What is a Life Insurance Trust and Is It Right for Me?

An irrevocable life insurance trust (or “ILIT”) can be a critical component of estate planning for certain clients.

Typically, the client who might benefit from an ILIT is the client who anticipates exposure to estate tax. At present, this includes DC clients who have more than $4 Million in total assets (life insurance, real estate, retirement, investment, and cash), Maryland unmarried clients who have more than $5 Million in total assets, and Maryland married clients who combined have more than $10 Million in total assets.

What is estate tax?

Estate tax refers to a tax that is levied by either the federal government or the state of domicile of a decedent (the person who passed away). Each individual is entitled to an exemption – an amount of wealth that can pass free of estate tax. The current exemptions can be found here. Assets bequeathed under a will or a trust in excess of the exemption are subject to estate tax. The estate tax rate varies from 40% at the federal level to 16% at the state level. Tax must be paid within 9 months of a decedent’s death.

Why life insurance?

Life insurance can be very important for clients who anticipate estate tax exposure and whose holdings are largely illiquid. 9 months is not much time to raise cash to fund a tax liability, particularly if the sale of real estate or business interests is required in order to fund the liability. Life insurance is a relatively rapidly available cash resource to fund a tax liability. Moreover, you may want your heirs to have the flexibility to hold on to appreciating real estate, stocks, or other assets, rather than sell them off to fund a tax liability.

What is the advantage of owning life insurance in an ILIT as opposed to in my own name?

If an insurance policy is owned by an individual, personally, then the policy proceeds are included in your taxable estate. If, on the other hand, an insurance policy is owned by an ILIT, the policy proceeds are not part of your taxable estate and are free from estate tax.

Let’s put it another way. If John has a $15 Million taxable estate and a $5 Million life insurance policy owned in his own name, John’s cumulative taxable estate is $20 Million. It is $20 Million that is exposed to estate tax. But if John has a $15 Million taxable estate and a $5 Million life insurance policy owned by an ILIT, John’s cumulative taxable estate is $15 Million. It is $15 Million that is exposed to estate tax. With the estate tax rate at 40%, this could be a savings of $2 Million in estate tax for the policy to be owned by an ILIT.

How does an ILIT work?

An ILIT is established by an individual as the “Grantor”. The ILIT owns a policy of life insurance. The ILIT is managed by a Trustee – this cannot be the same person as the Grantor. The Grantor, however, usually contributes money to the ILIT to pay the annual policy premiums. These contributions are considered gifts by the IRS. It is important to be mindful of the amount of premiums – if the contributions to the ILIT to pay premiums exceed the annual gift exemption, the Grantor will be required to report the gift to the IRS on a gift tax return. The Grantor can pay the premiums directly or the Trustee of the ILIT can pay the premiums.

When the Grantor dies, the Trustee of the ILIT collects the insurance proceeds. These are held in trust by the Trustee. The funds in the ILIT are first used to fund any estate tax obligations. If the Grantor is survived by his/her spouse, typically an ILIT is structured to permit the surviving spouse use of the remaining policy proceeds to fund their customary standard of living by making request of the Trustee. If the Grantor is not survived by a spouse – or, upon the surviving spouse’s later death — the funds in the ILIT are again first used to fund any estate tax obligations, and any balance can be distributed however the Grantor would like.

Can I transfer an existing life insurance policy to an ILIT?

Yes, with a caveat. You must survive the transfer by 3 years in order for the policy proceeds to not be included in your taxable estate. If you die within 3 years of the transfer, the policy proceeds will be included in your taxable estate.

If you do transfer an existing policy to an ILIT, this too is considered a gift. And, like all gifts, this gift must be valued. You will need to obtain the present value of the life insurance policy and, if in excess of the annual gift exemption, the Grantor must report the gift to the IRS.

In general, it is far easier to fund an ILIT with a new policy. However, for certain clients, getting through the underwriting process may be a challenge and transfer is the only option.

What are some of the drawbacks of an ILIT?

If you thought that surely an estate planning tool that could save your family millions in estate tax would have some drawbacks, you thought right!

First, an ILIT is irrevocable. Indeed, the irrevocability of an ILIT is in the name of the trust itself (the first “I” in “ILIT” stands for “irrevocable”). The Grantor cannot amend an ILIT after it is created. Although irrevocable trusts are becoming more flexible and susceptible to amendment, this is one area where modifications and amendments must be considered a last resort. The more tinkering with an ILIT, the likelier it is that the IRS will not give the policy proceeds the favorable tax treatment.

Second, an ILIT requires some annual work. The ILIT only works if the life insurance policy is considered by the IRS as a completed gift. To the extent the Grantor continues to make annual gifts to the ILIT to pay policy premiums, the Trustee must issue notices to the beneficiaries of the ILIT (called “Crummey notices”) advising them of their right to withdraw the amount gifted to the ILIT. If the beneficiary acknowledges receipt of notice and declines to withdraw the gifted amount, the contribution of the policy premium is a completed gift.

Third, the Grantor cannot be the Trustee of the ILIT. If the Grantor is also the Trustee, he/she is considered in control of the asset. And that, in turn, would cause the policy to be included in the Grantor’s taxable estate. A Grantor can name his/her spouse as the Trustee, but there may be limitations required in the ILIT with respect to the spouse’s authority as Trustee. Many Grantors name unrelated individuals or trust companies as Trustee.

Concluding Thoughts

An ILIT is certainly not an important tool for all estate planning clients. However, for clients with exposure to estate tax, an ILIT can save literally millions of dollars in tax exposure, provide heirs with the certainty of a readily-available pool of funds to pay taxes and final expenses, and protect heirs’ ability to inherit appreciating assets without liquidating these assets to fund tax liability.