Irrevocable Life Insurance Trust

Dean Hanewinckel

When determining the size of an estate for estate tax purposes, the death benefit of any life insurance policy owned by you is included.  Even with today's relatively high estate tax deduction (there is no federal estate tax on estates valued at less than $5 million), a large life insurance policy may create an estate tax liability and reduce the amount received by your beneficiaries.

The value of the life insurance can be removed from your estate through the use of an irrevocable life insurance trust.  An Irrevocable Life Insurance Trust (ILIT) is a trust created to own one or more insurance policies.  The Grantor of the ILIT can transfer existing policies to the trust or fund the trust with cash and purchase policies in the name of the trust.  Unless the Grantor has transferred any of the policies on the Grantor's life to the trust within 3 years of the Grantor's death, the death benefits of the insurance policies will not be included in the Grantor's taxable estate.

To make sure such policies are not subject to estate taxes, the Grantor (insured) should not act as trustee of the ILIT, and the Grantor cannot retain any incidences of ownership, such as the right to change beneficiaries or withdraw principal from the policy.

The ILIT may also be the beneficiary of the insurance policies.  This has a number of advantages with respect to the Grantor's estate plan.  A couple of them are:

1.  The proceeds from the death benefits will not be paid directly to individuals and the Grantor can put provisions in the ILIT to restrict and limit the use of funds.  This will help preserve the inheritance of a spendthrift child.

2.  The ILIT provides much greater flexibility in distributing the proceeds of the policies than the usual insurance policy beneficiary designation.  This is especially advantageous for the naming of contingent beneficiaries.

Because the ILIT is irrevocable, it cannot be amended, even if circumstances change in the future.  However, if a Grantor funds the ILIT with term life, he can stop funding the premiums, and create a new ILIT with new policies to take into account the change in circumstances.  The original ILIT, with the objectionable terms, no longer has a policy in it and is effectively terminated.

There are gift tax consequences associated with the transfer of life insurance policies into the ILIT.  Such transfer will constitute a taxable gift as will the transfer of money into the ILIT to pay insurance premiums.  Many of the details of the gift tax issues are beyond the scope of this article.  The annual exclusion for gifts of a present interest can be used to reduce or eliminate the gift tax, but special provisions allowing beneficiaries access to property gifted to the trust (called Crummey Powers) must be included in the ILIT and executed with each contribution in order for the payment to qualify.

If the income from property in an ILIT is or may be used to pay the permiums on a policy of life insurance on the life of the Grantor or the Grantor's spouse, the Grantor is taxable (income tax) to the extent of the premium payments.

The creation and use of an ILIT in estate planning is an advanced technique and should only be undertaken with the assistance of legal counsel.