside of the trust, those gifts must be considered for purposes of the exclusion amount.
Use of Lifetime Exemption
In addition to the annual gift tax exclusion amount, taxpayers are provided with a lifetime exemption amount that can be applied against either the federal estate tax or gift tax. In 2016, the lifetime exclusion amount is equal to $5,450,000. As a result, if a gift tax return is required to be filed with respect to contributions to an ILIT in excess of the annual gift tax exclusion, a portion of the taxpayer’s remaining lifetime exemption can be applied so that a gift tax will not be payable.
Gift tax returns may also need to be filed for contributions to “generation-skipping trusts,” even contributions in amounts below the gift tax annual exclusion, to ensure the assets of the trust are not subject to the federal generation-skipping tax (“GST”) upon a distribution to grandchildren.
By way of background, the GST is imposed, generally, on any transfers that “skip” generations – e.g., a transfer directly to a grandchild. Taxpayers are provided with a lifetime exemption amount (equal to the lifetime estate/gift tax exemption amount - $5,450,000 in 2016) for the GST that may be applied to such transfers. Taxpayers are also provided with an annual exclusion for the GST (also equal to the gift tax annual exclusion - $14,000 in 2016). However, contributions to ILITs are rarely eligible for the GST annual exclusion. As a result, taxpayers must usually file a gift tax return for all contributions to a GST Trust (i.e., a trust that benefits multiple generations) in order to allocate amounts of their lifetime GST exemption. If such exemption is not allocated, distributions from the trust to “skip persons” (e.g., grandchildren) may be subject to the GST – at a 40% rate!
If you are considering establishing a life insurance trust or have questions regarding an existing ILIT, the estate planning attorneys at Lasher Holzapfel Sperry & Ebberson can make this complicated technique make sense.