The Role of the Irrevocable Life Insurance Trust in Estate Planning
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The Irrevocable Life Insurance Trust (“ILIT”) has many potential estate planning uses and is used when an individual has a need for insurance but wants the proceeds to pass free of estate tax. An ILIT is an irrevocable Trust created to own life insurance as a separate taxable entity and, if structured correctly, the insurance proceeds from the policy owned by the ILIT are not included in the taxable estate of the individual.
Generally, an ILIT is used when the need for life insurance exists (i.e., where the insurance will generate liquidity for paying estate taxes or other expenses of the estate, be used to fund the buyout of business interests, or simply increase the size of the insured’s estate) and when it is advantageous to keep that amount out of a decedent’s gross estate for estate tax purposes. While life insurance proceeds are ordinarily added to the taxable estate of the insured owner upon death, creating an ILIT to own the insurance policy can remove the insurance from an individual’s taxable estate. Additionally, a Trust provides an effective and flexible tool for managing and distributing assets and can help to accomplish the purpose for which the insurance was purchased. For example, if the insurance was purchased to provide liquidity for the payment of debts, expenses and/or taxes, this goal can generally be achieved by authorizing the trustee to purchase assets from or make loans to the insured's estate or the beneficiaries of the estate.
The ILIT will have its own tax identification number that will be used on any Trust bank accounts and for any Trust tax returns. However, an ILIT generally does not have to file federal or state income tax returns until the death of the insured when it receives the insurance proceeds, since no income will be generated by the Trust until such time. Once an ILIT has been created, an individual can either transfer a pre-existing life insurance policy to it or the trustee can acquire one or more policies on the life of the individual in order to fund the Trust. In either case, the life insurance policy will be the property of the Trust (in the case of a transfer of an existing policy, the transferor must not retain any incidents of ownership and must outlive the transfer by three years in order to keep the policy out of the gross estate) and the Trust will be both the owner of the policy and the beneficiary of the proceeds therefrom. The Trust instrument will be named as beneficiary of the policy and the terms of the trust will designate the intended beneficiaries of the policy proceeds as well as how the proceeds are to be shared, used and distributed. Structured correctly, this form of ownership of a life insurance policy can eliminate federal and state transfer taxes, provide an effective vehicle for managing assets, and protect insurance proceeds from the claims of the creditors of the insured.
The insured will make annual transfers to the ILIT for the Trustee (who should be someone other than the insured) to use to pay the insurance premiums. Ordinarily, this money would be subject to the gift tax, but if the beneficiaries of the ILIT each have a limited right of withdrawal (usually exercisable between 30 and 60 days after the transfer) over such amount and the Trustee sends out notices of their rights of withdrawal, known as “Crummey notices,” to them each time a gift is made to the Trust, then the insured will be able to apply his or her $12,000 annual exclusion against the gifts and no gift tax will be incurred. If the beneficiaries do not elect to take the funds, the funds will be used to pay the insurance premiums on the policy or policies. If a beneficiary’s share of the insured's annual contributions to the ILIT plus any other gifts from the insured to that beneficiary in any one year exceed exceed the annual exclusion amount, gift tax returns may need to be filed. An accountant or tax advisor should be consulted to address any questions on the need to file a gift tax return. If there are generation skipping transfer tax consequences, the insured can elect to allocate GST exemption on the return (even though the exemption may be automatically allocated under the tax rules without such election, it is good practice to affirmatively apply it on a return if an allocation is desired).
An ILIT is irrevocable and cannot be changed once it has been created. An insured individual contemplating the use of an ILIT must be willing to relinquish control of the assets transferred to the trust and must recognize the limitations that arise as a result thereof. The insured may not retain the right to revoke, alter, amend, or terminate the Trust, meaning that the insured may not retain the power to change the trust beneficiaries and their interests. Likewise, the insured can not require that assets contributed to the trust be used to pay premiums or otherwise maintain life insurance owned by the trust. Finally, the insured may not retain any economic benefit in the life insurance policy, for example, the insured will not be able to cash in or borrow against the cash surrender value of any life insurance policy after it is transferred to the Trust.
The most common scenario in which an ILIT is used is where the insured wants to prevent the life insurance policy proceeds from being taxed either as part of their estate or of the estates of both the insured and the insured's spouse but wants to ensure that the surviving spouse and the insured’s descendants enjoy the benefits of the proceeds as Trust beneficiaries. The surviving spouse may be entitled to all or a portion of the income and/or the Trust principal, in the discretion of a Trustee other than the spouse, without causing the trust to form part of the surviving spouse's gross estate. The surviving spouse also may have the right to demand principal for his or her health, support, maintenance, and education, limited by an ascertainable standard. Alternatively, the surviving spouse may be given the power to remove the greater of $5,000 or 5% of the value of the trust annually, without subjecting it to tax in the survivor's estate, except for the portion subject to the withdrawal power in the year of the survivor's death.
However, if the insured intends for individuals other than his or her spouse to be the outright beneficiaries of the insurance policies, the ILIT may not be the solution and individual ownership of the proceeds may be more appropriate. For example, where the surviving spouse will not participate in the benefits of the insurance and where the individual wishes to pass assets outright, and not in trust, to his or her descendants, it may be simpler to have the insured's descendants acquire the policy directly. Assuming the descendants own the policy from its issuance, no part of the proceeds should be includible in the insured's estate. Similarly, if the insured only wishes that the surviving spouse alone benefit from the proceeds of the life insurance policy, the policy need not be assigned to a Trust as the insured may designate the surviving spouse as the beneficiary of the proceeds. However, in this case the proceeds will form part of the surviving spouse’s gross estate at his or her death or, if the insured's spouse predeceases the insured, the proceeds will be subject to federal estate tax in the insured's estate.
Under the proper circumstances, an ILIT can be an effective estate planning tool to minimize tax and provide for the effective management of assets. In order to fully utilize its effectiveness, the objectives of the client in investing in life insurance must be considered as well as the estate, gift, and generation-skipping transfer taxes arising as a consequence of that investment. If you think that an ILIT might be beneficial to you or would like to discuss this further, please contact any member of the Estates, Trusts and Exempt Organizations Section at any time
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