In estate tax planning, the irrevocable life insurance trust (ILIT) is not a new strategy, but it is one that stands the test of time and can prove to be a great tool for managing an estate tax burden when passing wealth to future generations.
What Is an ILIT?
An ILIT is an irrevocable trust primarily created and administered to be both owner and beneficiary of life insurance policies. The person who initially creates and funds the ILIT is known as the grantor or settler. The grantor is often the person whose life is insured by the life insurance policies held within the trust. In general, this trust holds no other assets, other than potentially prefunded cash and securities for future premium payments, and has been drafted in such a way that it is disregarded for income tax purposes as an intentionally defective grantor trust.
To pay the premiums on the policy or policies held by the trust, the grantor makes gifts to the ILIT. Gifts are often made annually, and trust beneficiaries may be granted annual withdrawal rights by the trust document to satisfy the present interest requirement (more on this later). Upon the grantor’s death, the trust/trustee collects the insurance proceeds and distributes them pursuant to the terms of the trust document. At the time of the grantor’s death, the trust is no longer a disregarded entity and becomes a separate tax-paying entity.
If the trust owns insurance on the life of a married person, often the surviving spouse and children are the beneficiaries of the trust assets. If the trust owns insurance that is considered “second to die,” then the death benefit is paid out to the rest of the beneficiaries after both of those insured have passed away.
Advantages of an ILIT
Estate Tax Benefits – An ILIT can be most advantageous in situations where a taxable estate is anticipated at death. In general, if an individual is the owner of a life insurance policy on their life, the proceeds of the policy are includible in their gross estate at death and may be subject to estate tax. By utilizing an ILIT, the life insurance proceeds are removed from the grantor’s taxable estate. The resulting reduction in the estate tax liability means a substantial increase in value that can pass to the next generation. There are many ways to transfer life insurance into an ILIT. If the insured owns the policy outright, it may be beneficial to use part of the insured’s lifetime exemption to gift the policy at the current fair market value into the ILIT. A gift of cash to fund the ILIT so that it can purchase life insurance is another method to transfer life insurance into an ILIT.
Benefits of Annual Gifting to an ILIT – Each year a person can gift up to the annual exclusion amount ($17,000 in 2023) to any other person, gift, estate, and generation-skipping transfer (GST) tax-free. This benefit is often underutilized. For example, if you wanted to give away a large portion of your estate to your family and friends—a total of 100 people—without having to pay estate or gift tax on it, you could give each person $17,000 (total of $1,700,000) in 2023. This annual exclusion amount can be used to fund the ILIT premiums each year if the gift is considered a present interest. To satisfy this requirement, a provision is included in the ILIT trust agreement to provide withdrawal rights to beneficiaries so in essence they are entitled to the funds now even if the investment is one that will pay a large death benefit in the future. To satisfy the present interest requirement, the trustee sends Crummey letters to the withdrawal right beneficiaries letting them know what amount they could withdraw from the trust.
GST Benefits – The GST tax is imposed on the direct and indirect transfers to those who are two or more generations below the grantor of the ILIT. An ILIT can be designed so that the assets in the ILIT can pass to the next generation GST tax-free. The grantor also may use GST exemption to gift a policy into an ILIT to maximize the benefits of the lifetime GST exemption, which is not portable to a surviving spouse as the estate tax lifetime exemption is.
Asset Protection – Often, it is not ideal to have insurance proceeds paid directly outright to a child, spouse, or other beneficiary. Using an ILIT can protect these assets and provide direction on how the proceeds can be used. Also, the proceeds will not be included in any probate estate and thus will be private because they are held in trust.
A few examples of the potential pitfalls of receiving insurance proceeds outright include:
- A grown child receives life insurance proceeds outright and then ends up divorcing their spouse and having to give half of those proceeds to the ex-spouse because they were not held in trust.
- As a teenager, a grandchild wanted a fancy car.
- A child with special needs is unable to take advantage of government assistance as a result of receiving life insurance proceeds.
Beware of the Risks
Though there are generally limited assets in an ILIT while the premiums are being paid on the insurance policy, there are still many inherent risks regardless of the amount of trust assets. An ILIT does require some annual administration before the insured dies, and it is important that the trustee is equipped to take on this administrative burden. The death benefit also could be pulled back into the grantor’s estate if the grantor transfers an existing policy into the ILIT within three years directly before passing away.
Working with a team of professionals who understand both your complex financial challenges and your goals for your financial security, estate planning, and philanthropic endeavors is critical to evaluate whether an ILIT is right for your situation. For more information on how Forvis Mazars Private Client can help, reach out to a professional at Forvis Mazars or submit the Contact Us form below.