Irrevocable Life Insurance Trusts

An Irrevocable Life Insurance Trust (ILIT) is a specific type of irrevocable trust designed to manage the ownership of one or more life insurance policies. ILITs can offer both tax and non-tax advantages for those with or exploring life insurance that are not possible through outright ownership.

Benefits of an ILIT:

A properly drafted and administered ILIT provides several benefits. The most common reason for establishing an ILIT is that it removes the life insurance proceeds from the Grantor’s taxable estate, limiting the Grantor’s estate tax liability related to such proceeds. In addition, there are non-tax benefits such as:

• Control – With an ILIT, the Grantor can control how the life insurance proceeds are received and used by the beneficiaries following their death. For example, rather than providing a beneficiary with a sudden lump sum insurance payout, an ILIT can establish guidelines for how the insurance proceeds are to be distributed to or for the benefit of the beneficiary over a period of time, which can hedge against undesirable spending habits of less mature beneficiaries.

• Estate Liquidity – For individuals with taxable estates and/or closely held businesses, liquidity is a common issue and concern at death. The liquidity provided by an influx of cash upon the Grantors death (not subject to or reduced by estate tax) can be a valuable tool to families who need to pay creditors or who are looking to equalize inheritance among multiple beneficiaries without needing to sell an illiquid asset or take out a loan. ILITs can help alleviate these concerns by providing an essential cash pool for expenses such as estate taxes, debts, and estate administration.

• Creditor Protection – Unlike insurance benefits directly paid to beneficiaries, benefits held in an ILIT may be protected from divorce, creditors, and legal action against the beneficiaries.

Basics of an ILIT – Structure & Funding:

ILITs are structured to allow the trust to both own and receive the benefits of a life insurance policy. The life insurance policy typically insures the life of the person establishing the trust (the “Grantor”). The trustee, who is selected by the Grantor, owns the policy and sees that the proceeds of such policy are paid to the beneficiaries of the trust according to the terms of the trust upon the death of the insured. The trustee of the ILIT generally is anyone other than the insured person.

During the life of the Grantor, the ILIT will need to pay the insurance premiums. This can be completed in a number of ways, but most commonly is accomplished through a disciplined regiment of cash gifts to the trust over time. As long as the gift to the trust is under the annual exclusion amount (currently $16,000 per person for 2022), and the recipient of the gift has a “present interest” in the gift, then the gift to the trust is not taxable.

Gifts are classified as a present interest if there is an unrestricted right to the immediate use, possession, enjoyment of the property, or property income. In the specific case of ILITs, contributions to the trust for purposes of paying the insurance premiums are classified as present interest gifts if the beneficiaries possess the power to withdraw the contributions for a limited period. This power to withdraw is commonly referred to as a “Crummy Power,” named after the 1968 Ninth Circuit case Crummey v. Commissioner. Through proper administration and adherence to the trust agreement, Grantors essentially make annual gifts to pay insurance premiums in a way that ensures the benefits of the policy are not subject to estate tax upon their death.

A Life Insurance Trust is a valuable tool that should be considered in your estate planning. If you are interested in learning whether a Life Insurance Trust suits your specific needs, please contact a member of Stadig Johnson for further discussion.