How Do Irrevocable Life Insurance Trusts Work?

In order to avoid the federal estate tax, many people transfer their policies to a trust rather than to children or other individuals. These trusts are called Irrevocable Life Insurance Trusts or “ILIT’s” (pronounced “eye-lets”). If this technique is used, the ILIT becomes the owner and beneficiary of the policies. The death benefit, when paid to the trust, is not subject to estate tax, assuming that the insured survives the transfer of ownership to the trust by at least three years.

If the Irrevocable Life Insurance Trusts acquires a new policy insuring the decedent’s life, rather than receiving the insurance policy by transfer, then the three year rule does not apply.

The death benefit is excluded from the estate from the start. This is a very important distinction. The reason the three year rule is inapplicable is because the insurance policy was not transferred, the insurance policy was purchased by the Trustee of the ILIT.

The beneficiaries of the trust are usually the family members; surviving spouse, children, more remote issue, or really anyone the Settlor wishes to benefit can be a beneficiary. Unless the policy owned by the trust is paid in full, the trustee will have to pay the annual premiums. The trustee could do so with the cash income earned by securities in the trust (if any), but this would make the trust income taxable to the grantor. This result also occurs if the policy is on the grantor's spouse.

The most common estate planning technique used to fund the premiums is for the Settlor to make gifts to the trust in sums sufficient to pay the premiums. The trustee can then choose to use these trust contributions to pay the premiums and keep the policy intact. Since these are considered gifts to the trust, they would not be gifts of present interest qualifying for the $14,000 annual gift tax exclusion. However, there is a technique used to make these gifts qualify for the annual exclusion by using Crummey Trusts.

Using an ILIT is a good way to plan for liquidity of an estate. The ILIT is funded with gifts during the decedent’s lifetime and invests cash in insurance on the decedent’s life. On the decedent’s death, the irrevocable life insurance trust receives the death benefit.

Many estate plans now provide for the unlimited marital deduction so that there is no federal estate tax due until the death of the surviving spouse. In these situations, often the ILIT will own a joint and survivor life insurance policy that does pay the death benefit until the death of the second spouse - this is when cash is needed.

When the death benefit is paid to the trustee, the ILIT does not distribute the proceeds. Instead, with this cash, the trustee of the life insurance trust can purchase illiquid assets from the estate, or loan cash to the executor. If the estate owns illiquid real estate or a closely-held business, the irrevocable trust is a source of cash for the executor to meet the estate’s obligations. The asset purchased from the estate, or the repayment of the loan when assets are finally sold, becomes the corpus of the ILIT and is administered according to its terms for the benefit of beneficiaries.

Thus, the terms of the ILIT for how the assets will be held, or distributed after death are very important and should not be taken lightly. Some folks assume that the death benefit goes to pay taxes and there is nothing left. That’s not the way it works. Yes, the cash is available liquidity for tax payments, but the way it gets to the estate is by buying assets from the estate, or making loans to the estate. The ILIT cannot direct that estate taxes be paid from it. If it did, it would lose its estate tax benefit and the death benefit itself would become subject to estate tax.

The above information is intended to provide general information about the subject matter contained therein. It is not meant to provide legal opinions, offer advice or serrve as a substitute for advice by legal and financial professionals. No representations are made to the acccuracy of the information contained herein as laws change and should not be relied on as legal advice. Nothing herein constitutes the establishment of an attorney-client relationship and should not be relied on for your particular circumstances.