How does an ILIT handle a policy that is part of a split dollar arrangement

It’s a scenario I see far too often: Dale, a successful physician, meticulously planned his estate, creating an Irrevocable Life Insurance Trust (ILIT) years ago. He’d even structured a split-dollar agreement with his practice to fund the policy premiums. Then, a critical codicil to his trust – altering beneficiary designations – was never signed. His estate faced a brutal tax bill, wiping out a significant portion of what he intended for his children. These mistakes, while painful, are preventable with careful planning. I’ve been practicing as an Estate Planning Attorney and CPA for over 35 years, and I’ve learned that seemingly complex situations like split-dollar policies require even more attention to detail.

What Exactly is a Split-Dollar Arrangement?

A split-dollar life insurance arrangement is a financial agreement where the policy’s death benefit, and sometimes the premiums, are shared between two parties – typically an employer and an employee, or between family members. It’s a common tool for businesses to provide executive benefits or for families to transfer wealth. However, integrating a policy subject to a split-dollar agreement into an ILIT introduces complexities that demand careful navigation. The primary concern revolves around maintaining the ‘incidents of ownership’ test.

The Incidents of Ownership Challenge

As you know, the core principle of an ILIT is that the grantor (Dale, in our example) cannot retain any control or “incidents of ownership” over the policy. Retaining such control, under Incidents of Ownership (IRC § 2042), would cause the death benefit to be included in their taxable estate. With a split-dollar agreement, the policy ownership is usually shared. This means Dale, even after transferring the policy to the ILIT, might still have certain rights or obligations tied to the agreement, potentially jeopardizing the ILIT’s tax-exempt status.

Navigating the Agreement Terms

The first step is a thorough review of the existing split-dollar agreement. Key questions to address include:

• Premium Payment Obligations: Who is responsible for paying future premiums? If Dale remains personally obligated to pay premiums even after the transfer to the ILIT, this constitutes continued ownership. The ILIT must be fully funded to cover these payments.
• Policy Loan Provisions: Does Dale have the right to borrow against the policy? This right, even if unused, is an incident of ownership.
• Beneficiary Designations: While the ILIT is ultimately the beneficiary, the split-dollar agreement might grant the other party (the practice, for instance) certain rights regarding the benefit allocation. This must be carefully scrutinized.
• Termination Rights: Can Dale unilaterally terminate the split-dollar agreement? If so, this is a significant issue.

Strategies for ILIT Integration

Several strategies can be employed to successfully integrate a split-dollar policy into an ILIT:

• Obtain Release of Rights: The ideal scenario is to obtain a complete release of all rights and obligations from the other party to the split-dollar agreement. This eliminates the risk of Dale retaining incidents of ownership.
• Amend the Split-Dollar Agreement: If a full release isn’t possible, amend the agreement to clearly state that all incidents of ownership have been transferred to the ILIT.
• Obtain Consent: Secure written consent from the other party to the transfer, acknowledging that they agree the ILIT now holds all policy rights.
• New Policy Purchase: In some cases, it may be more effective for the ILIT to purchase a new policy, funded with an irrevocable gift from Dale, rather than attempt to transfer an existing split-dollar policy.

Gift Tax Implications and Crummey Letters

Any transfer of the policy or amendments to the split-dollar agreement could be considered a gift. To qualify for the annual gift tax exclusion, the trustee must send ‘Crummey Letters’ to beneficiaries every time a deposit is made, granting them a temporary right to withdraw the funds (typically for 30 days). This is critical to avoid triggering gift tax liabilities and ensuring compliance with IRC § 2503(b).

The Three-Year Rule and Existing Policies

It’s also vital to remember IRC § 2035 (The 3-Year Rule). If you transfer an existing life insurance policy into an ILIT and pass away within three years, the death benefit is ‘clawed back’ into your taxable estate. This is why, whenever possible, having the ILIT purchase the policy directly is often the safest approach.

Digital Access and RUFADAA

Don’t overlook the practical aspects of policy management. Without specific RUFADAA language (Probate Code § 870) in the ILIT, service providers and insurers can legally block your trustee from accessing online policy portals to manage premiums or file claims. This can create significant administrative burdens and delays.

Missed Assets and AB 2016

I recently worked with an estate where the ILIT was fully funded, but $200,000 intended for premium payments remained in the grantor’s account. For deaths on or after April 1, 2025, if cash assets intended for the ILIT were legally left in the grantor’s name (valued up to $750,000), they qualify for a ‘Petition for Succession’ under AB 2016 (Probate Code § 13151). This avoids probate and allows the funds to be transferred to the ILIT. It’s important to differentiate this as a “Petition” (Judge’s Order), not an “Affidavit,” as some mistakenly believe.

As a CPA as well as an attorney, I understand the tax benefits – like the step-up in basis and capital gains implications – that careful estate planning can unlock. An ILIT, when structured correctly, is a powerful tool. However, integrating a policy subject to a split-dollar agreement requires a nuanced understanding of both insurance and tax law.

How do California trustee duties and funding rules shape the outcome for beneficiaries?

Success in trust administration depends on more than just the document; it requires active management of assets, precise accounting to beneficiaries, and careful navigation of tax rules. Whether dealing with a blended family or complex real estate, understanding the mechanics of trust law is the only way to ensure the grantor’s wishes survive scrutiny.

A stable trust administration relies on the trustee’s ability to balance investment duties, beneficiary communication, and tax compliance. When these elements are managed proactively, families can avoid the emotional and financial drain of litigation.

Verified Authority on ILIT Administration & Tax Compliance

• The “3-Year Rule” (IRC § 2035): Internal Revenue Code § 2035
  The critical statute warning that transferring an existing policy to an ILIT triggers a 3-year waiting period. If the grantor dies within this window, the insurance proceeds are pulled back into the taxable estate.
• Incidents of Ownership (IRC § 2042): Internal Revenue Code § 2042
  This code section defines why a grantor cannot be the trustee. Retaining the power to change beneficiaries or borrow against the policy forces the death benefit into the gross estate for tax purposes.
• Annual Gift Exclusion (Crummey Powers): IRS Gift Tax Guidelines (IRC § 2503)
  The legal basis for “Crummey Letters.” Without these withdrawal notices, money contributed to the ILIT to pay premiums does not qualify for the annual gift tax exclusion and eats into the lifetime exemption.
• Estate Tax Exemption (OBBBA): IRS Estate Tax Guidelines
  Reflects the OBBBA permanent increase to a $15 million per person exemption (effective Jan 1, 2026). ILITs remain the primary vehicle for ensuring life insurance proceeds sit on top of this exemption rather than consuming it.
• Missed Asset Recovery (AB 2016): California Probate Code § 13151 (Petition for Succession)
  If “unspent premiums” or refund checks intended for the ILIT were accidentally left in the grantor’s name, this statute (effective April 1, 2025) allows for a “Petition for Succession” for assets up to $750,000, bypassing full probate.
• Digital Policy Access (RUFADAA): California Probate Code § 870 (RUFADAA)
  Without RUFADAA powers, a trustee may be unable to access online insurance dashboards to verify premium payments, potentially causing the policy to lapse.