Irrevocable Life Insurance Trust (ILIT)

In a previous post, I discussed the role life insurance can play in an estate plan. In this post, I will specifically discuss a more complex estate-planning tool: the irrevocable life insurance trust, or ILIT.

Tax Considerations of the Irrevocable Life Insurance Trust

If an individual insured by a life insurance policy has an estate worth more than the estate tax exemption amount—set at $5,250,000 as of 2013—or two exemption amounts if the individual is married, it is a good idea to have someone other than the insured as the owner of the policy.

In these types of situations, an irrevocable life insurance policy, or ILIT, may be desirable. An ILIT can remove the life insurance proceeds from the estate of the insured and, if applicable, his or her spouse. If done correctly, this may result in little or no gift tax liability, maintain income tax exclusions, make the proceeds available to pay any estate taxes due after the death of the insured, reduce or eliminate generation-skipping transfer tax liabilities, and ensure flexibility if the trustee is given broad discretionary powers. Therefore, the irrevocable life insurance trust comes with a great number of benefits and can serve as a valuable estate-planning tool.

Ideally, the ILIT’s trustee will actually purchase the policy, rather than the insured. If the insured purchases the policy and then transfers it to the trust, the policy may be pulled back into the insured’s taxable estate if he or she dies within three years of the transfer. If the irrevocable life insurance trust purchases the policy directly, however, this three year waiting period may be avoided entirely.

When setting up an irrevocable life insurance trust, it is best to have an independent trustee—that is, someone other than the insured or the beneficiary of the policy—because this allows the trustee to exercise incidents of ownership over the policy without implicating the estate tax. (A surviving spouse can serve as a trustee of an ILIT, but he or she cannot transfer assets into the trust or have a policy covering his or her life in the trust.)

Whenever estate-planning tools are utilized to mitigate eventual estate tax liabilities, the gift tax is a matter of concern. Taxable gifts occur if the policy is transferred into the trust—assuming the policy has a cash value—or when funds to pay insurance premiums are transferred into the trust. An ILIT can minimize gift tax concerns by utilizing Crummey powers.

As discussed in my previous post on the subject, however, Crummey powers must be assigned very carefully. In addition, where there are multiple beneficiaries, utilizing the entire annual gift exclusion amount—$14,000 as of 2013—may still result in taxable gifts to the other beneficiaries whenever one beneficiary fails to exercise withdrawal rights. The irrevocable life insurance trust is certainly not a do-it-yourself trust.

Drafting Considerations for an ILIT

When setting up an ILIT, there are a few drafting considerations that should be kept in mind:

1. The insured must not have any incidents of ownership over the policy.
2. All policies should be assigned to the trustee.
3. The trust documents should preclude the insured from ever serving as a trustee.
4. The trust cannot allow its assets to be applied toward any support obligations the grantor may have.
5. The trust agreement should completely dispose of all interests in the policy, so that it cannot revert back to the grantor.
6. To avoid some of the rigidity and inflexibility of the trust, a trust protector can be added. The trust documents can specify when the trust protector is authorized to modify or terminate a trust, or it may allow the protector to take such actions in his or her sole and absolute discretion.
7. The policy owner—or his or her estate—should not be the primary beneficiary, or there may be gift tax consequences.

As a side note, a trust protector is a fiduciary who is given certain powers separate from that of the trustee, such as the power to change the trustee, amend the trust, transfer assets of the trust to a new trust, or terminate the trust. The role of the trust protector is to ensure that the intent of the creator of the trust is followed, serving as a check against a potentially unscrupulous, incompetent, or lazy trustee.