The 3 Year Rule of IRC Section 2035 when an ILIT Does Not Yet Exist

Often, a financial professional will be dealing with a wealthy client who needs life insurance to offset federal and state estate taxes. The common solution is typically a single life or survivorship life policy owned by an Irrevocable Life Insurance Trust (ILIT).

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Of course, the ILIT must legally exist for it to be the applicant, owner, and beneficiary of the policy. If the ILIT is the original owner, then the three-year estate inclusion rule of IRC Section 2035 (a) does not apply, and the death benefit is estate tax-free.

 

However, what options are available if the ILIT has not yet been drafted and the client wants to proceed with the purchase of the policy? Are there ways that the policy can be issued and still avoid the potential inclusion of the death benefit in the gross estate of the insured? These options may offer important alternatives, especially when planning for multi-million dollar policies that may be exposed to a 40% federal estate tax rate plus state death taxes.

 

Let’s take a look at a hypothetical example where life insurance can be purchased to offset estate taxes but the clients have not yet made up their mind on approaching an estate planning attorney to draft the ILIT.

 

 

Facts of Case

 

 

 

Mr. and Mrs. Black are in their early 70s and have a net worth of about $20 million. With a federal estate tax exemption of $5,450,000 in 2016 ($10,900,000 married), they are facing about $5,000,000 of combined federal and state estate taxes at the death of the survivor. They are contemplating the purchase of a $5,000,000 single life policy on the life of Mrs. Black or a $5,000,000 survivorship policy on the joint lives of Mr. and Mrs. Black.

 

Since Mr. Black is uninsurable, they have not yet made up their mind whether a single life policy on Mrs. Black or survivorship policy (one insured as uninsurable) will be the best financial choice. Due to favorable underwriting offers, they would like to get the insurance in force as soon as possible. However, the Blacks have not yet made up their mind about which estate planning law firm will draft the new ILIT document.

 

Based on this scenario, what options are available to Mr. and Mrs. Black to confront the three year IRC Section 2035(a) rule for estate inclusion if they purchased a policy today and at a later date transferred ownership to an ILIT?

 

1. The Blacks quickly have law firm draft the ILIT for a single life or survivorship life policy

 

 

The ILIT is the original owner and beneficiary of either a single life or survivorship life policy. In this case, the insurance death benefit is estate tax-free right from the start. The 3-year rule of IRC Section 2035(a) does NOT apply since the insured(s) never owned the policy at any time.

 

2. Mrs. Black is the insured and the original owner of a single life policy

 

At a later date after the policy is issued, the Mrs. Black GIFTS the policy to the ILIT so that the ILIT becomes the owner and beneficiary. The three-year rule of IRC Section 2035 (a) does apply. Mrs. Black would have to live three years from the date of the gift of a single life policy to keep the death proceeds out of the gross estate.

 

If a survivorship policy on the joint lives of Mr. and Mrs. Black was originally owned by Mrs. Black, and later gifted to the ILIT, then both insureds would have to die within three years of the transfer for the three-year rule to include the death proceeds in the gross estate. In other words, at least one insured must survive three years to avoid the three-year rule.

 

3. Mrs. Black is the original owner of either a single life or survivorship life policy

 

At a later date after the policy is issued, Mrs. Black SELLS the policy to the ILIT so that the ILIT becomes the owner and beneficiary. The three-year rule of IRC Section 2035 (a) does NOT apply because of the IRC Section 2035 (d) EXCEPTION for “any bona fide sale for an adequate and full consideration”.

 

Normally, the “adequate and full consideration” should be the fair market value of the policy. The fair value of the policy would be the modal premium to put the policy in force (i.e. monthly, quarterly, annually). Clients should consult their tax and legal advisors for advice on the fair market value when a policy is sold to a third party. A purchase and sale document should be drafted by legal counsel to show an arms-length negotiation between Mrs. Black and the trustee of the ILIT.

 

4. Adult child of the Blacks is the original owner and beneficiary of either a single life or survivorship life policy

 

At a later date after the policy is issued, the adult child “voluntarily” GIFTS the policy to the ILIT so that the ILIT becomes owner and beneficiary. The adult child is under no legal obligation to transfer ownership of the policy. The ILIT is drafted with language that allows gifts to the trust by trust beneficiaries (i.e. adult children). The three-year rule of IRC Section 2035 (a) does NOT apply since the insured(s) never owned the policy at any time.

 

5. Mr. Black is the original owner and beneficiary of a single life policy on the life of Mrs. Black

 

At a later date after the policy is issued, Mr. Black “voluntarily” GIFTS the policy he owns on the life of Mrs. Black to the ILIT so that the ILIT becomes owner and beneficiary. Mr. Black is under no legal obligation to transfer ownership of the policy. The ILIT is drafted with language that allows gifts to the trust by other persons (i.e. husband of insured). The three-year rule of IRC Section 2035 (a) does NOT apply since the insured (Mrs. Black) never owned the policy at any time.

For an estate that is exposed to federal and state estate taxes that could approximate a 50% rate at the margin, it is extremely important that any insurance purchased to offset these taxes be itself estate tax-free. Please contact BSMG Advanced Sales for a discussion of your case where an ILIT has not yet been drafted and executed.

 

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers’ Service Marketing Group
russ@bsmg.net