Irrevocable life insurance trusts are distinguished from other irrevocable trusts funded with other types of assets by a number of ways. Design options for life insurance trusts are somewhat limited for TOLIs because, in accordance with IRC 2042, the proceeds of a TOLI are included in the insured’s estate if they are payable to the insured’s estate, or the insured had any “incidents of ownership” at the time of death.
The proceeds from an insurance policy are payable to the insured’s estate (even with a TOLI) if the trustee uses the funds to pay the insured’s debts, cost of estate administration, or estate taxes. Thus, a TOLI should state that the trust can lend money to or purchase assets from the insured’s estate to pay off those expenses.
As it pertains to life insurance, an “incident of ownership” will arise if the insured (1) is the trustee of the TOLI, (2) has unrestricted power to remove and replace the trustee, (3) is a beneficiary, (4) has the power to change beneficiaries, (5) has the right to borrow against the policy’s cash value or cancel the policy altogether.
When funding a TOLI with an existing life insurance policy, which would have already been included in the insured’s estate (for the reasons discussed above), will trigger a 3-year rule. The 3-year rule requires that the owner/insured of the policy survives at least 3 years from the date of transfer in order to prevent inclusion of insurance proceeds from the owner’s/insured’s taxable estate.
