Is an Irrevocable Life Insurance Trust Right for My Family

One common trust that people use for estate planning is the Irrevocable Life Insurance Trust (ILIT). At its most basic, this is an irrevocable, un-amendable trust that a grantor funds with a life insurance policy. The grantor names the trust as the beneficiary of the life insurance policy, which is usually on the life of the grantor. From this basic framework, a grantor has many options to adjust and customize the trust to accomplish their goals. In this post we will look at some benefits and the mechanics of these types of trusts, to help you decide whether they can help you accomplish your estate planning goals.

Benefits of the Irrevocable Life Insurance Trust

We begin our review of the ILIT by reviewing some of their benefits:

1. Provide Liquidity

One main benefit of an ILIT is that it provides liquidity to an estate. Taxes are due on an estate nine months after the date of death. It is often the case, especially for business owners and larger estates, that there is not enough cash or other highly liquid assets readily available to pay these taxes. As a result of this lack of liquidity, the family of the deceased will have to sell part or all of the business, the family farm, or some other real estate holding in order to pay the taxes. Apart from familial and sentimental reasons that a family might not want to sell these items, there is also the issue that, because of the pressure to sell in a reduced time frame, it is highly likely that the family will not receive full value for the asset. With an ILIT, the family will automatically receive an influx of liquid assets that the trustee can transfer to pay these taxes. There are also many other expenses that come with settling an estate that the trust assets can provide the liquidity to pay, including debts, legal fees, probate costs, and income taxes.

2. Lower Estate Tax

This leads us to another main benefit of the ILIT. Because the insurance company pays the policy proceeds into an irrevocable trust, the IRS does not include the assets in the decedent’s taxable estate. This reduces the amount of estate taxes the estate you and your heirs will have to pay. If you are the owner of the policy, then the proceeds will be taxable to your estate. If your children or spouse is the owner, then the proceeds will go to them outright, and will be included in their taxable estate. By having a trust own the policy, the proceeds escape inclusion in anyone’s estate until the trustee distributes the proceeds to the beneficiaries.

-To avoid the IRS including the life insurance in the grantor’s taxable estate:

  • The trust must be irrevocable

  • The grantor cannot be the trustee

  • The grantor cannot have any “incidents of ownership” over the insurance policy

  • The “incidents of ownership” over the insurance policy that will take away the tax benefits of the trust include: policy ownership, the right to borrow the cash value, the right to change beneficiaries, and the right to change how the proceeds are ultimately distributed to the beneficiaries.

  • The grantor must live for at least three years after transferring the insurance policy into the trust

  • Any transactions between the trust and the estate must be reasonable arms-length transactions

Apart from estate taxes, having assets in the trust saves time and probate costs, as assets held in a trust do not have to go through the probate process.

3. Provide Support for Heirs

A third benefit of these trusts is that you can use the proceeds above the amount needed to pay the estates expenses to care for other beneficiaries of the trust. Depending on how much insurance you choose to purchase, the trust can hold a significant amount of money that the trustee can distribute to your chosen beneficiaries. You can put some rules on how your trustee will distribute this money when you set up the trust. By doing this, you can avoid a situation where, for example, your young adult child receives a large amount of money at a time when they are not yet able to handle it.

4. Shelter Property from Creditors

Finally, a major benefit of an ILIT is that, at death, the trust shelters the assets in the trust from the estates creditors. The trust does not automatically transfer assets in the irrevocable trust to the beneficiaries of the trust. As long as the assets remain in the trust, the creditors of the beneficiaries have no claim on those assets. This is also the case for court judgments and divorcing spouses of the beneficiaries.

Parties Involved in the Trust

Next, we review the parties involved in the trust:

1. The Grantor

The first party is the grantor, or the person who creates the trust. The way that the grantor drafts the trust affects the way that the IRS treats the trust for income tax purposes. If the grantor drafts the trust as a grantor trust, then the IRS will tax any income made on the trust assets to the grantor, i.e. the grantor will include the trust income on their individual tax return. Otherwise, the IRS treats the trust as its own separate entity for income tax purposes.

2. The Trustee

The trustee manages the trust. In an ILIT, it is very important to choose the correct trustee. If you select the wrong trustee, some of the specific benefits of the trust will go away. One person who can’t serve as the trustee is the grantor. The reason the grantor cannot act as trustee is because if they did the trust would not qualify as irrevocable. If the grantor was the trustee, they would still have control over the assets. You can, and most people do, choose your friend, child, or spouse as trustee. This can create some problems depending on your family’s other estate planning documents. Another issue with choosing your spouse, friend or child to run the trust is that they may not have the time, skill, or experience to manage the trust. You can also choose a bank or a trust company. They have the experience, and they will pay premiums on time and administer the trust properly, but they are also an added expense.

3. The Beneficiaries

The final party involved in the trust is the beneficiaries. Beneficiaries are often family members of the grantor. Do not name your estate or your living trust as a beneficiary, as this will bring the insurance proceeds back into your estate and make them taxable. If you name your estate or another revocable trust as beneficiary, it will allow a court to classify the ILIT as revocable, as you have now given yourself the ability to change the eventual beneficiary of the ILIT trust through your will or the terms of the beneficiary trust. You can grant your beneficiaries a short (less than 60 days) window to withdraw any annual gifts that you transfer into the trust to pay the policy premiums. By granting this power, called a Crummy power, you can use the annual gift exemption to make tax free gifts to the trust, and reduce the taxable value of your estate. (To learn more about Crummy Powers, please see our article on Crummy Trusts)

Mechanics of the Irrevocable Life Insurance Trust

Why Irrevocable

We continue our deeper dive by going into some of the specific mechanics of the ILIT. First, as the name suggests, the Irrevocable Life Insurance Trust is irrevocable. This means that you as the grantor completely give up all rights to the property transferred into the trust. You cannot retain any right to revoke, modify or terminate the trust. There are several reasons why this type of trust is irrevocable, the main reason being that by making the trust irrevocable; the assets in the trust will ordinarily not be included in your taxable estate. Irrevocable trusts are valuable for other reasons, including the ability to protect assets from creditors. As irrevocable trusts have to do with giving up control of assets, the grantor must create the trust during their lifetime. A slight exception here is that a grantor is allowed to have the power to remove the trustee and appoint a successor trustee, as long as the successor trustee isn’t related to the grantor, or a subordinate of the grantor[1].

How the Irrevocable Life Insurance Trust Adds Liquidity

Next, let’s go into how exactly the trust provides liquidity without adding to the taxable estate. The trustee of the ILIT cannot simply pay the bills of the estate. There are two reasons for this: one reason would be that if the trustee would pay those bills, then the estate would be a beneficiary of the trust. As we mentioned earlier in this article, if your estate is a beneficiary of the trust, the trust is no longer irrevocable, as you could direct the distribution of the trust assets through your will. In order to avoid this outcome, there are two options available for the trust to provide liquidity to the estate. For both of these options, the trust document must authorize the trustee to make proceeds available to the executor of the estate. The trust document must only authorize however, if the trustee is required to make the proceeds available, then it is likely that all of the proceeds will be included in the grantor’s taxable estate, undoing a major benefit of the ILIT. Assuming the trust document gives the trustee discretionary power to make the insurance proceeds available to the grantor of the estate, the two options available to provide liquidity to the trust are for the trustee to buy illiquid assets of the estate, or to make a loan to the estate. When making these loans or purchases, there are certain requirements that the trustee must follow in order to keep the liquid assets transferred from being included in the taxable estate. The requirement that the trustee must follow when transacting with the estate are that the trustee must make arms-length transactions. This means that the trustee must pay fair market value for the illiquid assets, and the loans must be at a market rate of interest, be secured by collateral, and must provide a repayment schedule. If the trustee overpays for assets, or provides under market loans, the IRS may consider these to be taxable distributions to the estate.

When to Start the Trust

Because an ILIT is irrevocable, many people wait until they are in their 50s, 60s or later to start one. Waiting this long allows the grantor to be surer about family relationships and their own financial situation. Waiting to start an ILIT is not without problems, though. Waiting too long to purchase a life insurance policy may make you uninsurable. A grantor can buy the policy themself, and then transfer it into the trust at a later time, but if so, they need to live for three years after the transfer, or the IRS will invalidate the transfer.

Funded vs. Unfunded

When you start an ILIT there are two options on how to pay for the insurance policy or policies that make up the trust. These options are to fund the trust with additional assets, or leave it unfunded. These additional assets may be cash, securities, or any other asset. Those additional assets will produce income, which the trustee will use to pay the premiums on the insurance policies. There are some drawbacks to a funded ILIT that makes them less commonly used. One drawback is that the IRS may tax the income made by the trust assets to the grantor[2]. Another disadvantage is that when you transfer the assets that fund the trust, they are subject to gift tax, though actual gift tax will be due only on very large estates. If the trust will have multiple beneficiaries, to whom you have granted Crummy Powers, it can be valuable for a grantor to fund the trust with an initial gift that is large enough to avoid gift tax being charged on subsequent transfers when the Crummy Powers lapse. Crummy Powers can activate something called a 5x5 right, where, if a beneficiary with a power of appointment does not exercise that power, the IRS considers any part of a gift above the greater of $5000 or 5% of the trust corpus to be a gift of future interest to the other beneficiaries. By seeding the trust with a large initial gift, you can increase the corpus of the trust to a point where even a gift that maximizes the annual gift exclusion will be within the 5% safe harbor. An unfunded ILIT is more common. With this type of trust, the trustee purchases the insurance policy and pays premiums on the policy with annual gifts. These trusts can use Crummy Powers to fit these gifts within the annual gift exclusion. If there are multiple beneficiaries of the trust then using Crummy Powers may also require you to deploy additional techniques to fit the gift into the exclusion.

Insurance Contract Options

There are almost no restrictions on the size, type, or number of life insurance policies that can be held in an ILIT In terms of the insurance policy that the trust will hold, you can have the trustee purchase the policy for the trust, or the grantor can transfer an existing policy into the trust/ the trust can purchase the policy from the grantor. If the grantor transfers the policy into the trust, then the grantor must live for an additional three years, or else the policy will revert back to the grantor and the IRS will include it in the grantor’s taxable estate. For married people, it is very common to buy a “second-to-die” policy which pays the death benefit only after both spouses are deceased. These types of policies often have lower premiums, and pay the benefits when estate taxes are more likely to be due. One spouse can make unlimited transfers to their spouse without having to pay gift or estate taxes. For this reason, it is rare that estate taxes are due on the death of the first spouse. Of course, if a purpose of the trust is to provide support for a surviving spouse, using only this type of insurance contract would not be useful in accomplishing this goal. It is preferable designate the trust as the beneficiary of the insurance contract. If a spouse or child is the beneficiary of the contract, then the proceeds will be included in their estate. Additionally, by making the trust the policy’s beneficiary, you will have some control over how the trustee distributes the proceeds to the beneficiaries. Rather than the insurance company paying the proceeds in a lump sum payment, you can have the trustee distribute the assets on a schedule that you create. You can also put some restrictions on how the beneficiaries can use the funds in the trust document. Another benefit of naming the trust as a beneficiary is that you can protect your beneficiaries in case of their incapacity. If you name an individual as the beneficiary of an insurance policy, and that individual becomes incapacitated, then the insurance company is unlikely to pay the proceeds of your policy to that incapacitated person. The insurance company will require court involvement and supervision before releasing the proceeds of the policy. If you name the trust as beneficiary, the insurance company will pay the proceeds to the trust, and the trustee will be able to provide for the incapacitated person without court interference.

Issues with Irrevocable Life Insurance Trusts

ILIT can be valuable tools that help you accomplish a number of estate planning goals. They are not without issues and risks, however. These trusts can increase the amount of assets that you can transfer to your heirs after estate taxes, because you are effectively reducing your estate tax burden, but the IRS has created a large number of requirements that need to be met if the trust is to be successful. We have spoken about a number of these requirements above, including making sure the trust is irrevocable, choosing the right trustee, choosing the proper beneficiary of the insurance policy, and making sure that the grantor lives for at least three years after transferring an insurance contract to the trust. There are also possible gift tax consequences when funding the trust, though there are techniques available to minimize these gift taxes. Another issue is also a way to get around the irrevocable trust restriction that you cannot reserve the right to cancel the trust. If you are using an unfunded ILIT, you are requiring yourself to gift the premium payments into the trust every year. If the premium payments are not made, the insurance policy lapses, effectively canceling the trust. A final issue is that if you have a funded trust, any income made by the assets in the trust will have income tax ramifications on the grantor.

[1] Rev. Rul. 95-58, 1995-1 C.B. 191

[2] IRC §677(a)(3)

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