Tax Court Upholds ILIT Structure in Estate of Becker
Wealthy individuals frequently utilize Irrevocable Life Insurance Trusts (ILITs) to shield substantial life insurance policies from federal estate tax. However, a misstep in establishing or maintaining an ILIT can lead to significant tax consequences. In the recent case of Estate of Becker, T.C. Memo 2024-89, the Tax Court sided with the taxpayer, validating the intended use of an ILIT and preventing the application of the ‘step transaction doctrine’.
Background on ILITs and Estate Tax
Generally, life insurance proceeds paid to beneficiaries are exempt from federal estate tax. This exemption relies on the insured not maintaining any ‘incidents of ownership’ with their policy. Incidents of ownership are broadly defined and include the direct ownership of a policy, and the right to change beneficiaries. To circumvent potential estate tax issues, taxpayers often establish ILITs.
If the ILIT owns the life insurance policies or is the recipient of transferred ownership rights, the proceeds are typically shielded from estate tax. However, a transfer of policy ownership within three years of the insured’s death can cause the proceeds to revert to the taxable estate. Moreover, to prevent tax avoidance, the IRS can apply the ‘step transaction’ doctrine, treating a series of transactions as a single, integrated action.
The Estate of Becker Case: Facts and Ruling
The taxpayer, a physician residing in Maryland, established an ILIT in 2014, following Maryland law. The trust document named the taxpayer’s son and daughter as co-trustees. The spouse, children, and grandchildren were designated beneficiaries. The trust was designed to hold assets, notably insurance policies on the taxpayer’s life. The trustee was prohibited from borrowing against any insurance policy in the trust to pay premiums. The taxpayer, as grantor, relinquished all power to modify or terminate the trust, retaining no beneficial interests or control over the trust’s assets.
The trust secured two life insurance policies on the taxpayer, with the ILIT named as the sole beneficiary. The first policy had a death benefit of $11.47 million with an initial premium of nearly $1 million. The second policy had a death benefit of $8 million with an initial premium of almost $700,000.
Although the taxpayer never owned the policies or retained any ‘incidents of ownership’, funding for the policies involved a complex series of promissory notes with other unrelated parties, in exchange for 75% of the death benefit. Following the taxpayer’s unexpected death in a car accident in 2016, the IRS argued that the real beneficiary was the unrelated funding party and tried to include these proceeds in the taxable estate, applying the ‘step transaction doctrine’. However, after evaluating the structure of the ILIT and Maryland state law, the Tax Court ruled that the ILIT setup was sound.
Implications and Recommendations
The ruling in Estate of Becker reinforces the importance of meticulous planning when using ILITs to minimize estate tax liabilities. To ensure compliance and protect the integrity of these financial instruments, it’s crucial that professional advisors properly establish the ILIT to comply with all applicable laws and regulations.
Furthermore, the federal estate tax exemption is subject to change. The exemption for 2025 is $13.99 million, but it is scheduled to revert to $5 million, plus inflation indexing, in 2026. This reinforces the importance of timely professional advice.
