Irrevocable Life Insurance Trusts

Under federal and state estate tax laws, the face (payout) amount of a life insurance policy owned by an individual will be included in the taxable estate of such individual at death if the policy is owned in the name of the insured during his or her life.  If the life insurance policies have substantial payout amounts,  the decedent’s taxable estate may exceed the allowable estate tax exemption.  If life insurance policies represent much of the taxable estate, a Irrevocable Life Insurance Trust (ILIT) is a good tool for removing the face amount of a life insurance policy from the taxable estate of the insured. 

The ILIT is created to own the life insurance policies in its name, and is also named as the beneficiary of any policies owned.  Upon the death of the insured, the proceeds of the policies on the life of the insured will be paid to the ILIT and held by the ILIT in accordance with its terms.  Generally the ILIT requires that the proceeds of policies owned by the ILIT are held for benefit of the surviving spouse. Distributions may be made to the spouse only at the discretion of the Trustees.  Upon the death of the surviving spouse, the terms of the ILIT will govern the division and distribution of the assets in the Trust.  Most commonly, upon the death of the surviving spouse, the proceeds will be distributed to children according to the terms of the ILIT, though any successor beneficiary may be named if there are no children to receive a share.  By using an ILIT, the policy proceeds will not be included in the taxable estate of either the insured or the surviving spouse.

If you are applying for new life insurance and have established an ILIT, the application should be made by the ILIT rather than by the individual.  When the policy is issued, it will be owned by the ILIT, and In that event, the tax protections of an ILIT are immediately available.   If you transfer already existing policies into an ILIT, there is a three year waiting period before the transfer is deemed complete.  If the insured dies within that three year period, the proceeds of the ILIT will come back into his/her estate.

It is important to note that or an ILIT to be effective, the policy owner must give up all “incidents of ownership” in the policy. Thus, an independent third party trustee must be named to take active responsibility and control at inception.  it is important to name a trustee with whom the surviving spouse will feel comfortable since the Trustee controls the payout of trust assets.  It is prudent to name at least one successor trustee in the event the initial trustee is unable to serve.  Because of the potential length of time the ILIT may exist, it is prudent to select a younger person as trustee to ensure they will be able to serve for the duration, and to name a series of successor Trustees to avoid a complete vacancy in that office.

The Trustee will be responsible for all administrative duties.  One such duty is the payment of annual premiums on the policy.   When a premium is due, the insured may not pay the premiums directly. Instead the insured must make a “gift “ in the amount of the premium to the ILIT, and the Trustee will then pay the premium from that gift.   To comply with gift tax laws, the beneficiaries are entitled to withdraw a portion of the gift within a 30 day period after the gift is made.  These are known as “Crummey Powers”.  The trustee must send written notices to each beneficiary of the gift made and the right of withdrawal.

Although there are great advantages to using an ILIT to own life insurance policies, there are certain downsides:

1.       An ILIT is irrevocable. The insured surrenders all control over the policies and any other contributions made.  The settlor of the trust cannot change the beneficiaries, cancel the policies, borrow against the trust, or otherwise alter the provisions of the trust if circumstances change, nor can anyone compel the Trustee to do any of those actions.  

2.       If an existing policy is transferred to the Trust less than three years prior to the death of the insured, the ownership of that policy will revert back to the estate of the insured and the face amount thereof will be includible in the calculation of his or her taxable estate.

3.               The beneficiaries are given a mandatory withdrawal right which could result in the exercise of that right in opposition to your intent.

4.               The surviving spouse as beneficiary of the ILIT does not receive the policy proceeds free and clear, but instead must work with the independent trustee on matters of management and distribution of trust assets.

Notwithstanding these limitations, an ILIT it is widely considered to be a worthwhile tool in estate planning as a very effective way of reducing the size of a taxable estate, thereby reducing estate taxes by a substantial amount.