Irrevocable Life Insurance Trusts

September 08, 2006

An Irrevocable Life Insurance Trust, or ILIT, may be used to transfer substantial proceeds from a life insurance policy to your children or other descendants, free of gift tax and estate tax.

Benefits:

• Pass proceeds of a life insurance policy on your life with little or no gift tax cost, and with no estate tax cost
• Create a trust to control the ownership and management of the life insurance policy during your lifetime, and to direct the distribution of the proceeds from the policy upon your death

The Basic Design:

• First, you create a trust, an ILIT, which will acquire and hold a life insurance policy on your life.  You make an initial cash contribution to the trust. The trustee of the ILIT uses the cash in the trust to purchase a policy of life insurance on your life. 
• You make regular, annual contributions of cash to the trust.  The trustee uses the cash to pay the premiums for the life insurance policy. 
• Your cash contributions to the trust may qualify as non-taxable gifts to your descendants who are the beneficiaries of the trust (i) if the contribution for each beneficiary is under the federal gift tax annual exclusion amount at the time (currently, $12,000), and (b) if the beneficiaries are given certain limited rights to withdraw the cash contributions.  If your contributions exceed the gift tax exclusion amount, or if you do not grant the beneficiaries the rights to withdraw the contributions, then the contributions will be deemed taxable gifts.  You pay no gift tax on taxable gifts until the aggregate value of the taxable gifts that you make during your lifetime exceeds your $1 million gift tax exemption.
• Upon your death, the life insurance proceeds are paid to the trustee of the ILIT.  Under the terms of the trust that you create, you direct how those proceeds will be distributed to your family.  For instance, you may wish for the trust assets to be held in further trust for your children until they reach a certain age.
• Because you were not the owner of the life insurance policy at the time of your death, the proceeds are not part of your taxable estate, and they are therefore not subject to estate tax in your estate.

 Common Questions:

• May I serve as Trustee of the Trust?  To insure that you have no ownership interest in the insurance policy, we recommend that neither you nor your spouse should serve as trustee.
• What happens if a child of mine exercises his or her right to withdraw his or her share of a contribution that I have made to the trust?  If you have given a child the right to withdraw his or her share of a contribution to the trust in order to qualify the contribution for gift-tax free treatment, then the trustee must deliver a portion of the contribution to the child.  This leaves the trustee with less cash to pay the premium. 
• When I die and the insurance policy pays off, do the beneficiaries of the ILIT have to pay income tax on the proceeds?  No, under current tax law, life insurance proceeds are not subject to income tax.  However, if the ILIT invests the proceeds and earns income from the investment, that income will be subject to income tax.
• I've heard that an ILIT can be used to pay estate tax.  How does that work?  Upon your death, the proceeds of the life insurance policy will be paid to the ILIT.  The trustee could use that cash to purchase assets from your estate (which, for example, could consist of your home and other real property, your investment accounts, or your family business interests). The purchase of assets would move cash into your taxable estate, and assets from your estate would move into the ILIT.  Your executor or trustee could use the cash to pay any estate tax due from your estate.  The trustee of the ILIT would hold or distribute the purchased assets in accordance with the terms of the ILIT.
• Someone mentioned that an ILIT could be partnered with a Charitable Remainder Trust.  What's the purpose of using these two estate planning techniques together?  A Charitable Remainder Trust, in brief, is a trust that you create to transfer an asset to charity, but also to retain an annual payment from the trust while it is in existence.  For instance, you could transfer stock to a trust that lasts for 15 years, and retain an annual payment from the trust that you would receive annually during the 15 year term.  When the 15 year term has run, the trust would terminate and the assets held in the trust would pass to your selected charity.  Some people wish to replace the "loss" of the asset that passed to charity, rather than to their family, by creating an ILIT.  The cash proceeds in the ILIT replace the asset that passed to charity.
• Does the ILIT have to file an income tax return?  Yes, a tax identification number is assigned to the trust, and the trustee must file an annual income tax return.