Irrevocable Life Insurance Trust - ILIT

Life insurance is becoming a frequently used tool in estate planning. However, the effects of using life insurance as an estate planning tool (irrevocable life insurance trust or ILIT) really aren’t that simple.

There are now dozens of advantages and disadvantages to using life insurance, depending on who owns the policy.

Most people are aware of the fact that if anyone owns a life insurance policy of which they are the insured, the death benefits payable upon their death are includible in their estate for estate tax purposes. Whether the death value will be taxed is dependent on who has been named as the beneficiary of that policy.

If someone has named their spouse as the beneficiary, the unlimited marital deduction prevents the proceeds from being taxed at their death. But, if those proceeds remain in the estate of the spouse, they will be included in the spouse’s estate upon death. The key to taxing life insurance proceeds revolves around ownership of the policy. The irrevocable life insurance trust is a technique that is used to address the issue of ownership.

An irrevocable life insurance trust is just that, irrevocable. When an individual creates such a trust, then the terms of the trust contract cannot be changed. As such, the individual relinquishes all control and capability of management over any assets owned by such a trust. Therefore, the IRS recognizes the fact that under such a scenario, the assets that are included in this type of trust cannot be included in the estate of the individual for estate tax purposes.

When an individual creates an irrevocable life insurance trust to hold the ownership of a life insurance policy, the policy proceeds are removed from the gross estates of both the insured and his/her spouse for estate tax purposes, assuming there is no direct policy transfer by the insured or the insured outlives any such transfer by three years. The insured person's spouse can have an interest in the trust after the insured’s death, as long as the policy is not a survivorship policy and he/she is not given an estate tax sensitive power or interest in the trust.

For decedents who have passed on since 1981, this is the only way to do more than defer the tax and give the spouse any benefit from the proceeds.

The advantages of naming an irrevocable life insurance trust as the beneficiary are as follows:

-- Flexibility

-- Protection of the beneficiaries against creditors’ and spousal claims

-- Investment management of the process

Avoidance of the generation-skipping transfer tax altogether, if the trust can be arranged to be effectively exempt from the tax by application of the insured’s GST exemption (and that of the spouse) or by relying on the non-taxable gift exception to the GST.

The proceeds can be made available to the executor to pay costs and taxes of the insured’s estate by a loan, purchasing of assets or direct payment.

Each of these techniques has possible disadvantages; the purchase of assets concept makes the most sense; assuming a stepped-up basis for the assets at death.

Another advantage is that an irrevocable life insurance trust solves the problem if the primary beneficiary dies before the insured. It also avoids problems of possible incompetence of the policy owner, the potential frustration of the insured’s plan by the owner during the insured’s life; and the problems of multiple or potentially legally incompetent owners.

Under state law, to name a trust as the policy owner provides creditor protection for the policy during the insured’s life. It also provides creditor and spousal protection for the beneficiaries.

The policy, although beyond the insured’s direct control, is in the hands of the trustee chosen by the insured to carry out the terms of an irrevocable life insurance trust created by the insured. Therefore, this is a fairly comfortable arrangement for most insured people once the decision has been made to give up policy ownership.