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ILITs: An Exceptional Estate Planning Tool

By: Investor Solutions

By: Investor Solutions

Properly used, Irrevocable Life Insurance Trusts (ILITs) can prove to be an exceptional estate planning tool. An ILIT is typically created to own the life insurance policy on the grantor’s life and thereby remove this potentially taxable asset from the grantor’s estate. That’s because if an individual owns or wants to buy a life insurance policy on his/her life, the proceeds of that policy, upon the grantor’s death will be included in his or her estate and taxable at the estate tax rate (currently 45%). However, by creating and properly executing an ILIT, the potential exists to forego paying estate tax on those proceeds.

ILITs typically work one of two ways. The first is that the grantor creates a trust and transfers ownership of an existing policy to the trust. In order for this policy to not be included in the grantor’s estate, three years must pass between the time the grantor transferred ownership of the policy and the time he or she passed away. If the grantor dies within the three-year window, the value of the life insurance proceeds is included in the estate. (If a gift is made within three years of the grantor’s death, it is technically referred to as “a gift in contemplation of death”.)

The second way an ILIT can be set up is if the grantor makes gifts of cash to the trust on an annual basis enough to cover the annual premiums required to keep the policy in effect. The three-year rule is not an issue in this case although gift taxes could be. In order for the cash gift to the trust not to trigger a federal gift tax issue, the value of the gift cannot exceed $12,000 (per beneficiary) for 2008. Additionally, upon gifting of the cash, the trustees must give the beneficiaries written notice that gives them thirty days to withdraw their share of the cash gift. If one or all of the beneficiaries decide to withdraw the cash, there may not be enough money left to pay for the premiums and the policy would lapse. Ideally, therefore, the beneficiaries would not take any distribution and thereby allow the trustee to pay the annual premium.

For individuals who feel that an ILIT would be a useful tool in their estate plan, it is important that they know the following:

Possible benefits of ILITs:

  • Reduce estate tax liability by removing assets from the gross estate
  • Provide liquidity to the estate in order to pay any estate tax liability
  • Allow for reduction of the gross estate with little or no gift tax issues
  • Provide for professional management of the assets according to the trust agreement

Potential downfalls of ILITs:

  • ILITs are irrevocable and therefore, cannot be changed
  • The grantor can no longer borrow against the cash surrender value of the policy
  • The creator gives us control of the assets
  • The creator gives up the ability to change the beneficiaries and terms of the trust
  • Filing requirement of Form 1041
  • Potential inclusion of insurance proceeds if policy transferred to ILIT within three years of policyholders death

Another consideration when establishing an ILIT is selecting a trustee. Because the grantor cannot retain any incidents of ownership, the grantor cannot also be the trustee. For obvious reasons, a beneficiary should not also be a trustee as their may exist a conflict of interest. Therefore, the best choice would be a trusted family member, friend or professional advisor.

An Irrevocable Life Insurance Trust s an exceptional estate planning tool but it is not for everyone. Consult with your legal and financial advisors about whether or not it is right for you.